Tilting the Wrong Firms? How Inflated ESG Ratings Negate Socially Responsible Investing under Information Asymmetries

59 Pages Posted: 14 Jun 2022 Last revised: 29 Oct 2022

See all articles by Dennis Bams

Dennis Bams

Maastricht University - Department of Finance; Open University Heerlen

Bram van der Kroft

Maastricht University: Finance; Open University: Accounting and Finance

Date Written: October 28, 2022

Abstract

Portfolio tilting deteriorates aggregate sustainable performance when investors use Environmental, Social, and Governance (ESG) ratings. Socially responsible investors shift their portfolios towards firms with high ESG ratings rather than sustainable firms because they experience difficulties assessing sustainable performance. We show in a causal way that this provides cost of capital incentives for firms to increase their ESG rating without improving sustainable performance. This ESG rating inflation is so prominent that Refinitiv, MSCI IVA, and FTSE ESG ratings are inversely related to sustainable performance because firms’ promises of sustainable performance improvements do not realize up to 15 years in the future. Consequently, ESG-rating-based portfolio tilting hinders rather than helps societal welfare as tilted portfolios are less sustainable than the market portfolio.

Keywords: Socially responsible investing (SRI), cost of capital, promised to realized sustainable performance, corporate social responsibility

JEL Classification: M14, Q56, G15

Suggested Citation

Bams, Dennis and van der Kroft, Bram, Tilting the Wrong Firms? How Inflated ESG Ratings Negate Socially Responsible Investing under Information Asymmetries (October 28, 2022). Available at SSRN: https://ssrn.com/abstract=4126986 or http://dx.doi.org/10.2139/ssrn.4126986

Dennis Bams

Maastricht University - Department of Finance ( email )

Maastricht, 6200 MD
Netherlands

Open University Heerlen ( email )

Netherlands

Bram Van der Kroft (Contact Author)

Maastricht University: Finance ( email )

Tongersestraat 53
Maastricht, Limburg 6211LM
Netherlands
0614812713 (Phone)

HOME PAGE: http://https://www.maastrichtuniversity.nl/about-um/faculties/school-business-and-economics

Open University: Accounting and Finance ( email )

Valkenburgerweg 177
Heerlen, 6419 AT
Netherlands
0614812713 (Phone)

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