ESG Rating Agency Incentives

Despite growing investor reliance on environmental, social, and governance (ESG) ratings, we know relatively little about how such ratings are constructed. Recent evidence of disagreement across ESG ratings raises concerns about their credibility. We note that while reputational concerns likely motivate ESG raters to issue credible and accurate ratings, several leading ESG raters also construct 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 relative to raters with weaker licensing incentives, after controlling for the firm's fundamental ESG performance. We also find that raters that construct ESG-based indices more often include and place greater weight on stocks with better stock return performance in the ESG-based indices. Overall, our findings suggest that index construction incentives affect the construction of ESG ratings, highlighting the need for greater transparency in the production of ESG ratings