A Theory of Socially Responsible Investment

Abstract

We characterize the conditions under which a socially responsible (SR) fund induces firms to reduce externalities, even when profit-seeking capital is in perfectly elastic supply. Such impact requires that the SR fund's mandate permits the fund to trade off reduced financial performance against reductions in social costs - relative to the counterfactual in which the fund does not invest in a given firm. Based on such an impact mandate, we derive a micro-founded investment criterion, the social profitability index (SPI), which characterizes the optimal ranking of impact investments when SR capital is scarce. If firms face binding financial constraints, the optimal way to achieve impact is by enabling a scale increase for clean production. In this case, SR and profit-seeking capital are complementary: Surplus is higher when both investor types are present.

Keywords: Socially responsible investing, ESG, SPI, capital allocation, sustainable investment, social ratings

JEL Classification: G31, G23