Asset Prices and Portfolios with Externalities

Elementary portfolio theory implies that environmentalists optimally hold more shares of polluting firms than non-environmentalists, and that polluting firms attract more investment capital than otherwise identical non-polluting firms through a hedging channel. Pigouvian taxation can reverse the aggregate investment results, but environmentalists still overweight polluters. We introduce countervailing motives for environmentalists to underweight polluters, comparing the implications when environmentalists coordinate to internalize pollution, or have nonpecuniary disutility from holding polluter stock. With nonpecuniary disutility, introducing a green derivative may dramatically alter who invests most in polluters, but has no impact on aggregate pollution.

Keywords: ESG, Externality, Hedging, Portfolio Theory, Socially responsible investment

JEL Classification: G11, H23, G18

Suggested Citation: Suggested Citation

Baker, Steven D. and Hollifield, Burton and Osambela, Emilio, Asset Prices and Portfolios with Externalities (September 19, 2022). Review of Finance 26(6): 1433–1468, 2022, Available at SSRN: https://ssrn.com/abstract=3344940 or http://dx.doi.org/10.2139/ssrn.3344940