ESG Investing: How to Optimize Impact?

Summary This paper develops a general equilibrium model of a productive economy with negative externalities. Investors are not willing to accept lower returns than their best investment alternatives and entrepreneurs maximize profits. If capital markets are subject to a search friction, an ESG fund can raise assets and improve social welfare despite the selfishness of all agents. The presence of the ESG fund forces companies to partially internalize externalities. We derive the fund's optimal policy in terms of industry allocation and pollution limits imposed to portfolio companies. The fund prioritizes investments in companies where (i) the inefficiency induced by the externality is particularly acute and (ii) the capital search friction is strong. We also show that the ESG fund can take advantage of the supply-chain network: It can amplify its impact by imposing restrictions on the suppliers of the firms where it invests.