Environmental, Social, and Governance (ESG) Integration under Asymmetric Information

Abstract

We present a model of ESG integration where borrowers can deviate from ESG promises ex-post. Borrowers are incentivized to pursue ESG projects only when lenders can charge a high borrowing rate, which decreases the borrowers’ private benefit from pursuing financial returns. In the presence of adverse selection on borrowers’ genuine preferences for ESG, there is an equilibrium in which borrowers invest in ESG when ESG lenders place bids first. Specifically, when ESG lenders take out non-ESG borrowers from the lending market, non-ESG lenders perceive the holdout borrowers to genuinely prefer ESG and demand a higher borrowing rate, which then leads to ESG integration.

Keywords: Socially responsible investments, ESG, moral hazard, adverse selection, financial market structure, greenwashing

JEL Classification: D82, D86, G23, G31