The Effect of Environmental Preferences on Investor Responses to ESG Disclosure

We study the effect of environmental preferences on portfolio allocation around the implementation of the European Sustainable Finance Disclosure Regulation (SFDR). In a model of asset allocation with heterogeneous environmental preferences, we show that the introduction of disclosure regulation leads to an increase in flows to ESG funds, in particular when investors have stronger environmental preferences. We also show that it can be optimal for some funds to misreport their greenness. We test these results by combining unique security-level data on the holdings of European mutual fund shares with survey data on country preferences for protecting the environment. We find that ESG funds experienced higher flows after the regulation, and that the development of these funds was largest in countries with stronger environmental preferences. Institutional investors appear to be more responsive to the disclosure rules than households, and funds with higher initial uncertainty about their true sustainability benefited most from the disclosure.