Governing ESG Ratings: Institutional Solutions to the Problem of Dimensional Distortion

Department of Business and Economic, University of Malaya, Malaysia

^* Corresponding author: s2175442@siswa.um.edu.my

Abstract

The impact of Environmental, Social, and Governance (ESG) ratings on sustainable investment and corporate accountability worldwide is significant. But there are major variances between ESG rating agencies that make them inconsistent and incomparable. This paper delves into the empirical phenomenon of dimensional distortion — systematic mis-specification of ESG factors in terms of their definition, weighting, and aggregating — discussing its origins and implications. Empirical evidence demonstrates that divergence leads to higher audit fees, greater financing costs, more extreme market fluctuations, and weakens the incentives for environmentally benign innovation and responsible institutional investors. Three main institutional drivers underlie this distortion of the bond-ratings market: (1) Fragmented and non-compulsory regulatory frameworks that lack common standards for disclosure and methodology; (2) Commercial incentives (and conflicts of interest) built into issuer-pay models, which encourage overrating; (3) Informal cultural-political factors that influence how companies behave and ratings are read in different countries. Meeting these challenges necessitates a coordinated approach of institutional governance reform emphasizing methodological harmonization, transparency, and cultural awareness. To sum up, this review highlights how badly new regulatory and governance solutions for making ESG ratings more credible are needed if a truly reliable, sustainable finance ecosystem is to emerge.