ESG Rating Confusion and Bond Spreads

Abstract: This paper investigates the impact of ESG rating confusion on bond spreads. Although confusion in ESG rating assessments is widely recognized, its effects on the bond market are not well understood. Using a pricing model for corporate bonds, the study finds that ESG rating confusion widens the bond spread. Data from China confirms that both primary and secondary bond markets are affected, with the latter being more impacted. The effect is amplified by increased information asymmetry and primarily driven by its effect on investors' preferences rather than the issuer's financial situation. Environmental and weighting inconsistencies are also documented as critical sources that account for the effects. Our research highlights the necessity of a more uniform ESG rating system to enhance investor confidence and facilitate issuers in financing ESG-related projects, as consistency among multiple rating agencies leads to smaller bond spreads. The findings have important implications for enhancing bond market efficiency and promoting ESG investment practices