Various types of analysts measuring environmental, social, governance (ESG) factors in the financial and corporate world come to the conclusion that the “E” is the most important part of the term, as either environment or emissions. In a new study by SMU Cox Marketing Professor Milica Mormann and coauthor Felix Mormann, they actually show the effects of general and specifically-worded climate risk ratings on investment choices, the E. The research illuminates how framing or communicating can influence behavior—their work cuts across the disciplines of behavioral finance, marketing and policy as it relates to the unceasing debate on ESG-related ratings’ effectiveness and the potential for more specific climate ratings.

As of late 2021, the Climate Action 100+ initiative united some 615 institutional investors managing assets worth over $60 trillion to engage companies regarding emissions, governance, and climate-related disclosures. Just ask Elon Musk whether ESG, and Tesla’s varied treatment among ESG regimes globally, is an objective, meaningful measure of a firm’s holistic operations. Asset managers, and firms, have a stake in how things evolve.
Through a series of survey experiments, the authors found that including climate ratings significantly increases investment in the stock of companies with favorable ratings. That was the case even as other competing stocks featured a stronger return profile. A basically-labeled climate rating, for example, boosted investment in a more climate-friendly stock by over 20 percent, compared to the control scenario. When ratings were framed in terms of a company’s vulnerability to climate change, the effect was even stronger, channeling over 50 percent of additional investment toward the most “climate-resilient” stock. Their results confirm the impact of climate ratings on investor decision-making and underscore the importance of communicating climate risk in a format that speaks to investors.
Those salient themes were derived from using the types of words that companies use when describing their characteristics that conjoin climate risk. “We were surprised at the magnitude of the effect across ratings when communicated in differing ways,” Mormann noted. “It’s amazing how changing one word can have such a profound effect.” In follow-up research, Mormann and her co-author hope to understand why these different types of communications trigger different responses. “When you understand what is effective, and why, then you can start communicating around those themes.” When asked about their word choice, specifically about vulnerability and its outsized response, she notes, “In a social investing context, vulnerability reflects the idea of care, harm, or vulnerability as related to climate change issues.”

Climate risk and capital

Numerous investment and policy implications surround climate risk and ESG. But climate ratings can help overcome legal barriers imposed on asset managers. The “sole interest rule” of fiduciary trust law requires these asset managers to maximize the bottom line, something the ESG lens cannot always meet. According to the authors, there are well-established impacts of both physical and transitional climate risks on a company’s bottom line. For example, California Public Employees’ Retirement System (CalPERS), a fiduciary required to maximize the profits of its members, holds a sustainable investments program as a strategy to minimize “absolute” climate risk in their portfolio.
Following modern portfolio theory, most institutional investors attempt to mirror the economy, holding a broadly-diversified portfolio across the economy. The authors cite one Professor Condon who suggests—as “universal owners”—the financial incentives are strong to advance governance that will “mitigate climate change risks and damages to their economy-mirroring portfolios,” even if hurting an individual firm’s bottom line through activism. In the reference, this applies to assets worth over $4.5 trillion. Large investors advocate that a safe climate will protect the long-term value of portfolios representing all sectors and asset classes, a new “portfolio-oriented paradigm of shareholder climate activism.” The gains of climate activism at a portfolio level (versus an individual firm level) likely outweigh the costs of shareholder stewardship, thus offering longevity to the movement, they note.
In the U.S., retail investors directly hold over $16 trillion of stocks, or 38% of all U.S. equities. Adding in mutual funds, retail investors own nearly 60% of U.S. equities, for a total value of almost $25 trillion. The authors suggest that this segment would be well-served by the inclusion of climate ratings, especially with the rise of online brokerages and need for investor information. Additionally, the pervasive information asymmetries on capital markets related to climate change have been the subject of recent and ongoing litigation.
Compared to broadly framed ratings of firm performance with ESG metrics, the greater focus of climate-specific ratings would provide better investor information. The authors say ratings are attainable now— without market distortions. In The Economist’s recent report of EGS, they write:
“Even if ESG does not guarantee bumper returns, there are other ways to attract investors. One is through risk-adjusted returns. If investors have long time horizons, it makes sense to have risk-management mechanisms to screen companies for problems like climate change, regulatory or reputational damage.” The Economist

Building a rating

Rather than gather and analyze climate-related information for a host of companies themselves, the authors used hypothetical climate ratings to provide proof of concept. That such ratings can guide investor behavior and warrant the effort of data compilation and analysis. Modeled after the existing ratings of creditworthiness, their proposed climate ratings build on familiar methodology. Rating agencies owe their existence to information asymmetries between issuers of debt and investors, and climate ratings agencies can fill information gaps in capital markets. Firms, such as S&P and Moody’s, are considered a blueprint for corporate climate ratings. Ultimately, the authors believe the ratings would redirect the flow of capital toward more climate-friendly assets.
Representation of physical climate risk via climate ratings allows investors to determine the likelihood that climate change will disrupt a company’s supply-chain, flood its factories, or otherwise diminish its productivity. By assessing transitional climate risk, climate ratings enable financial markets to determine the real burden or cost, if any, of a carbon tax, cap-and-trade regime, or any other form of carbon pricing. The authors believe the rating would be a deterrent to evasive strategies like the relocation of carbon-intensive activities.

The study

Mormann and her coauthor tested the effects of climate ratings on capital allocation through a series of experiments conducted with over 1,500 participants. Consistent with insights from behavioral economics and finance, the magnitude of the climate ratings effect depends on the framing and format of ratings. Participants were asked to allocate $5,000 across three stocks.
In one experiment, when offering a generic climate rating, it produced an increase of $292 or 20% in climate-friendly investment. In a “Global Warming Pathway” format championed by Carbon Disclosure Project, an acknowledged climate rating watchdog of firms, cities and geographies, climate-friendly stocks fared only slightly better; the rating raised average investment in the specified stock with the lowest global warming pathway to $1,634, a gain of $190 or 13% over the control condition.
The rating labeled “Vulnerability to Climate Change” delivered by far the greatest spike in climate-conscious investment, leading participants to invest, on average, $2,243 in the company with the most favorable climate rating. This finding confirms that investors care deeply about the climate risk exposure of their potential investment targets. The average additional investment in the most climate-friendly stock is $799 for the Vulnerability condition and $292 for the Climate Rating condition, out of $5,000 invested.
Their data offer a cautionary tale insofar as the effect varies depending on the framing and display format of ratings. Higher average investment was observed in the most climate-friendly stock across all four treatment conditions; this effect was statistically significant only for the two conditions where climate-relevant information was presented using the labels “Climate Rating” and “Vulnerability to Climate Change.”

The literature on climate communication highlights the challenges associated with presenting complex climate-related information in an accessible way, the authors note. In the context of financially-relevant corporate climate data, this will require gathering, decoding, and recoding information from a variety of sources. Mormann relays that the cross-discipline approach coupled with her expertise in study design and testing helped with setting up and framing the research into something meaningful that approximates the real world. Quantifying this otherwise from a singular discipline approach, like finance, might not yield the same insights into human behavior.

In the constantly evolving scientific and policy landscape of climate change, the task of informational gap-filling will be neither easy nor cheap, says Mormann. “Things are changing with millennials and GenZs where more than returns matter, a purpose angle.” She says this shows up in consumer behavior in general.


The study mirrors more of the real world in a practical way. Mormann offers that in a digital, visual world where people can trade online on Robinhood or E*Trade, and they care about something like climate or environment, they aren’t going to read a 100-page report. “The number of users on Robinhood and similar platforms is material,” Mormann says. “The Robinhoods and others, because they are digital and visual (the idea behind her experiment design) can adjust their information easily to their clients wanting or expressing interest in a certain measure.” The ability to display such a salient factor in a relatively simple way is meaningful.

The authors note that environmental externalities— like the greenhouse gas emissions that drive global warming—represent one of the most challenging market failures of our time. Conceptually and empirically, the authors make the case for using corporate climate ratings to catalyze more carbon-conscious investment.

The paper “The Case for Corporate Climate Ratings: Nudging Financial Markets” was recently published in Arizona State Law Journal (2022) by Milica Mormann of Cox School of Business, Southern Methodist University, and coauthor Felix Mormann, Professor of Law and Engineering, Texas A&M University.

Written by Jennifer Warren.