The Impact of Inflated ESG Ratings on Socially Responsit>le lnuestment: An Analysis of Aduerse Selection

Abstract

We find that sustainable investors can be deceived to preform unsustainable investments when relying solely on ESG ratings. This is because companies can artificially inflate their ESG rating by promising future sustainable performance and not implement what they promise. We find that Refinitiv ESG rating are negatively correlated with our realized ESG rank, hurting the incentive of sustainable investors. We also find evidence that companies may be motivated to inflate their ESG ratings for capital cost reductions, creating a moral hazard. Using our ESG ranks to construct a portfolio does not create abnormal returns compared to Refinitiv’s rating, but results in better overall realized performance.