Who should pay for ESG ratings?

Abstract

We model how a profit-maximizing rating agency decides whether to sell Environmental, Social, and Governance (ESG) ratings to firms or investors. For firms in sufficiently green sectors or when the proportion of socially responsible investors is large enough, ESG ratings increase expected stock prices, and the “issuer pays” business model is more profitable than “investors pay.” When all investors are socially responsible, the model coincides with a model of credit ratings, explaining why credit ratings are sold to issuers while most ESG ratings are sold to investors. Ratings have a positive effect on firms’ ESG performance, which is maximized when investors’ preferences are heterogeneous.