The implied risks caused by ESG rating divergence: a test based on the cost of equity capital

Abstract

ABSTRACT Environment, Social, and Governance (ESG) performance serves as a crucial factor in investor decision-making; however, the existence of ESG rating divergence adds complexity and investment risk to assessing a firm’s sustainable performance. This article investigates the impact and the mechanisms behind firms’ ESG rating divergence on the cost of equity capital, enriches the research content of the economic consequences of ESG rating. This article uncovers the following key findings: (1) Increasing the divergence in a firm’s ESG ratings correlates with a rise in the cost of equity capital. (2) The influence of ESG rating divergence on the cost of equity capital, primarily through stock market performance. Specifically, ESG rating divergence positively correlates with stock price synchronicity, exhibiting a mediating effect on the cost of equity capital; it is negatively correlated with stock returns and turnover rates. (3) Digital transformation and financial institution shareholding negatively moderate ESG rating divergence and the cost of equity capital. (4) The impact of ESG rating divergence on the cost of equity capital is more pronounced in non-state-owned, non-cross-border listed, and small-size firms. The conclusions of this study provide references for relevant institutions to standardize rating systems, provide references for firms to optimize ESG information disclosure.