Study argues ESG raters could have conflicts of interest (2023)
| Environmental, social, and corporate governance |
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A new research paper from Columbia Business School argues that a number of companies that earn a significant portion of their revenue from ESG rating services tend to rank businesses with better stock performance more favorably on ESG indexes.
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Despite growing investor reliance on environmental, social, and governance (ESG) ratings, we know relatively little about how such ratings are constructed especially because widespread disagreement across ESG ratings raises concerns about their credibility. At the same time, several leading ESG raters not only construct ESG ratings but also market index products based on their ESG ratings. We examine whether the incentives associated with deriving revenue from ESG rating-based indices contribute to the variation in ESG ratings. Consistent with this notion, we find that raters with strong index licensing incentives issue higher ESG ratings for firms with better stock return performance and those added to their ESG indexes, compared to raters with weaker licensing incentives. The results hold after accounting for the firm’s fundamental ESG performance and different rating methodologies. Overall, our findings suggest that index construction incentives affect the production of ESG ratings, highlighting the need for greater transparency in the production of ESG ratings.[1] |
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The researchers’ conclusions suggest that MSCI—a leading ESG rating service—has a strong financial incentive that impacts its ESG ratings:
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It is not clear how ESG data providers determine ESG ratings, and there is substantial disagreement in ratings across ESG data providers (Berg et al., 2022; Christensen et al., 2021). This raises concerns about the credibility of ESG ratings and underscores the need to understand the incentives that shape the production of ESG ratings. We examine whether raters with strong index licensing incentives issue higher ESG ratings for firms with better stock return performance and those added to their ESG indexes, compared to raters with weaker licensing incentives. We study MSCI as an example of an ESG rater with high index licensing incentives (HighIndex) and Refinitiv as an example of an ESG rater with low index licensing incentives (LowIndex). While most of Refinitiv’s revenue is from selling data, more than 60 percent of MSCI’s operating revenue is from index licensing fees. Using these raters, we also investigate the degree to which index licensing incentives influence ESG ratings by benchmarking HighIndex ESG ratings to LowIndex ESG ratings. Our results offer several new insights. First, we report that firms with higher (lower) stock returns receive higher (lower) ratings from a rater with high index incentives relative to ratings from a rater with low index incentives. As our inferences are based on comparisons across ratings issued for the same firm, we effectively hold “fundamental” ESG performance constant in our analyses. Second, we find that ESG ratings from a rater with high index incentives are systematically higher (lower) than those of a rater with low index incentives for firms added (dropped) from the ESG indexes, even after controlling for rating methodology differences. Notably, these ESG ratings upgrades and downgrades, relative to peers, do not appear to be informative about “fundamental” ESG performance. Third, we show that ESG index inclusion decisions are associated with stock returns. Collectively, our findings suggest that ESG data providers’ index licensing incentives influence their ESG ratings.[1] |
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See also
- Environmental, social, and corporate governance (ESG)
- Economy and Society: Ballotpedia's ESG newsletter
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