ESG Ratings of ESG Index Providers

Abstract

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 incentives of producers of ESG ratings.

Keywords: ESG, index providers, rating agencies, sustainability, disclosure

JEL Classification: G24, M14, M40, M41, M48, Q56