The Case for Corporate Climate Ratings: Nudging Financial Markets

Abstract

Capital markets are cast as both villain and hero in the climate playbill. The trillions of dollars required to combat climate change leave ample room for heroics from the financial sector. For the time being, however, capital continues to flow readily toward fossil fuels and other carbon-intensive industries. Drawing on the results of an empirical study, this Article posits that ratings of corporate climate risk and governance can help overcome pervasive information asymmetries and nudge investors toward more climate-conscious investment choices with welfare-enhancing effects.

In the absence of a meaningful price on carbon, three private ordering initiatives are trying to mobilize capital markets as a force for good in the war on carbon. But shareholder climate activism, calls for better climate-related financial disclosures, and the divestment movement have yet to usher in the paradigm shift toward low-carbon capitalism.

Corporate climate ratings overcome existing information asymmetries to nudge investors toward more carbon-conscious allocation of their assets. Every year, rating agencies like Standard & Poor’s, Moody’s, and Fitch pass judgment on over one hundred trillion dollars’ worth of securities. Modeled after these well-established ratings of creditworthiness, independent ratings of companies’ climate risk and governance can redirect the flow of capital away from high-carbon assets toward more climate-friendly options—without the need for government authorization or other market-distorting interventions.

A series of survey experiments with over fifteen hundred participants test, and demonstrate, the capacity of corporate climate ratings to promote low-carbon investment. Inclusion of climate ratings among the performance metrics commonly considered by investors significantly increases investment in the stock of companies with favorable climate ratings, even when other stocks boast a stronger return profile. Variations in the ratings’ framing and format, informed by insights from behavioral economics and finance, facilitate recommendations for best practices.

Keywords: climate, climate change, global warming, carbon, capital markets, financial markets, nudge, choice architecture, divestment, shareholder activism, financial disclosure, climate risk, retail investment, investor, decision making

JEL Classification: K10, K20, K22, K23, K32, Q01, Q50, G10, G18, G24