Nudging for the Green Equilibrium

We study the role of the financial sector in promoting environmentally friendly production in the real economy. Incorporating the commonly observed externalities of the green and brown production technologies, we model the strategic interactions between firms as a coordination game where multiple equilibria may arise. We show that ESG ratings may serve as a coordination mechanism during the contracting stage, such that the socially optimal green equilibrium is always selected, provided that a sufficient fraction of investors track these ratings with the best-in-class ESG investment strategy. Furthermore, we establish that mandatory corporate climate risk disclosure enhances the incentives provided to the firms by investors, and thus should be implemented by the regulator. Our findings generate several empirical implications regarding how various industry characteristics impact the coordination role of ESG ratings.