March 13, 2009

Can SRI Ratings Predict Corporate Behaviour?

by Ron Robins, MBA*

From my globally popular ethical investing website, Investing for the Soul

So far there are only a few studies in this area and at best they point to weak
linkages between an individual company’s SRI (socially responsible investing) ratings
—as assigned by ratings agencies—and its subsequent corporate behaviour.

The first study I will review is, Imitate or Differentiate? Evaluating the validity of
corporate social responsibility ratings, by Aaron K. Chatterji (Duke University), and
David I. Levine (University of California), published in February 2008. This study
analyzed data from top SRI ratings firms which included KLD Research & Analytics,
Inc., Calvert Group, FTSE4Good, Dow Jones Sustainability Indexes, and Innovest
Strategic Advisors. The focus was on the raters’ ability to predict which companies
they followed would later get involved in scandals. Regrettably, the results found
that raters could not predict which companies would become embroiled in them.

Firms with both high and low ratings were equally likely to be entangled in scandals,
according to the researchers. Furthermore, neither a “… narrow focus on governance
or a broad measure of social responsibility (including charitable giving, environment
impact, product safety, etc.) seems to distinguish firms that will have major scandals
from those who will not.”

However, in another study we see some glimmers of hope with SRI raters in
predicting corporate behaviour relating to the environment. The study is titled, How
Well do Social Ratings Actually Measure Corporate Social Responsibility? Researchers
again included Aaron K. Chatterji and David I. Levine, but now also included Michael
W. Toffel (Harvard Business School). Focusing on KLD’s SRI screening, they
concluded that, “… firms with more KLD ‘concerns’ have slightly, but statistically
significantly, more pollution and regulatory compliance violations in later years.
[However], KLD environmental strengths [ratings], in contrast, do not accurately
predict pollution levels or compliance violations.” The researchers say that KLD might
be able to significantly improve upon their predictive ability in the environmental
area with adjustments to the way they gather and use data.

Of course, besides looking at corporate scandals and environmental concerns, there

are many other variables that could be studied. Hopefully, in time such research will
be completed and provide us with a better understanding and modeling methodology
to improve the predictive power of SRI corporate ratings by rating organizations.

However, there is recent evidence that ratings can encourage companies with poor
ratings to perform better. In the 2008 study, How Firms Respond to Being
Rated, again by Aaron K. Chatterji and Michael W. Toffel, and covering 600 firms in
the USA rated by a prominent social rating agency, they say that, “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 [like SRI ratings].”
Congratulations to Aaron Chatterji and his colleagues in pioneering this important
area of research. Most likely many others will join them in such research and in time
create a set of variables that have greater predictive power in determining corporate
outcomes and activities.

My next editorial reviews the ability of SRI raters’ ability in foretelling an individual
company’s stock market performance. Similarly, the possibility of SRI raters in
predicting the outcomes of groups of stocks and portfolios will be examined as well.
And these results are more promising.

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*Ron Robins, MBA, is founder, Investing for the Soul,

(http://investingforthesoul.com/), a globally popular and respected ethical investing
website. He advocates, writes and teaches on the subject of ethical investing. To
contact him, e-mail to Ron Robins or call 705-635-3034.

© Ron Robins, 2009. Permissions: Provided full credit, which includes title, my name, and link to this post is
given, anyone may print or re-produce this article in part, or in full, to any relevant web page.