Socially Responsible Finance: How to Optimize Impact.

The article develops a general equilibrium model to analyze how socially responsible funds (SRFs) can simultaneously improve social welfare and maximize assets under management by addressing firms' emissions and investors' social preferences. It distinguishes two types of socially responsible investors: impact investors, who value the fund's positive effect on social welfare, and value-alignment investors, who prefer portfolios with low emission footprints regardless of impact. The model identifies three SRF strategies: mere exclusion of polluting firms, Scope 1 investing (direct emission caps on polluting firms), and upstream Scope 3 investing (investing in clean-sector firms that require low-emission inputs from polluting firms). The findings show that the Scope 3 strategy can attract both investor types and maximize SRF size and impact when value-aligned investors predominate or when the polluting sector is large and mainly produces intermediary goods. Conversely, when impact investors dominate and the polluting sector is smaller, a dual-fund approach combining Scope 1 and exclusion strategies is optimal. The paper highlights the critical role of capital market frictions and supply chain emissions (Scope 3) in enabling SRFs to incentivize emission reductions beyond directly financed firms, suggesting that mandatory Scope 3 emissions disclosure could significantly enhance the effectiveness of ESG asset managers.