The Power of ESG Ratings on Stock Markets

Abstract

This paper studies the impact of environmental, social, and governance (ESG) ratings on investors’ preferences and stock prices. We exploit a change in ESG rating methodology that non-linearly shifted ESG ratings for firms as a natural experiment. We show that the ‘pseudo’-changes in the ESG ratings induced by the change in methodology are unrelated to potential fundamental changes in firm’s sustainability. Yet, we find that an exogenous change in a stock’s ESG rating exerts a transitory price pressure and alters the composition of stock ownership. Individual investors are especially sensitive to the ‘pseudo’-changes in the ESG ratings. They (dis)invest in stocks that they misconceive as ESG (down-) upgraded. Short sellers act as arbitrageurs and take the other side of retail investors’ trades. Overall, we find that a one standard deviation quasi-increase in the ESG ratings translates into 1pp drop in stock monthly abnormal return.