Responsible Investors and Stock Market Feedback

Abstract

We analyze a manager's optimal reporting strategy when choosing between a green and a brown project in the presence of market feedback. The project's success requires the investment decision to match the state of nature. The manager may misrepresent brown signals as green to cater to the preferences of responsible investors who dislike investing in brown firms. Ex-ante, such manipulation reduces investors' incentive to acquire information, i.e, the extensive margin of informed trading. However, it also makes them more willing to trade on their signals, thus increasing the intensive margin of trading and strengthening feedback ex-post. Manipulation weakens market feedback and reduces firm value if the negative effect on the extensive margin dominates the positive effect on the intensive margin of trading. Truthful reporting of brown signals makes prices less informative and increases the negative externalities associated with brown projects. Our insights can be extended beyond the ESG setting to settings where investors prefer a specific type of project, such as a particular technology or geographic location.

Keywords: Manipulation, market feedback, reporting strategy, price efficiency, real efficiency

JEL Classification: G14, G30, M41