Do foreign institutional investors improve ESG ratings and reduce rating dispersion? Evidence from the US

Abstract

The integration of Environmental, Social, and Governance (ESG) factors into firms’ and investors’ decision-making has gained substantial momentum over the last decade. Despite the rising importance of ESG, significant challenges persist, including controversies in ESG ratings across rating agencies undermining investor confidence and complicating ESG performance assessment of firms. This thesis investigates the role of foreign institutional investors in influencing U.S. firms’ ESG performance reflected in ESG ratings and reducing rating dispersion between the two most used agencies, MSCI and Refinitiv, during the period 2013–2023.

Using a comprehensive dataset and employing an instrumental variable approach to address endogeneity concerns, we examine the impact of foreign institutional ownership in two dimensions: its effect on enhancing firms’ ESG scores and its role in harmonizing ESG assessments. Additionally, we include a country-level social norm perspective to explore how the social norms of investors’ home countries influence their impact in shaping firms’ ESG practices. By distinguishing between short-term and long-term investors, we further provide insights into the characteristics that drive ESG ratings.

The findings reveal that foreign institutional ownership significantly improves ESG ratings while also reducing rating dispersion. Long-term investors and those from high social-norm countries are particularly effective in driving these improvements. The results highlight the importance of foreign institutional investors in promoting sustainable and standardized investment practices.