Are ESG ratings influenced by index business incentives rather than firms’ sustainability performance?
Sonakshi Agrawal, Lisa Yao Liu, Shiva Rajgopal, Suhas A. Sridharan, Yifan (Eva) Yan, and Teri Lombardi Yohn examine whether ESG raters that also sell ESG indices adjust ratings in ways that favour index performance in their paper « ESG Ratings of ESG Index Providers ».
They use a comparative empirical design across rating agencies with different index-licensing incentives. Their main conclusions include:
- ESG raters with strong index-licensing incentives assign significantly higher sustainability ratings to firms with stronger stock return performance compared to raters with weaker index incentives.
- The rating gap between high-index-incentive and low-index-incentive raters increases with firms’ recent stock returns.
- Firms with higher ESG ratings and stronger past returns are significantly more likely to be included in a larger number of indices in general, in ESG indices specifically, and assigned higher cumulative index weights.
- Difference-in-differences tests around ESG index additions and deletions show that ratings from high-index-incentive raters rise when firms enter indices and fall when firms exit, while ratings from low-index-incentive raters remain largely unchanged.
- These rating adjustments do not predict subsequent improvements in firms’ ESG outcomes, such as regulatory violations or diversity indicators, which dispels the explanation that high-index raters simply have superior ESG foresight.
- Within-rater tests confirm that rating inflation persists even when holding rater methodology constant, reinforcing the role of commercial incentives rather than methodological differences.
- Overall ESG rating differences are driven primarily by score adjustments rather than by changes in specific ESG components, with stock returns emerging as a strong incremental predictor only for high-index-incentive raters.
This paper suggests sustainability ratings embed return-chasing behaviour, particularly when used to support index-linked products, which may amplify financial performance signals rather than isolate sustainability characteristics.
This calls for deeper scrutiny of rating providers’ business models and for separating ESG assessments from index-linked revenue streams to better prevent conflicts of interests.
The study faces limitations related to its focus on US firms and two major rating providers. Ratings are not validated against objective sustainability outcomes, which the authors explicitly acknowledge.