This paper investigates the effects of the European Union’s Sustainable Finance Disclosure Regulation (SFDR) on institutional investor behavior and firm-level sustainability transitions. Using investor-level ownership data and firm-level sustainability outcomes for EU-listed firms from 2018 to 2023, we provide evidence on how regulation shapes both market dynamics and corporate responses. First, employing a difference-in-differences framework with US investors as a control group, we show that EU-based institutional investors significantly reduce their holdings of high-emission (brown) firms following the SFDR, while no comparable changes are observed among US investors. Second, at the firm level, we find that the SFDR itself triggers meaningful sustainability initiatives. Brown firms, initially the least aligned with environmental objectives, exhibit the largest post-regulation improvements in emissions management, green patent, and environmental innovation, while gray firms show more moderate gains. Finally, we examine how institutional investor exit interacts with this transition process. We find that reductions in institutional ownership dampen the sustainability improvements of brown firms, weakening their capacity to sustain innovation and emissions reductions. Together, these findings reveal a dual mechanism: regulation incentivizes high-emission firms to accelerate their transition, but sustained investor engagement is critical to maintaining these efforts. Our results contribute to ongoing debates on whether sustainable finance regulation should emphasize investor exit or engagement to achieve long-term environmental goals.
