Sustainable Investing and Market Governance

This paper examines how sustainable investing affects the governance role of financial markets. We show that stronger pro-social preferences among informed investors can reduce price informativeness about managerial effort to improve financial performance, increasing the cost of incentive provision. Our mechanism gives rise to a positive relationship between firms’ environmental and social (“ES” of ESG) and governance (“G” of ESG) outcomes. We show that the agency cost of sustainable investing can incentivize financially motivated shareholders to reduce externalities to enhance price informativeness for governance purposes. We establish further insights into how sustainable investing affects asset prices and managerial compensation contracts.