11 Oct 2007Working Paper Summaries

How Firms Respond to Being Rated

by Aaron K. Chatterji and Michael W. Toffel

(Previously titled "Shamed and Able: How Firms Respond to Information Disclosure.") As national governments lose the ability to regulate business activities, interest groups and concerned citizens are turning to private governance to monitor global supply chains, ensure product safety, and provide incentives for improved corporate environmental performance. Proponents hope that private governance incentives will encourage firms to act responsibly, but critics worry that these developments will merely forestall necessary government regulation. Social ratings provide one way to benchmark and compare firms' social performance. But are such ratings schemes effective? This paper investigates the effects of third-party environmental ratings, and finds that firms are particularly likely to respond to such ratings by improving their environmental performance when two circumstances arise simultaneously: (1) when the ratings threaten their legitimacy, and (2) when they face relatively low cost improvement opportunities. Key concepts include:

Ratings provided by nongovernment organizations will be more influential on firm behavior if they do 2 things: highlight poor social issue management and performance while at the same time help firms identify low-cost improvement opportunities.
The role of third-party monitoring will be increasingly important as private governance replaces government regulations around the world.

Author Abstract

We apply institutional theory to explain how firms respond to information disclosure. Considering the impact of institutional and technical forces, we hypothesize that information disclosure is particularly likely to spur responses from firms whose legitimacy is threatened (and thus are shamed) and face lower cost opportunities to respond (and thus are particularly able). Testing this by examining how firms respond when their environmental performance is disclosed by a social rating agency, we find empirical evidence that supports our hypotheses. We present implications for theory and public policy.