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, https://doi.org/10.1093/rof/rfac029
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.