Ratings

Ratings, defined as measuring and signaling the quality of something or someone, have existed for well over 100 years. The social science literature generally acknowledges credit rating agencies as one of the earliest formal rating systems. However, historians note that commodities have been inspected, measured, and graded for quality and purity for far longer (although some of the grading regimes were closer to certifications than ratings). Today, it is hard to think of a person, company, or industry that is not subject to some sort of rating regime. There are ratings on the safety of cars, the cleanliness or culinary merits of restaurants, the appropriateness of movies for specific audiences, the quality of universities, people’s creditworthiness, and the environmental friendliness of hotels. This entry discusses the functions of rating systems, their benefits and drawbacks, and how these systems can be made more effective.

In general, rating systems perform three functions: (1) they set quality standards, (2) they develop and implement measurement instruments to evaluate whether the quality standards are met, and (3) they signal to the public or other stakeholders the degree to which selected quality standards are achieved by an entity or person. Unlike similar systems such as accreditation, certification, and auditing, the institutions and people being rated need not necessarily opt in. Anyone or anything can often be evaluated and rated without explicit consent. However, some rating systems will award higher scores to participants who willingly supply requested internal data.

Promises and Pitfalls of Rating

Ratings have been associated with at least four benefits. First, they help bridge asymmetries of information and increase transparency. Take Moody’s, the first credit rating agency, as an example. It was originally formed in 1909 by John Moody, to advise investors on the costs and benefits of investing in new and unknown business ventures. Prior to its formation, investors mainly invested in businesses owned by people they knew. As the investment market expanded, people needed a way to evaluate reputation, risk, potential, and other qualities of unknown ventures owned by unknown people. While its scope and purposes have expanded, originally Moody’s rating publications helped bridge these asymmetries of information, educate stakeholders, and create new market opportunities.

Second, ratings can help identify best practices. Unlike accreditation and certifications, which tend to evaluate entities according to whether they meet fixed external standards, ratings tend to give a grade or score that can be used to compare companies or people with other companies or people, thus finding trends and relative best practices. For instance, the Access to Medicines Index rates pharmaceutical and biotechnology companies according to how accessible their drugs are for low- to middle-income developing countries and then lists them in a ranking that shows which companies are the top performers in providing access. The evaluation form asks companies to identify their relevant best practices and, thus, help the Access to Medicines Index identify leading best practices for the industry as a whole.

Rating systems may also incentivize better performance and improve quality within rated entities. Studies have shown that restaurants rated for their implementation of sanitation standards tend to improve their behaviors. This improvement has been correlated with a sustainable reduction in hospitalizations for food-borne illnesses, showing that rating systems can also be effective tools for advancing the common good.

Obviously, not all the benefits of ratings accrue solely as public goods. Entities that receive good ratings and rankings can potentially increase their market share, improve their reputations, charge higher prices for their products or services, and better retain and attract customers, employees, and socially conscious investors. Michelin-rated restaurants, for example, can and do charge higher prices after inclusion in the Michelin guide. Similarly, when companies and products have comparable prices and quality, those with the best reputations for social responsibility, something ratings can measure and signal, are more likely to attract and retain customers, employees, and socially conscious investors (indicated by ratings, e.g., the Calvert Responsible Index Series). Last, ethical reputations can also make a company or product attractive for mergers, acquisitions, and partnerships. Cadbury Schweppes acquired Green & Black’s fair-trade organic chocolates, L’Oréal bought the Body Shop, and Colgate Palmolive bought Tom’s of Maine in part because of their marketability as socially responsible and good brands.

Ratings can also help companies protect or repair reputations. In fact, most corporate social responsibility initiatives emerge less to increase market share and profits than to avoid negative reputational consequences. Early corporate participants in the Forest Stewardship Council Accreditation and Rainforest Certification for environmentally friendly timber products, the Flipper Seal of Approval for dolphin-safe tuna, and the Kimberley Process Certification for conflict-free diamonds joined chiefly to avoid consumer boycotts and degradation of public trust in their products and brands.

Conclusion and Moving Ratings Forward

Ratings are, naturally, not without their own quality challenges, as the recent failures of credit agencies have shown. These challenges should be addressed for successful advancement of the field and practice. Perhaps the largest, or at least the best-studied, risk to the integrity and objectivity of rating systems are financial conflicts of interest.

Credit rating agencies, for example, are financially dependent on the entities they rate. Most of their revenue is generated from fees paid by rated entities. Additionally, credit rating agencies, like other rating systems, habitually offer consulting services to the entities they rate, compounding their conflicts of interest. This practice raises questions about whether rating agencies can award low rating scores to their clients without the risk of losing them as clients. Similarly, there is also a risk that raters, consciously or unconsciously, may award biased higher scores to consulting clients over nonclients.

Moreover, in the case of ratings, more is not always better. The presence of multiple competing rating agencies may create opportunities for rated entities to patronize the “easier” rating agencies, thereby tempting raters to lower their standards or evaluate more leniently to attract and retain clients. Again, this can occur on both the rational and the unconscious level within rating agencies. Other potential pitfalls for rating systems are similar to those of more formal regulatory systems, including the revolving-door phenomenoon, in which raters move in and out of the rated industry and rating systems; cultural capture, in which raters unconsciously adopt the views of the industry due to social interaction; gaming, in which the rated entities intentionally corrupt, manipulate, and subvert the intent of a rating system’s standards without technically breaking them; and the like.

Finally, for ratings to be optimally effective, they should signal to the right people in the right ways. In other words, the information they provide should be embedded in the choice architecture of the information user (the person receiving the quality signal released by the rating) or risk being irrelevant and unused. Car safety and restaurant hygiene ratings are perhaps the best examples of salient ratings. Car safety ratings are displayed via stickers on the windows of cars in car showrooms. Thus, car buyers have access to the rating information precisely when they need it—that is, at the point of purchasing a car. Similarly, diners can see a restaurant’s rating on the window before walking into the establishment.