Does Money Talk? Market Discipline through Selloffs and Boycotts

Market discipline is viewed by policymakers as essential to achieve a more environmentally and socially sustainable economy. Investors have ethical and social standards and may be willing to vote with their wallets and spurn firms that fall short of their expectations on ethical norms and environmental and social (E&S) principles. Similarly, customers are concerned with more than just product quality or prices and may be willing to pay a cost if firms meet their E&S preferences.

For market discipline to be effective, expectations on the combined impact of investors’ and customers’ actions must be large enough to affect firm valuations and trigger changes in corporate behavior. Unfortunately, little is known about whether small investors and customers can impose market discipline with their product purchases and trading of firms’ shares.

This lack of evidence largely reflects the difficulties of capturing changes in investors’ and customers’ discontent with firms’ E&S policies. Our paper overcomes this obstacle using a novel dataset, which monitors violations of internal policies and international standards for listed companies around the world. In particular, we use company-specific media coverage of potential risks and violations of internal or external sustainability standards to isolate environmental and social risks from broader firm governance risk and focus on the former to capture a firm’s E&S vulnerability.

We then explore how investors with different social preferences, measured using either the cultural attitudes towards E&S issues in their countries of origin or their investment portfolios’ sustainability ratings, react to E&S risks. We find that E&S conscious investors decrease their shareholdings in firms experiencing heightened E&S risks. Similarly, we measure customers’ social preferences using the cultural attitudes towards ESG issues in their countries of origin. We find that the sales of firms facing heightened E&S risks decrease in countries that are friendlier to E&S issues. As a consequence of the actions of E&S conscious investors and customers, firms’ stock returns drop following negative realizations of E&S risks.

Importantly, we show that investors’ divestitures and customers’ backlash not only affect stock prices, but also companies’ E&S policies. The effect of negative realizations of E&S risk on stock prices acts as an early warning. For fear of magnifying the negative effects on corporate valuations, firms take initiative to repair their reputations and to avoid possibly worse consequences in the future. Following negative realizations of E&S risk, firms with more E&S conscious investors and customers improve their E&S policies, regardless of their initial E&S rating.

Our paper provides important insights for the current debate on whether regulatory agencies should impose uniform disclosure standards regarding E&S issues. We show that market discipline can play a powerful role in improving firms’ E&S policies as long as investors and customers are able to evaluate firms’ E&S practices. Thus, mandated standards of disclosure increasing transparency of E&S policies may enhance the effectiveness of market discipline and serve as a powerful instrument to incentivize firms to adopt more sustainable policies.