How Firms Respond to Being Rated

Michael W. Toffel Harvard Business School, Soldiers Field, Boston, MA 02163, [email protected] August 28, 2008 While many independent rating systems are designed primarily to help buyers overcome information asymmetries when making purchasing decisions, we investigate whether these same ratings might also influence the companies being rated. We focus on corporate environmental ratings, the primary purpose of which is to help investors select “socially responsible,” and avoid “socially irresponsible,” companies. We hypothesize that company ratings are particularly likely to spur responses by firms that receive poor ratings, especially those that face lower cost opportunities to improve and that operate in highly regulated industries. Our empirical analysis examines how nearly 600 firms in the United States respond to corporate environmental ratings issued by a prominent independent social rating agency, and avoids selection issues by taking advantage of a natural experiment that arose when the agency expanded the scope of its ratings. We find empirical support for our hypotheses, and present implications for managers of rated companies and of private and public rating agencies. While negative ratings may “shame” firms that are performing poorly, the threat of regulatory action and the presence of “low hanging fruit” are important drivers of how firms respond to information-based incentives.