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This paper explores the effect of exclusionary "ethical investing" on corporate behavior in a risk averse, equilibrium setting. While arguments exist that ethical investing can inßuence a Þrm's cost of capital, and so affect investment, no equilibrium model has been presented to do so. We show that exclusionary ethical investing leads to "polluting" Þrms being held by fewer investors since "green" investors eschew polluting Þrms' stock. This lack of risk-sharing among "non-green" investors leads to lower stock prices for polluting Þrms, thus raising their cost of capital. If the higher cost of capital more than overcomes a cost of reforming (i.e., a polluting Þrm cleaning up its activities), then polluting Þrms will become socially responsible because of exclusionary ethical investing. A key determinant of the incentive of polluting Þrms to reform is the fraction of funds controlled by green investors. In our model, empirically reasonable parameter estimates indicate that more than 20% green investors are required to induce any polluting Þrms to reform. Existing empirical evidence indicates that at most 10% of funds are invested by green investors.

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This paper characterizes the conditions under which the adverse‐selection problem, which may prevent a firm from issuing securities to finance an otherwise profitable investment, may be costlessly overcome by an appropriate choice of financing strategy. The conditions are specialized when the information asymmetry may be characterized by either a first‐degree‐stochastic‐dominance or a mean‐preserving‐spread ordering across possible distributions of firm earnings. Possible financing strategies that resolve the information asymmetry are discussed, and the results are related to recent empirical findings concerning security issues.