ESG ratings are intended to provide information to market participants (investors, analysts, and corporate managers) about the relation between corporations and non-investor stakeholders interests. They do so by sifting masses of data to extract insights into various elements of environmental, social, and governance performance and risk. Investors rely on this information to make investment decisions, while corporations use ratings to gain third-party feedback on the quality of their sustainability initiatives.

Recently, ESG ratings providers have come under scrutiny over concerns of the reliability of their assessments. In this post, we examine these concerns. We review the demand for ESG information, the stated objectives of ESG ratings providers, how ratings are determined, the evidence of what they achieve, and structural aspects of the industry that potentially influence ratings. Our purpose is to help companies, investors, and regulators better understand the use of ESG ratings and to highlight areas where they can improve. We find that while ESG ratings providers may convey important insights into the nonfinancial impact of companies, significant shortcomings exist in their objectives, methodologies, and incentives which detract from the informativeness of their assessments.

Demand for ESG Information

Demand for ESG information has exploded in recent years. Ten years ago, the term ESG—although in existence—was rarely used by the investment community or in corporate boardrooms. Instead, public and professional interest was focused on the general concepts of corporate responsibility, sustainability, and impact investing. Only recently has the focus on ESG (environmental, social, and governance) as a unique concept come to the forefront and with it an explosion in the demand for information (see Exhibit 1).

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