ESG Performance and Corporate Financial Results: A Review

Introduction

Investors are increasingly recognizing that environmental, social, and corporate governance (ESG) elements can substantially affect companies' security valuations and financial performance. These components' contribution to financial markets has grown with the rise in ESG-related opportunities and risks within the contemporary international economy. Timely and improved access to organizational policy data, and the effect of organizational policy on communities, have made it considerably easier for customers to express their dissatisfaction by simply abandoning a brand. When international brands' images are tarnished by ESG-related problems, the resulting instantaneous backlash has the capacity to abruptly and negatively impact income and demand (Eccles, Ioannou & Serafeim, 2014).

Organizations with a poor ESG reputation are vulnerable to monetary risks, including a genuine threat of future lawsuits, greater remediation and regulatory expenses, vulnerability to natural and man-made catastrophes, and potential loss of competitive edge to more innovative, forward-thinking firms. Meanwhile, sound corporate citizenship will typically result in reduced personnel turnover, increased productivity, superior customer loyalty, and improved brand image — all of which successively improve financial performance.

Rather than risk the dissatisfaction of clients, stockholders, and regulators, or damage to organizational business strategies, companies are engaging in progressive attempts to moderate likely ESG risks as a means of safeguarding brand value and ensuring stable demand for their products and services. Furthermore, corporations are developing novel solutions for addressing universal sustainability-related challenges across multiple sectors. These approaches may help bolster businesses' long-run competitive edge and financial performance (Eccles et al., 2014). Investors who recognize the significance of non-financial data in investment decision-making can effectively employ ESG factors for improved risk management and the generation of surplus returns.

Traditionally, ESG problems and externalities — such as air and water pollution, unethical corporate practices, and inferior work environments — negatively affected stock prices and business functionality only in extreme scenarios. Consequently, organizations often overlooked them in their normal investment appraisal practices. Similarly, externalities weakly influenced organizational executives' behavior owing to the lack of a perceptible feedback loop driving organizations to react to their non-financial problems and the associated opportunities and risks. Non-governmental organizations and regulators generally managed negative externalities (Trunow & Linder, 2015).

However, the past twenty years have witnessed a drastic transformation in this dynamic, driven largely by the speed with which information is transmitted via social media and the World Wide Web. Corporate supply chain extension and globalization to encompass developing markets has also contributed to increased focus on ESG externalities and issues, as companies gain exposure to a greater range of geopolitical, geographical, and regulatory settings. Developing economies' regulatory and legal systems are normally less effective than those of industrialized economies, making it more difficult for businesses to protect themselves from ESG issues and creating added risk for companies operating in these regions (Ang, Lam & Zhang, 2016). As emerging economies are identified by multinationals as an important source of income growth, inadequately addressing local ESG concerns may disrupt corporate supply chains or cause firms to lose market opportunities, thereby appreciably affecting business operations.

Firms' responses to the changing global economic landscape take the form of steps designed to tackle ESG opportunities and risks that can affect corporate financial performance — steps that are increasingly drawing the attention of investors. According to 2014 estimates, approximately $21.4 trillion of professionally managed assets worldwide applied ESG measures to investment analysis and portfolio composition (Global Sustainable Investment Alliance, 2015). Related regional data shows that American assets under management (AUM) worth $6.57 trillion clearly took ESG factors into account when investing, constituting a 76% rise compared to 2012 figures. European investment plans taking ESG into account similarly amounted to almost ten trillion Euros, representing 46% growth between 2012 and 2014 (Eurosif, 2010; Trunow & Linder, 2015). While these figures should not be accepted uncritically — given that most represent self-reported data and that there is no universally agreed definition of ESG criteria — the AUM data helps explain the directional growth of responsible investing and its market opportunities.

Despite several decades of research into the link between organizational financial performance and corporate social responsibility, a number of researchers maintain that considerable investigation is still needed before this relationship can be thoroughly understood. In particular, there is a need to construct models that incorporate previously overlooked variables (Chong & Phillips, 2016). This research therefore aims to bridge the gap in the literature regarding the combined effects of ESG elements on corporate performance, by including the synergistic influence of all three ESG dimensions in the analysis (Schadewitz & Niskala, 2010). For examining ESG synergistic impacts, this research proposes a concept of "inter-dimensional consistency" among ESG dimensions, examining how such consistency potentially affects the ESG–financial performance relationship.

Theoretical Framework

This research makes several contributions to corporate practice and related literature. First, it furthers emerging work on consistency by examining the effect of ESG factor correlations on overall company performance. Second, it develops multiple consistency measures based on ESG factor strengths, comparing company results relative to peer groups. Third, it proposes three-tier ESG consistency for gauging corporate dedication and effectiveness in establishing a competitive edge. Methodologically, the study employs 2011–2014 panel data sets for listed companies in EU-15 nations. GMM (generalized method of moments) estimation is applied to address dynamic endogeneity and potential unobserved heterogeneity. Finally, the study confirms that organizations displaying first-rate ESG performance will not necessarily outperform rivals in every non-financial dimension of performance, and that outstanding ESG firms need not maintain inter-dimensional consistency, as they may compensate for strengths in certain areas with weaknesses in others.

To what extent does an organization's ESG performance impact its financial performance, and will this relationship be moderated by the organization's industry type?

The value of ESG performance is founded on the convergence and interface of two elements: sustainable and responsible investment (SRI) and corporate responsibility (CR). The latter may be described as intentional organizational action aimed at improving environmental and social performance beyond minimum legal requirements (Freeman et al., 2010). Corporate responsibility investments are a type of intangible corporate asset associated with long-run performance, acquired through reputational and functional advantages. Functional advantages resulting from internal organizational activity — such as cost-cutting, output, and operational efficiency — are slow to surface and offer no guarantee of future success. Concurrently, every corporate responsibility initiative is a potential source of positive client and market views of the organization (reputational advantages), which indirectly impacts future revenue. A strong reputation boosts sales, reduces the opportunity cost of investment, helps attract and retain competent individuals from the labor market, increases customers' willingness to pay a premium price, and encourages investors to hold or purchase company stocks. Positive client and stockholder attitudes toward effective CR performance and executive team competence are encompassed under reputational impacts (Ramiah, Martin & Moosa, 2013).

Additionally, a distinctive aspect of corporate responsibility as an accrual is its ability to alleviate the severity of litigation actions should future regulations become more stringent or new taxes arise from increased social and environmental concerns (Godfrey, Merrill & Hansen, 2009). When new laws and standards emerge, businesses in at-risk ESG segments face greater uncertainty, as corporate bottom lines are immediately impacted and cost pressures are imposed. A related CR function involves the reduction of future costs or income outflows linked to legal requirements, though the precise timing of these risks is difficult to ascertain.

Stakeholder theory operationalizes the CR dimension. The theory defines a company's stakeholders and reconciles stakeholder interests with corporate profit-maximization objectives. Clients, stockholders, suppliers, workforce, special interest organizations, non-governmental organizations, communities, and regulators typically constitute a company's stakeholders. The contemporary CR concept has evolved into three key stakeholder relationship categories: environmental (E), social (S), and governance (G). For instance, workforce satisfaction enhances motivation and retention rates, in addition to stimulating the development of novel patents, products, and deals. Through such long-run performance improvements, employee satisfaction ultimately proves beneficial to stockholders (Edmans, 2011).

Scholars have described organizational ESG performance with respect to corporate responsibility principles, CSR processes, and organizational policies, initiatives, and behavioral outcomes (Wood, 1991). Corporate environmental performance (CEP) largely denotes organizational environmental management, encompassing pollution prevention (through state-of-the-art technologies or procedures employed in manufacturing), pollution control (end-of-pipe processes involving physical equipment), and product management (improvements to product lifecycles through decreased material consumption, product reuse, and recycling).

Organizational social performance denotes stakeholder management, requiring the organization to address the interests of key stakeholders including the workforce, suppliers, and community. The chief emphasis is on organizational adherence to fundamental human rights norms and procedures. Personnel relations indicate a company's employment systems and policies, including employee engagement, job satisfaction, safety and health initiatives, and equality policies (Bauer et al., 2009; Edmans, 2011). Community participation encompasses charitable contributions, support for academic and housing programs for disadvantaged groups, operational policies specific to sensitive nations, and volunteer programs. Supplier management involves the extent to which the firm takes human rights into consideration in its contractor or supplier selection process.

For research purposes, organizational governance performance represents shareholder-rights levels that ensure the executive team and lower-level managers act in the long-run interests of shareholders (Gompers, Ishii & Metrich, 2003). This includes, for example, autonomous decision-making via a self-governing, qualified, and diverse executive team, the establishment of key board committees, and linking compensation to corporate or individual financial and non-financial goals.

On the whole, the concept of corporate responsibility indicates that ESG elements, as distinct intangibles, likely affect the firm's future risk profile and anticipated revenue. Share price effects are essential to non-financial performance according to the basic valuation model.

Renneboog, Zhang, and Horst (2008) define SRI as a process of investment that combines investment decisions and ESG factors with financial objectives. SRI share markets are often divided into two parts — profit-seeking and values-driven — on the basis of the investment screens used in portfolio construction (Derwall, Kojedijk & Horst, 2011). The latter segment is associated with norm-constrained stockholders who incorporate ethical conditions for reasons unconnected to future organizational revenue. The SRI sector was dominated by negative screens for more than seven decades, during which portfolios commonly excluded stocks in controversial sectors such as tobacco, alcohol, military, gambling, and firearms. According to Kacperczyk and Hong (2009), values-driven segments lead to underpriced controversial stocks with higher anticipated returns. This type of stockholder behavior gives rise to market inefficiency when "sin stocks" are traded below their fundamental values. The researchers also found that greater abnormal rates of return, as compensation for out-of-market risks, were linked to increased litigation risk. Because positive differentials between anticipated and actual earnings for sin sector firms are unlikely, sin-related impacts tend to remain fairly constant over time due to the widespread nature of social norms (Derwall et al., 2011).

More recent research reveals that the profit-seeking segment of the SRI market comprises stockholders who incorporate ESG factors into their basic valuations to achieve conventional financial objectives. This approach makes use of positive screens, selecting stocks with superior ESG scores for portfolio construction. Derwall and colleagues (2005) found that an environmentally efficient, highly ranked portfolio is linked to a greater abnormal rate of return, as such shares are mispriced by the market within a short valuation horizon — that is, the market under-reacts to ESG factors. Consistent with this finding, Borgers and colleagues (2012) and Greenwald (2010) found that ESG stocks generally achieve actual returns beyond estimated returns, producing surprises for market analysts.

Derwall and colleagues (2011) further asserted that such market inefficiency disappears once the market becomes fully aware of ESG influences on anticipated future cash flows. An examination of expectation errors indicated that stocks' abnormal rates of return associated with strong employee relations weaken as the valuation horizon lengthens, as investors correct their erroneous predictions. Bebchuk, Wang, and Cohen (2013) were among the first to address the learning and diminishing effects of governance on abnormal revenue, finding that sound governance is not linked to abnormal returns once it has been incorporated into stock price calculations. An alternative explanation — misspecification of the Fama-French-Carhart four-factor model — is not supported by this study. The learning and prediction-error assumptions align with the conventional efficient market hypothesis, which holds that stock prices fully reflect all publicly available corporate data, including ESG data.

The United Nations' Principles for Responsible Investment (UN PRI) program has actively promoted the incorporation of ESG factors into ordinary investment decisions, reinforcing analyst understanding of ESG elements' contribution to the accuracy of return predictions and risk management. The United States' SIF (Social Investment Forum) and Europe's EUROSIF (Sustainable Investment Forum) estimated the 2012 SRI market's size at approximately fourteen and eleven percent of AUM in Europe and America, respectively. Eurosif's 2010 analysis of SRI markets indicated that the region's SRI market doubled within two years despite the global financial downturn, with overall SRI AUM growing from 2.7 trillion Euros in December 2008 to five trillion Euros within a single year. The 2012 American SRI report showed $3.74 trillion worth of overall SRI assets by the end of 2011, representing a 22% growth from the 2009 figure. The same year's European SRI analysis revealed 6.8 trillion Euros worth of assets at the end of 2011.

According to UN PRI's 2012 statistics, almost 1,100 parties across the globe with $32 trillion in AUM had adopted a policy taking ESG factors into account in investments. Mainstream financiers accounted for nearly three-quarters (73%) of PRI parties. With the PRI's growing emphasis on ESG integration, a better understanding of the tangible effects of ESG elements on organizational financial performance is increasingly significant for organizations and their stockholders.

In summary, the SRI framework indicates that stockholders' activity of buying stocks associated with superior ESG ratings has been guided by wealth-maximization effects, owing to the positive impact of ESG factors on future returns and to positive market expectations created by both individual and institutional investors. Abnormal ESG-linked trading returns will persist until market participants become aware of the distinctions between ESG leaders' and laggards' financial incomes and incorporate these differences into basic valuations.

Measuring ESG Performance

Numerous rating agencies — including Sustainalytics, Vigeo, Calvert, GES, ASSET4, Trucost, and KLD — gauge organizational ESG performance. KLD ratings are among the first and most prominent, particularly within the American stock market, and are most commonly used by research scholars for comparisons with more recent global ratings such as GES and ASSET4. In 2009, a consolidation of financial and ESG data providers took place, serving a broad collection of users including research scholars, stockholders, and financial analysts. Riskmetrics Group acquired esteemed ESG rating firms such as Innovest Strategic Value Advisors and KLD; these were subsequently acquired by MSCI, which provides performance and risk data analysis and stock market indices. ASSET4, the recognized non-financial data provider, was purchased by leading financial data firm Thomson Reuters.

Pfeiffer, Cho, and Lee's (2012) study found that CSR performance scores derived from KLD ratings decrease data asymmetry. Informed financiers, particularly institutional ones, capitalize on their informational advantage in assessing businesses' market value. Specifically, they show that community, diversity, and employee relations ratings reduce uncertainty in market data. Negative corporate responsibility performance scores depict a relatively stronger effect on bid-ask spread (a proxy for information asymmetry) than positive performance scores.

KLD ratings utilize both positive and negative ESG screens to identify an organization's strengths and weaknesses, respectively. Individual screens are encoded as binary variables indicating whether firms satisfy specific conditions. The widespread academic practice is to derive a net score by subtracting concerns from strengths (Chatterji, Levine & Toffel, 2009; Statman & Glushkov, 2009). Researchers also study KLD measurement systems individually; for instance, the KLD environmental concerns component has been used to differentiate between better and worse environmental performers (Cho & Patten, 2007) and to identify firms with inferior environmental performance ratings (Chatterji & Toffel, 2010). Prior studies consistently support the view that KLD measures form reliable ESG performance proxies (Cho, Lee & Pfeiffer, 2012; Kim, Park & Wier, 2012).

More recently, scholars have employed other ESG measures as well. A complex Innovest environmental efficiency measurement system (Derwall et al., 2005; Guenster et al., 2011) was used to operationalize environmental efficiency, defined as the simultaneous maximization of organizational process efficiency and minimization of environmental impacts (Sinkin, Wright & Burnett, 2008).

Olsson (2007) and Hassel and Semenova (2008a, 2008b) developed a multifactor approach to organizational environmental performance using GES firm-specific environmental performance and preparedness measures, as well as sector-specific environmental risk ratings. The environmental readiness outcome denotes the extent to which an organization applies environmental policies and discloses policy implementation publicly to demonstrate proactive participation in environmental strategies. The environmental performance outcome encompasses corporations' proactive functional capacity to decrease environmental vulnerabilities and impacts through environment-oriented competences and resources. Environmental industry risk refers to the sector's overall environmental risk level; environmentally sensitive industries such as mining, metals, paper and pulp, gas, oil, and chemicals therefore carry higher environmental industry-level risk scores.

Hassel, Nilsson, and Semenova (2010) also examined how stock prices are separately affected by different GES social performance scores. These GES indices assess how organizations manage their relationships with their workforce, suppliers, and communities in terms of globally accepted human rights standards. Organizations are assessed under the following social performance categories: (I) personnel, including safety and health policies, working hours and pay, forced or child labor, and diversity; (II) suppliers, encompassing human rights initiatives and supply chain firms; and (III) community, encompassing community engagement initiatives and policies.

Several research works have examined the validity of ESG ratings. Sharfman (1996) studied the construct validity of a collective KLD organizational social performance measure by comparing it with information from a Fortune reputation survey and from the asset lists of well-known mutual funds selected on the basis of social performance. Results suggested that KLD organizational social performance scores were moderately correlated with other organizational social performance measures, indicating that they measure the same underlying concept, at least in part.

Mattingly and Berman (2006), using descriptive factor analyses, aimed to group KLD organizational social performance elements into four latent constructs based on existing organizational social activity typologies. Their results chiefly revealed that KLD strengths and concerns are theoretically and empirically distinct organizational social activity constructs.

Semenova's (2010) study found that GES, ASSET4, and KLD environmental scores exhibit convergent consistency and validity across both low- and high-risk sectors. ASSET4 and GES environmental performance scores and KLD environmental strengths represent reliable aggregate measures converging on an identical construct. KLD environmental weaknesses, however, tend to be risk-specific measures of environmental actions closely linked to GES environmental sector risk. Cho and colleagues' (2012) study aligns with this finding and recommends that future studies avoid using net KLD scores, in order to preserve the information inherent in both positive and negative KLD performance measures.

Past research has also scrutinized ESG performance as reported in organizations' standalone sustainability reports and annual financial reports (Cormier & Magnan, 2007; Schadewitz & Niskala, 2010). More corporations than ever are now publishing Global Reporting Initiative (GRI)-based sustainability reports, with almost 8% of the world's largest 250 corporations currently reporting their ESG performance; of these, 4% report on a combined basis.

Researchers have, however, raised questions about the applicability of voluntary ESG performance disclosure, arguing that such disclosures vary in content and scope and have limited utility in ESG performance measurement (Barth & McNichols, 1994; Hedberg & Malmborg, 2003; Clarkson et al., 2008; Tagesson et al., 2009). Bouvain and Chen (2009) note that some organizations have a long history of non-financial data reporting across the full continuum of ESG aspects, while other firms offer limited or no data. Semenova and colleagues (2010) assert that content analyses of organizational reports may produce conflicting findings when studying the association of corporate market value and ESG performance with ESG disclosures. This is because researchers often fail to distinguish between voluntary and mandatory disclosure types, combine ESG performance elements, employ multiple indicators for assessing voluntary disclosures, and face time constraints. Prior research presumes that a relationship exists between ESG scores and underlying corporate disclosure because rating firms scrutinize these facts alongside alternative sources over time before constructing their measures (Cho et al., 2012). Inclusive third-party scores on corporate ESG performance aim to aid stockholders in making informed decisions.

GRI attempts to formulate a reporting system that strongly underscores corporate ESG performance, offering stakeholders comparable, applicable, and significant data. One may expect a gradual shift in emphasis from separate sustainability reports and financial data toward an integrated form of reporting in which all relevant information for assessing organizational management quality, company value, performance, and impact is presented comprehensively. On the whole, the development of ESG scores illustrates a slow assimilation of non-financial and financial measures for acquiring an inclusive picture of long-run corporate risk and performance (Hassel & Semenova, 2013). Solitary past ESG performance statistics, such as pollutant emission measures, are of limited analytical value from a fundamental evaluation standpoint as well as from the perspective of the primary multidimensional ESG performance construct.

Conclusion

This study contributes to the growing literature on ESG performance and corporate financial outcomes by examining the synergistic effects of all three ESG dimensions simultaneously. Firms displaying first-rate ESG performance will not necessarily outperform rivals in every non-financial element of performance. The study implies that every outstanding ESG firm need not maintain inter-dimensional consistency; they may be able to counterbalance strengths in certain areas with weaknesses in others. These findings carry important implications for investors who rely on ESG-integrated investment strategies and for managers seeking to align non-financial and financial performance goals.