Investors are increasingly concerned about a company’s social and environmental impact, but that impact is not as easily assessed as the company’s financial performance, which can be summarized by its “bottom line” (net income) or its stock return. To help socially and environmentally responsible investors, raters such as Sustainalytics and S&P Global provide ESG ratings. Each rating aggregates information about a company’s performance in several categories, such as greenhouse gas emissions, workplace diversity, and board composition. A company’s performance or “score” in each ESG category depends on various indicators that ESG raters will measure and aggregate differently. As a result, ESG ratings for the same company can differ substantially (Berg et al. 2022; Christensen et al. 2022). This has prompted calls for harmonization and even regulation of ESG measurement.

In a new paper, we study how ESG ratings can be used to improve corporate governance when shareholders care about social and environmental outcomes. When the objective of companies is merely financial, corporate governance is relatively straightforward: Equity-based compensation allows the interests of the firm’s management to align with the interests of its shareholders (Hall and Liebman, 1998). When the company’s shareholders, as represented by its board, also have social and environmental concerns, interest alignment is not as straightforward. A good performance measure needs to reflect the impact of a firm’s actions on some dimension that shareholders care about, and it should not be cherry-picked or easily manipulated by the firm’s management (Bebchuk and Tallarita, 2022). ESG ratings, which are comprehensive third-party assessments of corporations’ ESG performance, are seemingly well-suited for this purpose. To our knowledge, our paper is the first to analyze the use of ESG ratings-based incentives for corporate governance.

Management compensation can be explicitly contingent on ESG ratings ,or alternatively on a subset of ESG scores relevant to the company. However, this is not necessary. To the extent that stock market investors are socially and environmentally responsible and informed, the social and environmental impact of a publicly listed firm will be incorporated into its stock price (Barber et al., 2021; Bauer et al., 2021). ESG ratings play a …