ESG Rating Competition and Rating Quality

ABSTRACT This paper examines how increased competition among environmental, social, and governance (ESG) rating agencies relates to ESG rating quality. We exploit the entry of Sustainalytics as a new ESG rating agency in 2010. We conduct a difference‐in‐differences analysis and provide three main findings. First, we find that higher competition decreases incumbents' ESG rating disagreements of the same scope. The negative relation between competition and ESG rating disagreement persists for same‐scope rating metrics not covered by Sustainalytics, suggesting that neither learning nor herding drive the results. The relationship between competition and rating disagreement strengthens for firms with more ESG disclosures, which generally require more effort to analyze. Second, we find that incumbents' ratings of ESG concerns are more strongly associated with future negative ESG news for firms additionally covered by Sustainalytics. This finding is consistent with competition improving ratings' ability to predict future negative ESG incidents. Third, we find that incumbents evaluate more difficult‐to‐measure outcome metrics for firms covered by Sustainalytics, consistent with competition inducing more effort. Overall, our findings suggest that competition serves as an implicit disciplining mechanism of ESG rating agencies' quality.