A common gripe we often hear about ESG ratings is that multiple firms can come to widely different conclusions about the same company. Many cite the uniformity of credit rating systems as the ideal model for ESG. However, unlike credit ratings, ESG ratings measure entirely different criteria depending on the rating firm’s methodology. While many see this discordance as a drawback, some view it as valuable. With multiple firms providing nuanced perspectives, one can get a holistic view of ESG performance by consulting multiple ratings. Under the status quo, with many firms offering ESG ratings, one might think this is already the case. However, a new paper in The Journal of Finance finds that the very competition that produces a wide variety of firms may also homogenize their ratings. The researchers present the possibility that competition hurts ESG ratings:
“We present a model of competition between environmental, social, and governance (ESG) raters who acquire information about multiple unrelated categories and sell ratings. Raters specializing in different categories maximize the amount of information transmitted and surplus, and can be an equilibrium outcome. When investors place a high value on ESG performance across multiple categories, the unique equilibrium is for the raters to generalize—splitting their effort among the categories, resulting in less informative ratings. Greenwashing by firms can make generalization the only equilibrium. We also demonstrate that specialization maximizes ratings disagreement, and thus empirical measures of disagreement may be poor measures of surplus.”
The cause of this decrease in specialization comes down to investor expectations. Investors want one-stop shopping for their ESG ratings. One number or grade at a high level that will tell them whether a company is exposed to risks or stands to benefit from ESG. However, ESG is incredibly nuanced. Environmental, social, and governance issues certainly have areas of overlap and interplay, but on the whole they are drastically different. This leads firms to try to meet these expectations by becoming more generalist and less specialized. A tough problem to solve to be sure.
In addition to their findings regarding competition, the authors also echo similar sentiments seen in another recent study on the issue of ESG rating regulations. They argue that rating regulations should aim to increase transparency of methodologies, not harmonize them. Ultimately, a handful of firms publishing similar information may be less useful than a myriad of firms publishing bespoke information. Regulators must thread the needle of ensuring firms are issuing transparent ratings, while not stifling perspectives. If competition hurts ESG ratings, that will prove another challenge for regulators to resolve.
Our members can learn more about ESG ratings here.
If you’re not already a member, sign up now and take advantage of our no-risk “100-Day Promise” – during the first 100 days as an activated member, you may cancel for any reason and receive a full refund. But it will probably pay for itself before then. Members also save hours of research and reading time each week by using our filtered and curated library of ESG/sustainability resources covering over 100 sustainability subject areas – updated daily with practical and credible information.
Practical Guidance for Companies, Curated for Clarity.
