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

61 Pages Posted: 10 Nov 2022

See all articles by Dennis Bams

Dennis Bams

Maastricht University - Department of Finance; Open University Heerlen

Bram van der Kroft

Massachusetts Institute of Technology (MIT)

Multiple version iconThere are 2 versions of this paper

Date Written: November 9, 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.

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 (November 9, 2022). MIT Center for Real Estate Research Paper No. 22/12, Available at SSRN: https://ssrn.com/abstract=4271852 or http://dx.doi.org/10.2139/ssrn.4271852

Dennis Bams

Maastricht University - Department of Finance ( email )

Maastricht, 6200 MD
Netherlands

Open University Heerlen ( email )

Netherlands

Bram Van der Kroft (Contact Author)

Massachusetts Institute of Technology (MIT) ( email )

77 Massachusetts Avenue
50 Memorial Drive
Cambridge, MA 02139-4307
United States

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