How can investors use capital markets to encourage emissions reductions? In new research, Matthew E. Kahn, John G. Matsusaka, and Chong Shu examine whether public pension funds are more effective in mitigating pollution when they divest from fossil fuel companies or actively engage their management.

Unable to persuade governments to aggressively regulate greenhouse gas emissions, activists have turned to capital markets in the belief that private pressure by investors can induce fossil fuel companies to cut their emissions. Whether private markets can effectively address externality problems is an open empirical question, complicated by a disagreement among activists over what type of pressure is most effective. Some argue for divestment, calling for investors to sell their fossil fuel stocks in order to starve “brown” companies of capital and instead direct funds to green energy resources. The divestment movement has attracted significant support: according to one estimate by an activist organization, more than $40 trillion of assets under management have committed to divestment. 

Others argue for acquiring fossil fuel stocks and engaging companies as owners to advocate for change. California’s two huge public pension funds have loudly argued against a proposed state law that would force them to divest from fossil fuel stocks. They assert that “divestment has little—if any—impact on a company’s operations and therefore does nothing to reduce greenhouse gas emissions,” and that engaging with companies is more effective by giving investors a “seat at the table.”

In our new working paper, we provide empirical evidence to parse through these arguments by estimating the effect of “green” ownership on corporate carbon emissions. Our approach is to examine whether companies are more likely to reduce carbon emissions if they have high or low levels of ownership by green investors who prioritize emissions reductions. From 2010 to 2021, we find strong and robust evidence that engagement is more likely to yield emission cuts than divestment: green investors lead to green companies.

We focus on an important group of investors, public pension funds, which collectively manage $5 trillion in assets. We measure the environmental preferences of public pension funds by the political party in control of the fund, with Democratic-controlled funds (such as the California Public Employees’ Retirement System) more in favor of decarbonization than Republican-controlled funds (such as the Florida State Board of Administration). Control is defined by the party of the governor—because governors can influence pension fund investment through legislative and regulatory actions and by appointing pension board trustees—or by the majority party on a fund’s board of trustees—as trustees can influence pension funds’ operations directly.

A critical empirical issue is distinguishing whether a company’s green ownership is a reaction to the company’s decarbonization efforts or a cause of those actions. To isolate the causal effects of green ownership, we focus on two sources of variation in green ownership that are arguably not directly related to company emissions. The first source is changes in control of a pension fund that result from shifts in the political party of the governor and trustees. The second source is variations in a fund’s stock holdings due to fluctuations in the returns on the non-public-equity components of its portfolio. As public pension funds typically maintain target ratios for their investment in public equities versus other asset classes such as private equity, real estate, and commodities, changes in the value of non-public-equities holdings require a fund to acquire more public equities to maintain its target ratio. We demonstrate that this rebalancing, unrelated to emissions from portfolio companies, strongly predicts changes in a fund’s stock holdings.

Our baseline estimates indicate that a one percentage point increase in a company’s shares held by green pension funds was associated with an approximately 3% reduction in plant emissions over four years. We find no association between non-green ownership and changes in carbon emissions. Green investor engagement reduced emissions and divestment appears to have been counterproductive. Divestment, by definition, involves the sale of assets to new owners. The incoming shareholders are incentivized to maintain or increase output from their investment so long as it generates profitable returns, even if it results in greenhouse gas emissions.

We also explore mechanisms through which ownership of a company’s stock led to emission cuts. One possibility is that the mere ownership of a company’s stock by environmentally conscious shareholders may influence corporate managers to modify company policies. This scenario is likely if managers aim to maximize shareholder utility, as some scholars suggest they should. Alternatively, ownership can empower investors to engage with management. Such engagement can be collaborative, such as the expression of preferences, or confrontational, such as voting against incumbent directors. Our evidence points to a more significant role for collaborative engagement than for confrontation. We observe that emissions reductions were more strongly correlated with ownership by pension funds known for their active engagement with management. We do not find that green ownership attracted more shareholder proposals related to environmental issues or that green pension funds had markedly more confrontational voting records. 

In addition to offering an answer to the debate over divestment versus engagement, our study speaks to the broader issue of public versus private solutions to externalities. As the United States has yet to implement a carbon tax, standard economic reasoning implies that in the absence of such regulations companies are unlikely to voluntarily incur costs to reduce emissions. Our evidence suggests that private actors—in this case, investors—may also be able to induce firms to restrict their emissions by acquiring a company’s stock and asserting their rights as owners, even in the absence of government regulations.

Articles represent the opinions of their writers, not necessarily those of the University of Chicago, the Booth School of Business, or its faculty.