As financial markets take on societal challenges like climate change, new research from Robin Döttling, Doron Levit, Nadya Malenko and Magdalena Rola-Janicka explores how shareholder democracy interacts with the political process to impact public goods provisions. The authors investigate the potential of investor-driven governance to supplement the shortfalls of the regulatory system, highlighting both benefits and risks posed by wealth inequality and ESG backlash.
Concerns that public policy and regulation have been ineffective in addressing societal challenges such as climate change, due in part to political system shortcomings, have led financial markets to become more involved. Investor activism promoting socially responsible corporate practices, the rise in environmental and social (E&S) shareholder proposals, and the expansion of impact investing, all demonstrate how “shareholder democracy” is pushing companies to consider broader societal interests alongside profit maximization.
While the literature has made substantial progress in understanding the effects of such shareholder engagement taking the limitations of the political system as given, it is important not to overlook how it interacts with the political process itself. The increased investor involvement in E&S issues feeds back into the political system, prompting it to respond to these developments. A notable example is the growing politicization of ESG matters and the resulting backlash, 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 to study the interplay between political democracy and shareholder democracy in the provision of “public goods” – corporate activities that create benefits to the society (such as green energy investments, emissions reductions, or protecting biodiversity). We explore how political outcomes respond to financial market developments and whether these responses enhance or diminish the effectiveness of shareholder democracy compared to a profit-maximization governance regime, as advocated by Milton Friedman.
In our framework, political processes determine 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 carbon tax.
ESG backlash and the irrelevance of shareholder democracy
While shareholder democracy can encourage firms to invest more in public goods, the response of the political system can offset the effects of shareholder engagement. For example, if shareholders are highly pro-social, meaning they are driven by a strong desire to contribute to the public good, they may prompt firms to make public goods investments that are excessive from typical citizens’ perspective. Anticipating this, citizens, through political channels, advocate for smaller subsidies, reducing firms’ financial incentives to invest in public goods.
This dynamic resembles the concept of “ESG backlash,” where political systems counter ESG efforts in the financial market. In fact, when there are no frictions in public policy provisions, this political response makes the firm’s governance regime irrelevant: Whether firms operate under shareholder democracy or focus solely on profit maximization, the end result for public goods provisions remains the same.
The trade-offs of shareholder democracy
When public policy implementation has costs, such as costly “greenwashing” activities 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.
In this sense, shareholder democracy fills the void left by the imperfect regulatory system. The key cost, however, is that public goods provisions may be skewed toward shareholders’ preferences, which reflect those of the wealthier citizens and not align with those of 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 goods 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 problem. 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. Effectively, wealth and ownership have a dual role: the voting power linked to large ownership creates a representation problem, while greater economic ownership reduces its negative effects.
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 goods provisions 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 goods provisions 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 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 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
In today’s environment, where households typically own shares through funds, households do not participate in corporate voting directly but delegate their votes to fund managers. Concerns about the influence of large asset managers on E&S issues have led to a heated debate and a move towards “pass-through voting,” which returns voting power to the underlying investors. If the fund manager’s preferences are highly pro-social, pass-through voting can limit the preference representation problem, in line with the common rationale for this voting system. However, if the fund manager’s preferences are not too strong, pass-through voting can exacerbate the representation problem. This is because under delegation, the fund gains influence by aggregating and voting the shares of many investors as a block. By doing so, delegation “gives voice” to the interests of the underlying less wealthy households, who may otherwise hold stakes too small to influence outcomes. By disaggregating the votes, pass-through voting can decrease the representation of small investors in corporate decisions.
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.
Authors’ note: This article is based on their recent paper, “Voting on Public Goods: Citizens vs. Shareholders,” available here. A similar version of this article was featured on Columbia Law School’s Blue Sky Blog.
Author Disclosure: The authors report no conflicts of interest. Read ProMarket’s disclosure policy here.
Articles represent the opinions of their writers, not necessarily those of the University of Chicago, the Booth School of Business, or its faculty.
