ESG Ratings—Guiding a Movement in Search for Itself

Abstract

ESG ratings deliver the short-hand evaluation that investors need to incorporate environmental, social, and governance aspects in their decision-making. In this capacity, they give direction to the ESG movement and define its objectives. The paper argues that an ESG rating can serve two distinct purposes: either to inform financial investors about long-term risks and returns from ESG-related factors or to guide prosocial investors in awarding a “greenium” subsidy for social performance. Because the information demands differ, ESG rating providers should commit to either one of these missions. The paper analyzes the specific problems of ratings serving prosocial investors. Implicitly or explicitly, such ratings reflect an ordering of political priorities that rating providers have to set. To maximize the impact of the subsidy, ratings should be tailored to the incentive structure of firms. Standardizing ESG ratings would further strengthen the effect of impact investing but seems unlikely to be attainable.

Keywords: ESG ratings; ESG investing; impact investing; active ownership

JEL Classification: D21, D62, D64, D71, G11, G32, K22