In recent years, institutional investors have been at the center of the global effort to advance an economic transition toward sustainability. Asset managers are increasingly expected to use their financial influence to promote environmental, social and governance (ESG) objectives. However, their ability to do so remains highly contested.

In a recent article, I present an analytical framework for evaluating the capacity of institutional investors to promote sustainability. The article argues that legal limitations and structural economic disincentives sharply constrain the effectiveness of institutional investors, and that recent regulatory approaches – particularly in the European Union – may weaken rather than strengthen investor engagement on ESG issues.

The dynamics of this constraint are shaped by divergent political and institutional environments across jurisdictions. In the European Union, a dense network of legislation – —the Shareholder Rights Directive II (SHRD II), the Sustainable Finance Disclosure Regulation (SFDR), and the Corporate Sustainability Reporting Directive (CSRD) – seeks to mobilize investors as key participants in achieving the objectives of the European Green Deal. In contrast, the United States has moved in the opposite direction. Several conservative states have enacted “anti-ESG” statutes that prohibit public investment funds from considering non-financial factors in investment decisions. Federal efforts to impose climate-related disclosure obligations have also been met with litigation and political opposition. The resulting landscape is highly fragmented. While European regimes encourage investors to integrate ESG considerations, parts of the U.S. regulatory system penalize them for doing so. This divergence highlights the influence of national politics and institutional design on the ability of market actors to contribute to sustainability.

In this broader context, fiduciary duties impose fundamental constraints on investor behavior. Asset managers are legally bound by duties of loyalty and prudence to their clients. These duties are traditionally interpreted as requiring the pursuit of financial returns above all else. ESG integration is only permissible insofar as it serves this fiduciary mandate, typically by mitigating long-term risk or enhancing value. However, where sustainability objectives lack demonstrable financial relevance, pursuing them risks exceeding the permissible scope of managerial discretion, unless authorized by investors. Thus, the law defines a narrow channel within which ESG engagement can operate, balancing prudent management with the prohibition of subordinating beneficiaries’ economic interests to external goals.

These legal boundaries are reinforced by economic factors. The business model of modern asset management, particularly with regard to passive index funds, offers little incentive for active stewardship. Large institutional investors hold small positions in thousands of companies, which dilutes the benefits and motivations for costly engagement. Collective action problems also discourage activism: Any gains from successful engagement are shared among all investors, including those who contribute nothing toward the costs. Fee compression and the absence of performance-based compensation in passive management mean there are few resources available to fund meaningful stewardship programs. These structural features explain why ESG initiatives are often confined to low-cost, standardized, and largely symbolic forms of engagement.

Despite these limitations, major asset managers continue to publicize their extensive ESG-related activities. This paradox is partly explained by reputational incentives. In a market where returns are largely homogeneous, promoting an image of responsible ownership has become a means of product differentiation. By signaling their commitment to sustainability, asset managers can attract new clients, particularly institutional allocators and younger investors who are seeking to align their investments with their values. Under such conditions, engagement serves as both a governance tool and a marketing strategy.

This shift is reinforced by current disclosure-based regulation. The SFDR, a cornerstone of the European sustainable-finance regime, classifies investment products as Article 6, 8, or 9 based on their level of sustainability integration. Although the framework was designed to improve comparability and prevent greenwashing, it has had some unintended consequences. The classification system incentivizes exclusionary screening – divesting from firms with poor ESG performance – to achieve a “green” label. While this improves portfolio metrics, it eliminates the companies that would benefit most from investor engagement. Consequently, the regulation prioritizes exit over voice, which could reduce the impact of capital markets on transitions in the real economy.

Excessive formalization can encourage investors to focus on ticking boxes and cleansing their portfolios, while overly permissive regulation allows unfounded sustainability claims to flourish. A more nuanced regulatory framework would recognize that sustainable investing exists along a continuum, ranging from exclusionary and impact-based approaches to engagement-driven strategies, and would tailor obligations accordingly. This differentiation would align regulatory incentives with investor activity, encouraging engagement where it is most likely to yield environmental and social benefits.

A constructive solution would be to refine the European regulatory framework by creating a new category of transition-oriented funds. These funds would be designed for investors seeking to finance, monitor and influence companies that are making measurable improvements to their sustainability, such as reducing their carbon emissions, improving labor standards, or ensuring environmental compliance. Unlike Article 8 or 9 funds under the current SFDR, transition-oriented products would reward engagement with transitioning firms rather than divestment from them. This approach acknowledges that achieving climate and social objectives requires the transformation of existing industries rather than the mere reallocation of capital away from them.

Ultimately, the green transition requires regulatory systems that make stewardship economically rational rather than politically aspirational. By recalibrating sustainability frameworks to reward active participation in corporate transformation, policymakers can bridge the gap between legal duty and social responsibility. While institutional investors may not lead the transition based on moral conviction alone, they can contribute meaningfully when law and finance make doing so both permissible and profitable.

This post comes to us from Giovanni Strampelli, a professor of business law at Bocconi University, Milan. It is based on his recent article, “The Dubious Role of Institutional Investors in Driving the Green Transition: Legal and Economic Constraints,” available here. A version of this post was published on the Oxford Business Law Blog, here.