Navigating New Waters: Public Accounting Firms as ESG Raters

Abstract

This study examines how an accounting firm’s entry into the ESG rating market affects rating quality, exploiting Deloitte’s launch of ESG ratings in China. We find no evidence that Deloitte inflates ratings for its existing audit clients; instead, these ratings are more predictive of future ESG-related negative events as well as positive ESG performance. However, Deloitte assigns more favourable ratings to three types of potential clients: (i) large audit clients of other accounting firms, (ii) companies with high institutional ownership, and (iii) portfolio companies of mutual funds audited by Deloitte. For these companies, the ratings are more favourable but no more predictive of future ESG outcomes. In addition, these potential clients who receive high ratings from Deloitte are subsequently more likely to switch to Deloitte as their auditor. Overall, our findings offer a nuanced view of regulations that restrict auditors from providing ESG ratings to their own audit clients. The evidence suggests that independence concerns may be less pronounced for current audit clients, who are subject to greater scrutiny, and more relevant for prospective clients.