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Kenan Institute 2022 Grand Challenge: Stakeholder Capitalism
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Market-Based Solutions to Vital Economic Issues
Kenan Insight
Nov 7, 2022

Getting Dirty Firms to Clean Up Their Act: Should You Divest or Invest?

Part of our series on: Stakeholder Capitalism

As the planet warms and the consequences of climate change continue to intensify, the need to develop solutions that will swiftly achieve deep carbon reductions is ever more pressing. Climate policy efforts are starting to see some success, but inaction and delays have motivated stakeholders to search for complementary solutions as well. A burgeoning fossil fuel divestment movement has thus emerged with the aim of spurring businesses to implement cleaner practices and invest in green innovation. The idea is that, since firms in pollution-intensive industries typically do not pay for all of the costs they impose on society, so-called dirty firms have little economic incentive to improve their environmental performance without intervention. The goal of divesting, then, is to starve these firms of capital unless they clean up their act. More than 1,500 institutions have committed to some form of divestment so far.1

Whether divestment will actually work comes down to whether it can put enough upward pressure on dirty firms’ cost of capital – that is, how much it costs to borrow money. My recent review of the existing literature (which is detailed in a chapter I wrote for an National Bureau of Economic Research book) suggests that the effects of divestment on the cost of capital might be quite small, raising questions about whether firms will sufficiently and quickly respond.2 Alternatively – and perhaps surprisingly – continuing to invest in pollution-intensive industries might offer a promising avenue toward hastening the transition to greener business practices under the right conditions.

Doing so requires knowing which strategies and management practices can actually steer firms in the right direction, though. I explore this open question in the chapter by analyzing the relationship between firms’ stated strategies for reducing their environmental footprint, if they have them, and environmental performance as measured by whether they are on track to meet the Paris Agreement emissions targets. I focus on large firms in 16 pollution-heavy industries, like oil and gas, cement, and steel. I find that a subset of strategies is linked to a firm being on track, but not all. Those that seem to make a difference involve integrating and aligning incentives throughout the organization rather than simple disclosure of emissions, such as tying environmental performance to executive compensation, using third-party verification of emissions data, and setting an internal price of carbon. While my study is descriptive and more research is certainly warranted, I hope this work can offer environmentally-minded investors some insights into how they can use markets for good – and to also offer a case study for how stakeholder capitalism can function in practice.

The Double Externality Challenge: Understanding the Incentive to Invest in Green Innovation

Innovation that has the potential to drive innovation for social progress – innovation that protects the planet and people, such as new green energy technology – is characterized by a unique “double-externality” challenge. The first is common to innovation of all stripes: knowledge spillovers. When one organization innovates, others can build upon it and “stand on the shoulders of giants,” as the famous saying goes. Henry Ford’s creation of the automobile assembly line is one example, as it became a model that his competitors would eventually capitalize on and employ themselves. The inability to fully capture the value created by one’s innovation can dampen the incentive to invest in such pursuits.3

The second externality relates to the harm pollution causes and the societal benefits that come with decreasing it. For example, cleaner energy sources increase global welfare by reducing the environmental impact of producing and consuming various products, but their prices (and thus returns from investing in them) often do not fully reflect these benefits. This further dampens the incentive for firms, individuals, and institutions to invest in pollution-reducing technologies or processes rather than the “dirty” status quo. In other words, it is this externality that can impact the direction of innovation.

These challenges (or “market failures,” in dry economics language) are typically invoked to justify government intervention. Putting a price on carbon, for example, would increase the price of dirty fuels and could reduce demand for them. But climate policy historically has been highly uncertain and controversial, and the social costs generated from producing and consuming dirty fuels are not yet internalized in most parts of the world.

Divestment vs. Investment: One Goal, Two Strategies

Brewing frustrations about climate policy delays have thus incited a movement towards fossil fuel divestment, whereby institutions and investors “starve” dirty firms of capital. In theory, divestment can raise the cost of capital for firms in polluting industries, essentially making it more expensive for them to borrow money. This could, in turn, make it difficult to continue their status quo operations that harm the planet and even put them out of business if the increase is large enough.

My review of the existing divestment literature, though, suggests that the effects will likely be too small to meaningfully steer dirty firms toward green solutions, at least those that do not rely critically on external finance. Recent research has found that roughly 85% of investors would need to be socially conscious to increase the cost of capital by just 1%.4 While more research is needed to draw strong conclusions around the divestment movement’s potential effects, this figure is striking. It highlights how the majority of wealth likely must be in the hands of ESG investors to make a dent.

An alternative mechanism through which socially-minded investors can seek to bring about environmental change involves continuing to invest. Doing so allows them to leverage their proverbial seat at the table and influence organizations’ strategies, practices, and innovation pursuits, as long as they actively engage with leadership and management. A Deloitte survey from 2021 found that shareholder concerns were the top motivator for executives to turn to more sustainable practices.5 Governing through “voice” inherently requires continued investment rather than divestment of course, since investors relinquish their seat, and thus their influence, when they sell their shares. And if they sell to someone who is less socially-conscious, divestment might even worsen a firm’s chances of going green.6

How to Make Investment (in Dirty Industries) Work With – Not Against – the Environment

So how can investing in polluting industries be a tool for fostering sustainability? Investors can engage with a firm’s leadership and managers to encourage and even demand such efforts, including voting at shareholder meetings, having direct conversations with and monitoring management, proposing or blocking specific strategies or projects, and electing socially-conscious board members. As others have noted, the potential for these strategies to work likely depends on the investor’s financial stakes in the firm and the firm’s corporate governance structure and culture, and actively engaging and monitoring comes with its own costs to consider, but if investors are socially conscious, such an approach could offer promise.

Counterintuitively, this means that investors might be able to have the highest impact by targeting even the dirtiest of firms – those that have the furthest to go when it comes to improving their environmental footprint. This then raises the question of how investors can reliably assess the “dirtiness” of a firm. Environmental, social and governance (ESG) indicators are the most commonly employed metric in the impact investment community – usually in the context of evaluating “greenness” – providing broad ratings of a company’s ESG-related practices. These can be problematic tools and even misleading, though. They are aggregate measures capturing a wide array of information based on opaque methods, and rating agencies use different approaches, leading to confusing guidance. A previous Kenan Insight documents that the divergence in measurement methods, scope, and weights across rating agencies creates significant inconsistencies; one of the papers discussed estimates that the correlation between ESG ratings can range anywhere from 0.38 to 0.71.7

Another critical challenge is that the type of pollution generated varies across industries, making it difficult to compare environmental performance and improvements. Even when tracking a single firm’s progress, how can environmental performance be reliably measured in the first place? And what is the threshold that reflects “good” environmental performance? 

Lastly, the effectiveness of engaging with leadership as a means toward fostering green innovation hinges upon understanding which firm strategies and management practices actually work. Yet ESG measures conflate the practices firms can implement, like waste management and the allocation of resources, with actual environmental improvements, like reduced pollution. This makes it difficult to tease out the drivers of progress (i.e., the means to the end) from the progress itself (i.e., the end goal). The measures must be decomposed to learn more.

These behaviors and policies can also take a number of forms with varying degrees of strength. For example, firms may claim to set greenhouse gas emissions reduction targets, but is this just a qualitative statement or do they set quantitative thresholds? And on what timescale? These important nuances are lost when reduced to a single ESG score, or even when at least considering the “E” of ESG.

To begin to explore some of these open questions, I analyzed the relationship between 14 specific strategies and a newly developed measure of environmental performance for large firms across 16 pollution-intensive industries using data from the Transition Pathway Initiative. The TPI database provides information on the responses to many of the environmental-specific questions that frequently go into the ESG metrics, covering responses from over 250 large firms in pollution-intensive sectors that were recorded between 2017 and 2021. Importantly, the measure of “carbon performance” developed by TPI assesses firms based on industry-specific benchmarks and whether they are aligned with pathways that would meet the greenhouse gas targets set forth by the Paris Agreement, allowing for comparisons across industries.

Albeit just a descriptive analysis, my findings suggest that there are five main practices and strategies that are linked to better carbon performance. Two of these are associated with metrics although they go beyond just measurement – having greenhouse gas emissions data verified by a third party and developing long-term, quantitative reduction targets. Simply disclosing emissions does not seem to be sufficient. The other three practices that are strongly correlated with better carbon performance are arguably more strategic in nature, perhaps reflecting the importance of integrating and aligning environmental objectives and incentives throughout the organization: incorporating climate change performance into executive remuneration policies, supporting domestic and international climate change efforts, and setting an internal price of carbon.

Wrapping Up: Steering Firms Through Investment

While the effects of divestment are still to be seen, and drawing strong conclusions about which firm strategies and management practices can most effectively improve environmental performance and foster green innovation will require continued research, these findings provide some initial insight into how environmentally-minded investors can use their financial power to push polluting firms toward a greener future. A takeaway so far is that managers and firm leadership might want to ensure that objectives and incentives for improving environmental performance are integrated and aligned throughout the organization, just as they do for the more traditional objective of maximizing financial performance, and investors can encourage such an approach when aiming to steer firms in this direction.

To be sure, this can only be accomplished if investors commit the time and resources to engage with organizations’ leadership and decision-makers, which of course can be costly. But if they do, leveraging one’s seat at the table and governing through “voice” might offer an underappreciated opportunity to drive progress. Likewise, stakeholder capitalism is not a passive pursuit. After all, it is the firm that must ultimately implement such strategies, and for stakeholder capitalism to function as its adherents intend, stakeholders must also remain actively informed and engaged.

This insight is part of our yearlong, solutions-based analysis of stakeholder capitalism. 


1 These include pension funds, educational institutions, for-profit corporations, government, and more. For example, in 2020, the University of California system became the largest university system to fully divest from fossil fuels. More recently, the state of New Jersey is deliberating whether to similarly divest its $92 billion employee pension fund from all fossil fuel investments. Others have made partial commitments, like divesting only from coal or only a proportion of their current fossil investments overall. See divestmentdatabase.org for a complete list.

2 See Pless, “To Starve or to Stoke? Understanding Whether Divestment vs. Investment Can Steer (Green) Innovation,” in NBER’s Entrepreneurship and Innovation Policy and the Economy, Volume 2.

3 Firms also usually need to invest in research and development to learn from others’ knowledge spillovers, so this externality could enhance the incentive to innovate as well, offsetting the negative effects.

4 See “The Impact of Impact Investing” by Berk and van Binsbergen (2021).

5 See Deloitte, “2021 Climate Check: Business’ Views on Environmental Sustainability,” 2021.

6 Note that this is distinct from investing in companies that are developing clean tech solutions as their primary business. This also needs to be part of the solution, but here I am referring to the implications of continuing to invest in polluting industries.

7 See “Aggregate Confusion: The Divergence of ESG Ratings” by Berg, Kölbel, and Rigobon (2022).


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