ESG ratings have long been under scrutiny for perceived conflicts of interest. When most of us think of conflicts of interest in the ESG ratings space, we think of ratings firms with consulting arms. However, researchers at Columbia Business School and Goizueta Business School published a paper that examines another kind of conflict of interest.
Many ESG ratings firms also sell ESG market index products. Companies are included in the index based on their ESG performance as evaluated by the ratings firm. Researchers wanted to know if this business model impacted the ratings in question. Their findings were interesting as their abstract states:
“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 the production of ESG ratings”
What the differences in ratings don’t appear to reflect is ESG performance with the authors stating:
“Notably, these ESG ratings upgrades and downgrades, relative to peers, do not appear to be informative about ‘fundamental’ ESG performance.”
The trend is troubling. ESG raters appeared to give better ESG scores to those companies whose financial performance excelled, and lower ESG scores to companies with lower financial performance. This of course is reflected in the performance of the raters index funds, which perform better when they include higher financially performing companies. This presents another transparency and credibility issue for ESG raters.
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