On Price Regulation in the ESG Rating Industry

Lorenzo Coppi, Sander Heinsalu, and Salvatore Piccolo examine how price regulation shapes information quality and welfare in the ESG rating industry. Their paper demonstrates that while tools such as price caps or floors can correct distortions in rating precision, their effectiveness depends critically on the project’s risk structure, and misapplied regulation can significantly reduce value and welfare.

The views expressed in this article are the sole responsibility of the authors and cannot be attributed to Compass Lexecon or any other parties.

Abstract

A profitable, but potentially socially harmful project is financed by an uninformed lender inclined to fund socially valuable initiatives. To make more accurate investment decisions, the lender can buy information about the project type from two (or more) competing certification providers (raters). We compare two regulatory regimes: a laissez-faire regime, where raters are free to choose prices and information precision to maximise profits, and a regulated regime where rates are subject to price oversight by a regulator that maximizes the total value generated by the project. We show that information precision monotonically increases in price. When the project revenue features a decreasing Arrow-Pratt index, raters under-invest in information precision, and a price floor restores efficiency. Conversely, raters over-invest in precision when the project revenue features an increasing Arrow-Pratt index. Then a price cap restores efficiency. No regulation is needed in the knife-edge case of a constant Arrow-Pratt index. More generally, these findings indicate that, if misplaced, an indiscriminate imposition of price controls, such as universal price caps or floors, can significantly reduce value and welfare.