Concerns that public policy and regulation have been ineffective in addressing climate change and similar challenges have led to a search for possible solutions in financial markets. Investor activism promoting socially responsible corporate practices, the rise in environmental and social (E&S) shareholder proposals, and the expansion of impact investing demonstrate how shareholder democracy is pushing companies to consider the interests of society along with efforts to maximize profits.

Yet this shareholder engagement and the political process do not operate separately but interact, with investor initiatives often prompting the political system to respond. A notable example is the growing politicization of ESG issues and the resulting backlash against them, evident in the introduction of anti-ESG bills in 37 states and the adoption of some form of anti-ESG legislation in 22 states.

In a new paper, we provide a theoretical framework for the interplay between political democracy and shareholder democracy in creating benefits to society – providing “public goods.” We explore how political outcomes respond to financial market developments and whether these responses enhance or diminish the effectiveness of shareholder democracy compared with a profit-maximization regime, as advocated by Milton Friedman. In our framework, political processes determine Pigouvian subsidies designed to encourage firms to invest in public goods such as green technologies. Once these subsidies are set, companies decide how much to invest. While we frame the problem as one of providing public goods, it can be similarly interpreted as discouraging firms from creating something damaging to society – a “public bad” like pollution – through a Pigouvian tax, such as a carbon tax.

Irrelevance of Shareholder Democracy in Frictionless Markets

Our first finding is that, when there are no frictions in the process of public policy, shareholder democracy becomes irrelevant. Whether firms operate under shareholder democracy or focus solely on profit maximization, the end result for public good provision remains the same. The reason is that political processes naturally adjust the equilibrium subsidy based on the expected actions of firms. For example, if shareholders have a strong desire to contribute to the public good, shareholder democracy will lead firms to invest heavily in these areas. Anticipating this, citizens, through political channels, advocate for a smaller subsidy, effectively neutralizing the pro-social actions of shareholders. This dynamic resembles the concept of “ESG backlash,” where political systems counter pro-ESG efforts in the financial market.

The Trade-Offs of Shareholder Democracy

When public policy implementation has costs (such as “greenwashing” by firms to secure subsidies), shareholder democracy and profit maximization are no longer equivalent. The key benefit of shareholder democracy is that if shareholders are pro-social, it can achieve the desired level of public goods with smaller subsidies, reducing the loss from encouraging public goods through a costly policy intervention. The key cost, however, is that public good provision may be skewed toward the preferences of wealthy shareholders rather than typical citizens. This distinction arises due to the different voting rules of corporate and political democracy — “one share, one vote” vs. “one person, one vote.”

The Role of Wealth Inequality

Wealth inequality can create a preference-representation problem: Wealthier citizens may favor higher levels of public good investment than the typical citizen does, as ESG initiatives can be viewed as luxury goods. As a result, shareholder democracy, which tends to amplify the voices of wealthier individuals due to their larger ownership stakes, could make the general population worse off than would a system focused solely on profit maximization. However, wealth inequality also creates a counteracting effect that might mitigate the preference representation of shareholder democracy. Very wealthy investors, due to their substantial ownership stakes, end up internalizing a larger share of the costs associated with public good provision by the firms they own. This financial responsibility reduces their incentives to push for excessively pro-social investments. The overall impact of wealth inequality on the effectiveness of shareholder democracy depends on the balance between these opposing forces.

Investor Diversification and Universal Owners

The degree of investor diversification plays an important role in these dynamics. As shareholders’ portfolios become more diversified, the level of public good provision under shareholder democracy rises. This is because diversified shareholders, by spreading their investments across more firms, become more pro-social. They internalize a smaller share of the costs associated with public good provision by each firm, such as environmental initiatives or social programs, while still enjoying the benefits. Additionally, firms owned by diversified shareholders are less prone to engaging in wasteful diversion activities, like greenwashing, because diversified shareholders internalize a greater share of the associated losses. These conclusions underscore the potential of “universal owners” – diversified investors with a stake in the entire economy – to play a significant role in addressing issues like climate change.

The benefits of investor diversification notwithstanding, it can also exacerbate the preference representation problem of shareholder democracy, leaving a typical citizen at a further disadvantage. The political system then responds by implementing even deeper subsidy cuts. Thus, greater investor diversification can intensify the ESG backlash. This aligns with the real-world rise of index investing preceding the growth of ESG backlash as a political phenomenon, and with index funds often being the targets of anti-ESG regulation.

Pass-Through Voting

Households typically own shares through funds, meaning they do not participate in corporate voting directly but delegate their votes to fund managers. We show that pass-through voting, which returns voting power to the underlying investors, can mitigate the preference representation problem of shareholder democracy. This suggests that transitioning from profit maximization to shareholder democracy should be accompanied by enabling pass-through voting, in line with recent developments in the industry.

Corporate Lobbying

The interplay between politics and business creates the possibility that corporations will engage in costly activities to tilt public policies in their favor. We show that lobbying precipitates its own form of backlash: Citizens cut subsidies to counteract the distorting impact of lobbying. Yet that impact persists, leading to decreased welfare for the typical citizen and lower profitability for firms. Notably, compared with the profit-maximizing regime, shareholder democracy mitigates the adverse effects of lobbying and is more likely to yield welfare improvements.

Conclusion

The nuanced interplay between political and shareholder democracy highlights the complexities of providing public goods. While shareholder democracy offers potential benefits in addressing issues like climate change, issues like wealth inequality and preference representation pose challenges.  Understanding these trade-offs is crucial for designing governance regimes that effectively integrate broader societal interests with corporate practices.

This post comes to us from Robin Döttling at Erasmus University Rotterdam, Doron Levit at the University of Washington’s Foster School of Business, Nadya Malenko at Boston College’s Carroll School of Management, and Magdalena Rola-Janicka at Imperial College Business School. It is based on their recent article, “Voting on Public Goods: Citizens vs. Shareholders,” available here.