ESG ratings shape markets — regulating their practices is a policy imperative

As environmental, social, and governance (ESG) factors become central to investment strategies, a parallel ecosystem has gained immense influence over global capital markets: ESG rating agencies. Their scores now inform portfolio construction, drive capital allocation, and shape corporate behavior. Yet, behind these metrics lies a critical question: how much of what ESG ratings capture reflects a company’s actual sustainability performance, and how much reflects the rater’s own methodology? 

What are ESG ratings and why do they matter?

ESG ratings are designed to assess how well a company manages non-financial risks and opportunities from climate strategy and labor practices to governance standards. These ratings are issued by specialized organizations, known as ESG raters, that gather and analyze a vast range of public and proprietary data to assign companies a score or grade reflecting their sustainability performance. 

Over the past two decades, ESG rating providers have proliferated. Today there are more than 600 agencies globally. Major names like MSCI, Sustainalytics, and LSEG Data & Analytics dominate the field, but dozens of smaller regional players cater to niche markets and sectors. 

While ESG ratings aim to bring transparency, they also introduce a new layer of opacity: methodological divergence. Each rater uses its own proprietary model, with different weights, indicators, and data sources. Previous research on ESG ratings shows that the correlation between ESG ratings is in average 0.54 and 0.61. In contrast, credit ratings from the major credit rating agencies report as high as 0.92 to 0.994. 

For investors, this inconsistency can have real financial effects: firms with higher ESG scores tend to benefit from lower debt costs and attract a broader investor base, while those with worse ratings may face higher financing costs or be excluded from ESG-focused funds. Even more interesting, some studies find that ESG-labeled or high-rated firms see shifts in their institutional ownership composition, suggesting that ratings directly affect how capital flows across the market. 

But if ESG scores can move capital, what happens when the methodology behind them changes — not because a company’s performance improved or worsened, but simply because the rater changed its model?  

That’s the main question of our study co-authored with Albane Tarnaud and Zakriya Mohammed (both from IESEG School of Management). Using a quasi-experimental approach (a real-world scenario that mimics the conditions of an experiment, allowing us to observe cause-and-effect relationships), we study how changes in ESG rating methodologies, rather than changes in corporate behavior, can alter investor decisions. 

The 2010 MSCI case

In 2010, the global financial data provider MSCI acquired RiskMetrics Group, which included well-known sustainability research firms like Innovest and KLD. Following the acquisition, MSCI revised its ESG data collection methodology, moving from an industry-neutral approach to one focused on industry-specific indicators.  

This methodological shift, though independent of any changes in firms’ ESG practices, caused mechanical upgrades and downgrades in company ratings and created a unique opportunity to isolate the effects of a rater’s methodology on investment behavior. We compared two groups of firms between 2001 and 2018: a treatment group whose ESG ratings changed because of the methodology shift, and a control group whose ratings remained stable. The goal was to assess how this exogenous methodological shock affected the breadth of ownership, that is, the number of distinct investors holding a firm’s stock. 

1. Individual investors are highly responsive, especially to upgrades

The most pronounced reaction came from individual (retail) investors. Firms whose ESG scores were mechanically upgraded experienced a 16.9% increase in the number of individual shareholders in the years following the methodology change. 

Importantly, this reaction was asymmetric: retail investors responded strongly to upgrades but ignored downgrades. Firms whose scores fell did not experience any significant decline in retail ownership. This “positive bias” aligns with behavioral finance evidence showing that individuals react more enthusiastically to favorable news while disregarding negative signals. 

Retail investors, it turns out, were not reacting to genuine changes in sustainability performance, but to the appearance of improved ESG standing. This highlights how ESG ratings serve as powerful signals, particularly for investors who may lack the time or expertise to analyze detailed ESG data themselves. 

2. Institutional investors remain largely unmoved

By contrast, institutional investors (such as mutual funds, pension funds, and asset managers) showed little to no reaction to these methodological changes. Their ownership levels, both in terms of breadth and percentage, remained statistically unchanged. 

This difference makes sense. Institutional investors typically have more sophisticated analytical tools and in-house ESG research capabilities, allowing them to look beyond rating labels and assess companies on underlying fundamentals. 

This indifference reflects the fact that institutional investors are more sophisticated. Equipped with ESG research teams and access to raw data, they are less likely to be swayed by superficial rating shifts. Instead, they focus on fundamental ESG performance rather than on methodological artifacts. 

3. Visibility amplifies the effect

The study also found that the reaction among individual investors was strongest for large, visible firms — those with high market capitalization, active trading volumes, and broad analyst coverage. Visibility acts as a multiplier: when a well-known company’s ESG score improves, it attracts attention and new investors more quickly. In contrast, smaller or less visible firms saw little change in investor composition, even if their ratings shifted. 

What does this mean for the market 

The findings reveal that ESG rating agencies have a significant influence on financial markets. Their methodologies not only shape perceptions of corporate sustainability but also influence ownership patterns and capital allocation — particularly among less sophisticated investors. 

This raises several implications: 

• For companies, this means that managing sustainability performance alone isn’t enough; understanding how ESG raters evaluate and update their methodologies is equally crucial. A methodological change can alter perceptions, affecting valuation, investor interest, and access to sustainable financing.
• For investors, the lesson is twofold. Institutional investors may need to continue developing in-house ESG expertise to mitigate dependence on third-party scores. Individual investors should recognize the limitations and inherent subjectivity of ESG ratings and avoid interpreting them as definitive measures of a company’s sustainability performance.
• And for regulators, the study underscores the importance of transparency and accountability in ESG rating practices. The European Union, for instance, is already moving in this direction: new regulations require ESG rating providers to disclose their methodologies, models, and key assumptions more clearly — an essential step toward restoring trust in the system. 

ESG ratings are meant to guide markets toward sustainable outcomes. Yet, this research reveals how methodological opacity can distort investor behavior and capital flows. When investors, in particular retail investors, treat ESG ratings as absolute measures of sustainability, changes in scoring models can create misleading performance shifts in perceived performance, driving investment decisions disconnected from actual environmental or social impact. 

Policy implications: bridging the transparency gap

The European Union’s Regulation (EU) 2024/3005 marks a significant step toward addressing the opacity and inconsistency in ESG ratings highlighted by our study. By requiring ESG rating providers to disclose their methodologies, models, and key assumptions — and mandating authorization by ESMA (European Securities Markets Authority) — the regulation aims to improve transparency, comparability, and trust in ESG assessments.  

However, gaps remain. The regulation excludes private ratings used internally or embedded in regulated financial products, leaving a substantial portion of ESG evaluations outside its scope. Moreover, while disclosure is mandated, there is no standardized framework for how methodologies should be constructed or weighted, meaning methodological divergence may persist. To fully align market behavior with genuine sustainability outcomes, future policy efforts should consider harmonizing rating standards and expanding oversight to cover all ESG-related scoring systems that influence capital flows. 

The broader lesson is clear: measurement drives markets, but the way we measure matters just as much as what we measure. As ESG investing continues to expand, ensuring methodological consistency and transparency in ESG ratings will be critical to maintaining market integrity and achieving genuine sustainability outcomes.