New Schulich Research Shows ESG Ratings Can Lead to Stock Mispricing
Study published in Management Science highlights risks of relying on ratings without understanding how they are constructed
Investors who rely on environmental, social and governance (ESG) ratings without understanding how those ratings are developed may be contributing to stock mispricing and market inefficiencies, according to new research from York University’s Schulich School of Business.
The study, “Investor Reliance on ESG Ratings and Stock Price Performance,” was recently published in Management Science, one of the world’s leading business research journals. The paper was co-authored by Aleksandra Rzeźnik, Assistant Professor of Finance at Schulich, along with Kathleen Weiss Hanley and Loriana Pelizzon.
The researchers examined investor reactions to a change in ESG rating methodology introduced by Sustainalytics and later made publicly available through Morningstar and Yahoo! Finance.
Their findings suggest that many retail investors misunderstood the revised ratings, interpreting changes as improvements or declines in companies’ ESG performance when they largely reflected methodological adjustments, including an inversion of the rating scale.
“Our findings show that ESG ratings are highly influential and can have a meaningful impact on stock prices,”said Rzeźnik. “But they also demonstrate the risks of blindly relying on ratings without understanding how those ratings are constructed.”
The study found that less sophisticated investors often viewed higher ratings as positive and lower ratings as negative, regardless of whether the changes reflected new information about a company’s ESG risk profile. As a result, temporary stock price distortions emerged.
“Many individual investors appeared to react to the ratings themselves rather than to the underlying information,” said Rzeźnik. “In some cases, they interpreted changes that were purely methodological as signals about a company’s ESG performance.”
More sophisticated market participants, including institutional investors and short sellers, recognized these misinterpretations and frequently traded in the opposite direction, helping prices eventually return to their fundamental values.
“As ESG investing continues to grow, transparency around rating methodologies becomes increasingly important,” said Rzeźnik. “Clearer disclosures and greater comparability across rating providers could help reduce investor confusion and improve market efficiency.”
The findings provide new evidence that ratings themselves can influence investor behaviour and stock returns, independent of changes in underlying fundamentals.
