Do Commercial Ties Influence ESG Ratings? Evidence from Moody's and S&P

• Published date: 01 December 2024
• Author: XUANBO LI,YUN LOU,LIANDONG ZHANG
• Date: 01 December 2024
• DOI: http://doi.org/10.1111/1475-679X.12582

DOI: 10.1111/1475-679X.12582

Journal of Accounting Research

Vol. 62 No. 5 December 2024

Printed in U.S.A.

Do Commercial Ties Influence ESG

Ratings? Evidence from Moody’s

and S&P

XUANBO LI,∗YUN LOU,†AND LIANDONG ZHANG †

Received 24 October 2022; accepted 14 August 2024

ABSTRACT

We provide the first evidence that conflicts of interest arising from commer-

cial ties lead to bias in environmental, social, and governance (ESG) ratings.

Using the acquisitions of Vigeo Eiris and RobecoSAM by Moody’s and S&P as

shocks to the commercial ties between ESG rating agencies and their rated

firms, we show that, after their acquisitions by the credit rating agencies

(CRAs), ESG rating agencies issue higher ratings to existing paying clients

of the CRAs. This effect is greater for firms that have more intensive business

relationships with the CRAs, but weaker for firms with more transparent ESG

∗City University of Hong Kong; †Singapore Management University

Accepted by Valeri Nikolaev. We gratefully acknowledge helpful comments and sug-

gestions from two anonymous referees. We also thank Thomas Bourveau, Stefano Cas-

cino, Qiang Cheng, Alper Darendeli, Elizabeth Demers (discussant), Bin Ke (discussant),

Mozaffar Khan, Kelvin Law, Alvis Lo (discussant), Ningzhong Li, Xi Li, Hao Liang, Xiumin

Martin, Clemens Otto, Anywhere Sikochi (discussant), Ane Tamayo, Dragon Tang, Dushyan-

tkumar Vyas (discussant), Rencheng Wang, Luke Watson (discussant), and seminar and con-

ference participants at London School of Economics and Political Science, the 2nd London

Business School PhD Alumni Workshop, the 3rd Swiss Accounting Research Alpine Camp,

the 2022 MIT Asia Conference in Accounting, the 2022 Nanyang Business School Account-

ing Conference, the 2022 SOAR Research Summer Camp at Singapore Management Uni-

versity, the 2023 Hawaii Accounting Research Conference, and the 2023 Midyear Meeting

of the Financial Accounting and Reporting Section for helpful comments and suggestions.

Lou and Zhang gratefully acknowledge the financial support of the Lee Kong Chian Fellow-

ship and Professorship at Singapore Management University. Wehave no conflicts of interest

to declare. All errors are our own. An online appendix to this paper can be downloaded at

https://www.chicagobooth.edu/jar-online-supplements.

1901

© 2024 The Author(s). Journal of Accounting Research published by Wiley Periodicals LLC on behalf of The

Chookaszian Accounting Research Center at the University of Chicago Booth School of Business.

This is an open access article under the terms of the Creative Commons

Attribution-NonCommercial-NoDerivs License, which permits use and distribution in any medium,

provided the original work is properly cited, the use is non-commercial and no modifications or

adaptations are made.

1902 x. li, y. lou, and l. zhang

disclosures or higher long-term institutional ownership. The upwardly biased

ESG ratings help client firms issue more green bonds and enable the CRAs to

maintain credit rating business. Finally, the upwardly biased ESG ratings are

less informative of future ESG news. Overall, the business incentives of rating

providers appear to engender ESG rating bias.

JEL codes: G20, G24, G28, M48

Keywords: ESG; conflicts of interest; rating agencies; sustainability; com-

mercial ties; disclosure

“The giant firms that audit the books, rate the bonds, advise on proxy vot-

ing and categorize the world’s companies are spending billions to boost

their climate-related operations. That could accelerate the shift away from

fossil fuels but could also create a new set of conflicts of interest for indus-

tries that struggled to manage them in the past.”

(The Wall Street Journal [2022])

1. Introduction

In recent years, regulators and academics alike have raised significant

concerns about the reliability of environment, social, and governance

(ESG) ratings (e.g., IOSCO [2021], Berg, Kölbel, and Rigobon [2022],

Christensen, Serafeim, and Sikochi [2022], NGFS [2022]). For example, in

his 2021 letter to the European Commission, Steven Maijoor, then Chair of

the European Securities and Markets Authority (ESMA), highlighted the

issues of inconsistency and opacity in ESG rating methodologies and po-

tential conflicts of interest that may arise in the business models of the ESG

rating agencies (ESMA [2021a]). Independent and impartial assessment of

corporate ESG performance is critical not only for sustainable investing in

the financial market but also for the sustainable growth of the real econ-

omy (e.g., Hartzmark and Sussman [2019], Pástor, Stambaugh, and Taylor

[2021], Edmans, Levit, and Schneemeier [2023]). In this study, we examine

whether conflicts of interest engendered by commercial ties influence the

quality of ESG ratings.

The exponential growth in sustainable investing has motivated many tra-

ditional financial services firms to expand their business into the ESG rating

arena (Eaglesham [2022]). From 2017 to 2019, there were 11 acquisitions

of ESG rating agencies; the acquirers included ISS, Morningstar, Moody’s,

S&P, MSCI, Sustainalytics, and Thomson Reuters (SustainAbility [2020]).

Although these financial services firms may be able to leverage their fi-

nancial and informational resources to produce better-quality ESG ratings,

their multiple business lines can also create a hotbed of potential conflicts

of interest. Thus, we take advantage of the consolidations in the ESG rat-

ing space as potential shocks to commercial ties and examine how such ties

affect ESG ratings.

do commercial ties influence esg ratings? 1903

Specifically, we focus on Moody’s and S&P’s acquisitions of ESG rating

agencies Vigeo Eiris and RobecoSAM. Most credit rating agencies (CRAs),

including Moody’s and S&P, use the so-called issuer-pay business model and

generate most of their revenue from bond issuers. This compensation ar-

rangement creates incentives for CRAs to cater to the preferences of bond

issuers.1Although ESG rating agencies currently obtain revenue from in-

vestors or other users of ESG ratings, the acquisition of ESG rating agen-

cies by CRAs represents a shock to the commercial ties between ESG rating

agencies and certain rated firms (i.e., CRAs’ credit rating clients). After the

acquisitions, the existing credit rating clients of the CRAs become “indi-

rect clients” of the ESG rating agencies via their parent companies. As a

result, the ESG rating agencies may experience pressure from the parent

companies to issue favorable ESG ratings to their credit rating clients that

desire higher ESG ratings.2Essentially, the CRAs’ conflict-of-interest prob-

lem spills over to their ESG rating subsidiaries. The spillover may take the

form of explicit directives from the parent CRAs, or it can work more sub-

tly via the “tone at the top” or a corporate culture of currying favor with

clients. Moreover, the substantial discretion in the ESG rating process facil-

itates favoritism toward CRAs’ clients.3Overall, we predict that after being

acquired by Moody’s and S&P, ESG rating agencies issue higher ESG ratings

to the existing credit rating clients of these CRAs, relative to non-clients.

CRAs often respond to criticisms of potential conflicts of interest by stat-

ing their incentives to maintain reputational capital (e.g., Pittman [2008]).

However, a substantial body of empirical evidence on credit rating infla-

tion suggests that reputation concerns do not eliminate conflicts of interest

(e.g., Becker and Milbourn [2011]). Although the reputational and regu-

latory costs of credit rating inflation have increased substantially since the

financial crisis,4the cost of ESG rating inflation likely remains consider-

ably lower because the ESG rating industry is currently unregulated and ex-

periences severe rating disagreement. Moreover, relative to credit ratings,

which can be verified by future default events and disciplined by the mar-

ket for credit risk (e.g., Piccolo and Shapiro [2022]), ESG ratings are much

less verifiable, and there is currently no market for ESG risks. Nevertheless,

establishing a strong reputation from the outset is imperative for capturing

1Prior literature has documented mounting evidence that conflicts of interest arising from

the issuer-pay model lead to optimistically biased credit ratings (e.g., Jiang, Stanford, and

Xie [2012], Bonsall [2014], Baghai and Becker [2018], Cornaggia, Cornaggia, and Israelsen

[2023]).

2Investors tend to pay a premium for shares of firms with high ESG ratings (Ramkumar

[2022]).

3ESG rating agencies could either use their discretion within the existing methodologies

or adjust the rating methodologies to favor their credit rating clients. While examining the

exact means of generating biased ESG ratings is beyond the scope of this study, the anecdotal

evidence is more consistent with the former in our setting.

4See, for example, Bolton, Freixas, and Shapiro [2012], Bongaerts, Cremers, and

Goetzmann [2012], Dimitrov, Palia, and Tang [2015], and DeHaan [2017].