Divestment, information asymmetries, and inflated ESG ratings

Socially responsible divestment reduces aggregate sustainable performance when investors use Environmental, Social, and Governance (ESG) ratings. Due to information asymmetries, socially responsible investors shift their portfolios towards firms with high ESG ratings rather than firms with exemplar sustainable performance. We causally show that this provides incentives for firms to reduce their cost of capital by inflating their ESG ratings. Consequently, ESG rating inflation is so prominent that Refinitiv, MSCI IVA, and FTSE ESG ratings are inversely related to sustainable performance because promises of sustainable performance improvements do not materialize up to 15 years in the future. Accordingly, the ESG-rating-based divestment portfolios are less sustainable than the market portfolio. Therefore, divestment hinders rather than helps societal welfare.