Research Findings

The unintended consequences of favorable ratings

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January 19, 2023

It seems as if every day a new rating comes out to assess organizations on some measure of performance. The thought is that by providing greater transparency and accountability, ratings will motivate these organizations to improve certain behaviors to obtain the praise of a positive rating and avoid the shame of a poor rating.

In most cases, this makes sense: a highly-rated hospital should be more appealing to patients than one with poor ratings, a highly-rated university should attract more applicants, and a highly-rated restaurant should garner more local interest. But what about ratings where the attributes being measured may be seen as less desirable by some stakeholders?

In today’s divisive society, it seems ever so timely to consider how companies respond to ratings on potentially polarizing issues. While we know that ratings are effective in shaping organizational behavior, most studies have examined widely valued issues such as reduced toxic emissions or the health and safety of nursing homes. What we don’t know is how companies react when the behavior being rated is more controversial.

Our Study

We explored this question in a recent paper published in Administrative Science Quarterly. In this study, we collected data on how firms responded to one of the first environmental, social, and governance (ESG) ratings by KLD Research & Analytics, a pioneering rating agency that emerged in the 1990s to rate corporate performance on charitable giving. The time period of this study is important because during this time, prosocial activities such as philanthropy were controversial, and were even seen as inappropriate by many in the investment community.

Consistent with sociological theories of reactivity, KLD had hoped that recognizing the most generous corporations would incentivize companies that didn’t receive the generous rating to give more. In contrast to this expectation, we found that firms that were initially rated as generous actually decreased their charitable contributions in subsequent years. So, how do we make sense of these findings?

Additional analyses suggest that these recognized firms decreased their giving because they were concerned that the rating served as a signal that was inconsistent with the notion of shareholder value maximization, the dominant business logic at the time. Wanting to avoid the “appearance of virtue,” many of these seemingly generous firms appeared to decrease their subsequent giving to avoid being rated as charitable altogether or at least minimize the perception that they were “overinvesting” in philanthropy.

But not all firms responded in the same way. Firms that were headquartered in communities known for corporate philanthropy (such as Minneapolis-St. Paul) or operated in “risky” industries known for producing negative social externalities (for example, tobacco, alcohol, gambling, etc.) seemed to maintain high levels of giving, presumably because they had alternative reasons for giving, including community norms and reputations to support. On the flip side, firms that were struggling financially or controlled by a founding family decreased their contributions even more, perhaps because they were more sensitive to the perception of misusing corporate funds for personal benefit.

Theoretically, our work highlights the importance of contextualizing ratings, especially the extent to which the attributes being rated are consistent with prevailing social values. When these dimensions are inconsistent, companies may actually see a favorable rating as a potentially risky signal that draws attention and scrutiny to behaviors that may not be appreciated by some of their key stakeholders.

Implications for ESG Ratings

While our results are specific to this particular rating over 30 years ago, we believe they still provide key insights for rating agencies and policy makers who wish to motivate improvements in corporate social and environmental responsibility.

First, ESG rating agencies should carefully consider whether the issues they rate are generally valued by society as recognizing certain behaviors that are currently contested may lead firms to reduce rather than improve their performance. This concern is especially relevant given recent concerns voiced by some that corporations have become too “woke.”

Second, some critics claim that ESG ratings do little to change corporate behavior, suggesting that any responses at all are just mere instances of “window-dressing” or “greenwashing.” Our results provide clear evidence that companies do indeed respond to ESG ratings in substantive ways, albeit in ways that were likely unintended by the rating agency.

Finally, we anticipate that although ratings may initially lead organizations to respond in ways that diverge from the intent of the rating, they may increase awareness around issues that may lead to changes in social values over time. Consequently, one should not ignore the longer-term consequences of ESG ratings even if the short-term responses do not produce the desired response.

Read more

Ben W. Lewis and W. Chad Carlos. “Avoiding the appearance of virtue: Reactivity to corporate social responsibility ratings in an era of shareholder primacy.” Administrative Science Quarterly 2022. (open access)

Image: Jernej Furman via flickr (CC BY 2.0)

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