Does Money Talk? Divestitures and Corporate Environmental and Social Policies

November 16, 2022

Does Money Talk? Divestitures and Corporate Environmental and Social Policies
Nickolay Gantchev, Mariassunta Giannetti, Rachel Li
Review of Finance, Volume 26, Issue 6, November 2022, Pages 1469–1508,

There is an ongoing debate about whether divestitures can influence firms’ environmental and social (E&S) policies. Theory provides conflicting predictions. On the one hand, if investors vote with their wallets and spurn firms that fall short of their expectations on E&S standards, such firms are expected to experience a higher cost of capital, which would in turn hamper their ability to invest. Thus, managers may have incentives to improve corporate E&S policies to enhance their firm’s reputation and decrease its cost of capital. On the other hand, market discipline is ineffective if the proportion of agents who are motivated by E&S concerns is small or the demand by other investors is very elastic.

This debate largely ignores that shareholders discipline managers through their exit decisions and could thus also affect firms’ E&S policies. If this were the case, market discipline, that is, the investment decisions of even small E&S-conscious investors, could lead to a more sustainable economy.

We study whether, and under what conditions, divestitures and the threat of exit are effective in channeling investors’ E&S preferences to firms and triggering changes in firms’ E&S policies.

We conjecture that following a negative E&S incident, the exits of a few E&S-conscious investors are likely to increase managerial concerns that even more E&S-conscious investors could revise downwards their beliefs about the firms’ E&S standards and sell if more E&S incidents were to happen. Firms may also wish to attract back the E&S-conscious investors that divested to improve their valuations. Thus, following an E&S incident, the managers of firms with ex-ante more E&S-conscious investors are expected to have stronger incentives to improve their E&S policies and avoid future E&S incidents, especially if they care about the firms’ market valuations because they receive equity compensation.

We find that E&S incidents are followed by some, but relatively small, divestitures. The average market reaction to a negative E&S incident is also close to zero. However, negative realizations of E&S risks trigger more pronounced negative abnormal returns in firms with ex-ante more E&S-conscious investors. For instance, a one-standard-deviation increase in E&S-conscious institutional ownership is associated with a 0.058% decrease in the five-day CAPM-adjusted CARs.

This suggests that market prices reflect investors’ preferences and discontent with firms’ E&S policies. Importantly, the extent of discontent following E&S incidents, proxied by a more negative market reaction, is associated with subsequent improvements in firms’ E&S policies. We estimate that firms with a one-standard-deviation higher E&S-conscious institutional ownership decrease their greenhouse gas emissions by 36.5% and improve their E&S scores by 7.2% more than other firms if their managers receive equity compensation. Importantly, in the years following the initial E&S incidents, companies that improve their E&S policies experience an increase in ownership by E&S-conscious investors and improve their corporate valuations.

We do not observe any improvements associated with sales in E&S-conscious countries. Our results suggest that the threats of future exits and divestitures can improve E&S policies if shareholders are E&S-conscious and managers’ compensation is linked to the stock price.