Socially responsible investors often imagine themselves as drivers of environmental or social progress, convinced that by directing capital toward polluting firms, they can help steer them onto a cleaner path. The logic appears intuitive: invest in what is “bad so that it can become “good.” Yet a recent study by finance scholars from the University of Rochester, Johns Hopkins University, and the Stockholm School of Economics reveals a troubling paradox. Instead of hastening reforms, these well-intentioned investors may inadvertently motivate companies to delay environmental improvements, waiting for the moment when an impact-minded buyer arrives.

The researchers illustrate this counterintuitive dynamic through a scenario that reflects real corporate dilemmas. Imagine owning a profitable but polluting factory. You could invest now to make it greener, or you could postpone action, anticipating that a socially responsible investor might later pay a premium precisely because the firm has not yet begun to change. As study coauthor Alexandr Kopytov notes, although the idea may seem surprising at first, it becomes logical once one recognises that many SRIs prefer firms with unrealised potential to those that have already completed their reforms. By delaying improvements, companies keep themselves attractive to investors seeking to make a visible impact.

Compounding this problem is the presence of traditional investors who care only about financial returns. These investors can act as intermediaries, buying polluting firms at lower prices and later reselling them to SRIs at a profit. Because socially responsible investors pay more for firms that still have room to improve, financially motivated owners become tougher negotiators, inadvertently reinforcing incentives for pollution-heavy firms to wait. In this environment, environmental reform becomes something to postpone rather than accelerate.

Seeking solutions, the researchers examine standard investment policies such as excluding polluters from portfolios, but find these approaches insufficient to counteract the underlying incentive structure. A more impactful strategy involves SRIs publicly committing to pay a premium for companies that have already undertaken environmental reforms before any investment is made. This shift in emphasis would encourage managers to reform early to capture the promised benefit.

However, such commitments must be credible, or firms will not trust that the premium will truly materialise. To strengthen credibility, impact investors may need binding rules or public mandates that impose reputational or contractual costs if they fail to honour their commitments. Principles of responsible investing, consistently and transparently applied, help ensure that firms feel secure enough to undertake reforms without waiting for a future buyer.

Ultimately, the study argues for a rethinking of impact investing. Genuine influence often occurs not after investors take ownership, but before, as firms adjust their behaviour to attract the right kind of capital. Good intentions alone are insufficient. Real progress depends on designing investment incentives that reward action now rather than later, ensuring that attempts to promote sustainability do not inadvertently slow it.

More information: Alexandr Kopytov et al, The Pace of Change: Socially Responsible Investing in Private Markets, The Review of Financial Studies. DOI: 10.1093/rfs/hhaf083

Journal information: The Review of Financial Studies Provided by University of Rochester