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

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