In today’s context, corporate ESG (Environmental, Social, and Governance) performance exerts a crucial influence on large-scale investment decisions. But can ESG rating agencies truly drive enterprises to operate more responsibly?

A recent study published in the Journal of Banking and Finance by Prof. Yi XIANG, from the School of Accounting and Finance (AF) at The Hong Kong Polytechnic University (PolyU), titled "The Rise of ESG Rating Agencies and Management of Corporate ESG Violatios", provides a clear answer.

This study explores whether ESG rating agencies affect managers’ incentives to reduce corporate misconduct, using the likelihood and frequency of ESG violations as metrics. By analyzing data from four major ESG rating agencies (ASSET4, KLD, IVA, and Sustainalytics) on U.S. firms between 2000 and 2018, the study observes a significant negative correlation between the initiation and intensity of ESG rating agency coverage and the incidence and number of ESG violations. This result confirms that ESG rating agencies can effectively act as external monitors to reduce corporate ESG violations.

The study finds that ESG rating coverage is associated with fewer violations: compared to firms without rating coverage, firms covered by ESG rating agencies experience an 8.77% decrease in the incidence of ESG violations and an 11.23% reduction in the frequency of such violations. Moreover, as firms are covered by more ESG rating agencies, the severity of their ESG violations (proxied by penalty amounts) may also decrease. Through dynamic tests, the study further confirms that firms’ violations only decrease significantly after the initiation of rating coverage (not before), ruling out the interference of "firms avoiding violations in advance."

Notably, the supervisory effect of ESG ratings is more pronounced for firms with "lower levels of corporate monitoring" (whether through internal or external mechanisms). Firms with less analyst coverage, limited media attention, and poor ESG disclosure quality show a greater reduction in violations after being covered by ratings. This indicates that ESG rating agencies fill the governance gap for such firms—i.e., firms with lower prior monitoring levels are more likely to change their ESG-related behaviors after gaining coverage from ESG rating agencies.

In addition, the study finds that rated firms tend to have a stronger incentive to prioritize addressing "common and high-frequency violations." Firms focus on resolving high-frequency violations that are easily noticed by rating agencies, such as those related to safety, the environment, employee rights, and consumer protection; in contrast, the impact of rating coverage on low-frequency violations (e.g., those related to government regulation or healthcare) is weaker. This reflects firms’ response logic to the key areas of focus of rating agencies.

Compared to the disclosure of positive information, the public disclosure of firms’ negative information is more likely to strengthen public scrutiny and motivate firms to avoid the detection of irresponsible behaviors. Furthermore, firms with lower initial ESG ratings are also more likely to attract the attention of the public and regulators, increasing the probability that their violations are detected. Compared to firms with strong ESG performance, firms with poor ESG performance may face greater external pressure once their ESG scores are published by ESG rating agencies; this enhanced scrutiny, in turn, incentivizes underperforming firms to avoid corporate misconduct. Meanwhile, firms with less divergent ESG ratings have a stronger incentive to reduce violations after being covered by ESG rating agencies.

The study’s findings offer several specific implications for firms, policymakers, and the corporate governance role of ESG rating agencies:

For firms: ESG rating agencies act as governance tools and help mitigate ESG risks. Firms should leverage such insights to strengthen internal controls and governance, managing ESG risks effectively and meeting stakeholder expectations.

For policymakers: The findings underscore the need for a regulatory framework for ESG rating agencies. As ESG ratings’ influence on corporates grows, regulators should ensure transparent and consistent methodologies. Clearer standards and disclosure of rating criteria/weightings will boost ESG ratings’ credibility and supervisory role, making them reliable tools for corporate change.

From a corporate governance view, ESG rating agencies are key participants, complementing traditional mechanisms (e.g., board oversight). They act as external monitors to push firms toward ethical and sustainable practices. Rating agencies must prioritize objective, accurate assessments, optimize methodologies to comprehensively capture corporate ESG performance, and avoid rating divergence. Consistent, accurate ratings will solidify their role as trusted capital market intermediaries, supporting firms’ long-term sustainable and ethical governance.

Keywords: Rating Agencies, Misconduct, Violation, Scrutiny

Research Paper: Tsang, A., Wang, Y., Xiang, Y., & Yu, L. (2024). The rise of ESG rating agencies and management of corporate ESG violations. Journal of Banking and Finance.

👉 Read the full article here: https://www.sciencedirect.com/science/article/pii/S0378426624002267