DP17262 Socially Responsible Divestment
Blanket exclusion of "brown" stocks is seen as the best way to reduce their negative externalities, by starving them of capital and hindering their expansion. We show that a more effective strategy may be tilting -- holding a brown stock if it is best-in-class, i.e. has taken a corrective action. While such holdings allow the firm to expand, they also encourage the corrective action. We derive conditions under which tilting dominates exclusion for externality reduction. If the corrective action is unobservable to the market, the investor is unable to tilt even if she has perfect information -- doing so would lead her to hold a company that has taken the action but the market thinks it has not, leading to accusations of greenwashing. Even if managers can costlessly disclose a signal of their actions, they will only do so under certain circumstances, and even a manager intending to take the action will only disclose a noisy signal.