How Market Structures Can Prevent the Misuse of Funds Intended for ESG Projects

A tremendous amount of capital has already been committed to environmental, social, and governance (ESG). With it has come mounting concern over monitoring and guiding the proper integration of ESG into firms. ESG integration is not straightforward due to the lack of a standard measure of firms’ ESG performance. It is therefore important to understand whether and how financial markets can create incentives for  ESG integration. As it stands, however, evaluating ESG performance relies mostly on claims that firms make through voluntary disclosure, and they are thus hard to verify. This is one of the main reasons for “greenwashing,” where corporate issuers and asset managers dop not delivering on their ESG promises (Kim and Yoon 2023, Liang, Sun, and Teo 2022).

In a new paper, we investigate the financial market conditions that facilitate ESG integration. We also provide a simple theoretical analysis of corporate borrowers’ decisions on ESG integration under different competition structures in the financial market. Our model has several components reflecting key features of greenwashing in corporate finance. We use the hypothetical of a  firm that must finance its project through an outside investor. After raising capital, the firm invests in one of two projects: the “green” project yields a low expected financial return but generates a valuable social externality; the “brown” project yields a high expected financial return but generates no social externality.

In the financial market, there are two types of investors: green investors value social returns as highly as financial payoffs; brown investors value financial payoffs only. All investors compete to finance the firm’s project by simultaneously offering financial contracts that specify the repayment schedule contingent on the realized financial return. The firm borrows from an investor who makes the most favorable offer. Although the firm inherently cares about the social consequence of its investment, it does not always prioritize the social return over  profit. A crucial assumption in our model is that the firm’s investment decision is not governed by a contract: The firm may choose the brown project to maximize its payoff, even if such a decision is against the interest of the investor who funds the firm’s project.

We first characterize the structure of financial contracts that encourage the firm to choose the green project. The firm will invest in the green project only if a sufficiently large portion of the financial return is repaid to the lending investor, and so the firm gets little financial payoff. In particular, the firm’s repayment must steeply increase with the realized financial return of its investment. Suppose a contract specifies a repayment schedule that requires the firm to repay a significantly large amount of its financial return to the investor, particularly when the firm’s project realizes high financial returns. Then, the brown project will become relatively unattractive; even though it is likely to yield a high financial return, the high payment means that the firm’s financial payoff may not increase enough to compensate the firm for the social loss. Herein we find the first policy implication: To prevent greenwashing, policymakers may have to consider restricting the types of securities that corporate borrowers issue for funding ESG projects to those that are sensitive to the firm’s investment decision – i.e., the expected repayment sharply increases if the firm switches from the green project to the brown project. Examples of such highly sensitive securities are equity or call option contracts (Demarzo et al., 2005).

We further analyze how financial market structures influence the firm’s incentive for green investment. We find that intense competition with brown investors hampers green investment. To win the competition for lending to the firm, each investor must bid the lowest possible interest rate – i.e., she must offer a security that specifies the lowest expected repayment she could accept. Brown investors only pursue the financial payoffs from lending, so they do not hesitate to offer a low interest rate even if it gives the firm an incentive to choose the brown project, which has a low financial risk. However, green investors are reluctant to lend at an interest rate as low as brown investors would. Instead, green investors will raise the interest rate by attaching a “dirty” premium as compensation for funding the socially harmful brown project. Therefore, brown investors will be more likely to win the lending competition, and the resulting low interest rate will induce the firm to choose the financially lucrative but socially harmful brown project. Here we find the second policy implication: Where possible, it may be socially desirable to restrict entry into the capital market for ESG by traditional financial investors who pursue only financial.

We last consider adverse selection where investors cannot discern the firm’s inherent concern with the social impacts of its investment. This is  another source of the greenwashing problem. In this modification, we identify market conditions that give a brown firm an incentive to choose the green project. We find that the brown firm invests in the green project when at least one green investor bids her lending offer ahead of all the other investors. With such a market structure, we can find an equilibrium where the brown firm leaves the financial market early by borrowing from the first-moving green investor. In such equilibrium, the firm borrowing in the later financial market will be indirectly identified as the green firm that considers the social impacts when making an investment decision. The brown investors in the later market will then expect the remaining firm to invest in the green project and charge a high interest rate as compensation for funding the financially unprofitable green project. The first-moving green investor also rationally infers that the firm will face a tough funding condition even if it borrows in the later financial market. Therefore, the first-moving green investor can charge the same high interest rate as the brown investors will do in the later market; the brown firm has no choice but to accept this early offer and then choose the green project.

However, such a “cleansing” mechanism cannot exist if there is at least one brown investor who can bid simultaneously with the first-moving green investor: The first-moving brown investor will offer to lend at a significantly lower interest rate, resulting in the brown investment. This analytical result reveals the last policy implication: Regulators should support green investors’ incumbency advantages in the credit market for ESG. Restricting investors from entering unless officially verified as green can help achieve this. Also, recently criticized lending practices by incumbent green institutional investors may serve the purpose of cleansing the credit market by excluding “dirty” borrowers.

Overall, our analysis suggests regulators should consider giving green investors the first opportunity to allocate capital in the credit market for ESG.[1] Preventing investors from financing ESG projects until they are officially verified as green by a regulatory or assurance body can help achieve this.


[1] This is the new norm in some jurisdictions. China started requiring lenders to always integrate ESG into their credit allocation and investment processes in June 2022 (JunHe LLP, 2023). Also, a majority of limited partners in private equity around the world are shifting towards an ”ESG or nothing” investment philosophy, with over three quarters of them planning to cease investing in non-ESG private markets products by the end of 2025 (PwC, 2023).


DeMarzo, P.M., Kremer, I. and Skrzypacz, A., 2005. Bidding with securities: Auctions and security design. American economic review95(4), pp.936-959.

Kim, Soohun, and Aaron Yoon. 2023. “Analyzing Active Fund Managers’ Commitment to ESG: Evidence from the United Nations Principles for Responsible Investment.” Management Science.

Liang, Hao, Lin Sun, and Melvyn Teo. 2022. “Responsible Hedge Funds.” Review of Finance, 26(6): 1585–1633.

JunHe. 2023. “Key ESG Compliance Attentions for Bank Credit and Investment Business.” https: // www. lexology. com/ library/ detail. aspx? g=422febb2-13e9-47c9-bdb4-61d4dc7c2b71.

PwC. 2023. “ESG or nothing – The sustainable finance transformation in private markets.” https: // www. pwc. lu/ en/ press/ press-releases-2023/gp-global-esg-strategies.html.

This post comes to us from Dongkyu Chang at City University of Hong Kong, Keeyoung Rhee at Pohang University of Science and Technology, and Aaron Yoon at Northwestern University. It is based on their recent paper, “Environmental, Social, and Governance (ESG) Integration under Asymmetric Information,” available here.