Inflated ESG Ratings: An Inverse Relation to Non-Financial Performance

Socially responsible investors rely on ESG ratings to allocate their investments. This reliance under asymmetric information incentivises firms to overstate their ESG ratings for cost of capital benefits. By segregating what firms promise to contribute to society from what they actually realise, we show that Refinitiv, MSCI and FTSE ESG ratings are inversely related to non-financial performance. Specifically, ESG ratings solely capture what firms promise in terms of non-financial performance, while these promises do not materialise up to ten years in the future. As a result, socially responsible investors prioritise unsustainable firms, effectively increasing the cost of capital for sustainable investments. In aggregate, firms with superior ESG ratings have lower non-financial performance.