Link of Environmental, Social, Governance and Firm Performance: History
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Amir gholami
,
Peter A. Anthony Murray
,
Stephen Sands

ESG performance has a positive relationship with profit in large firms but not in SME firms. Large firms are motivated by stakeholder and other needs, while SME firms do not have the same priorities. Similarly, small and nascent firms may not have the resources of large firms, suggesting that competitive factors related to downstream networking will markedly differ for both groups of firms.

  • environmental
  • social and governance
  • firm financial performance

1. Introduction

The irresponsible disclosure behaviour of firms leading up to the 2008–2009 period of financial turmoil has been a consistent global driver of corporate efforts to improve environmental, social and governance (ESG) performance [Global Economic Crisis (GFC)] [1][2]. Improving corporate ESG performance creates a win-win situation for firms, direct shareholders and stakeholders, and the overall economy [3][4]. This can be supported conceptually by both legitimacy and stakeholder theory, where the increasing number of social contacts between firms and their community of stakeholders is beneficial.
Firms are encouraged to enhance their ESG performance to achieve greater support from stakeholders [5][6][7][8] and provide improved financial performance for firms [9][10][11]. However, previous studies report inconclusive findings. For example, Whelan et al. [12] summarized published or corporate studies between 2015 and 2020 that concentrated on the association between ESG and a firm’s financial performance, such as ROA and ROE. Their analysis identified positive, neutral or negative results of prior studies, which is consistent with the results produced by Margolis and Walsh [13]. Margolis and Walsh [13] found only a positive association. However, these studies tested the association between ESG and financial performance for large firms with largely diverse ownership. By comparison, smaller firms, such as small to medium enterprises (SMEs), tend to have narrower and more concentrated ownership structures, with many SMEs not practising the same level of disclosure (e.g., Zadeh and Eskandari [14]). Al Fadli et al. [15] argue that this difference in disclosure levels may be due to narrow ownership of smaller firms providing access to more proprietary information than experienced by large firms’ shareholders and internal stakeholders, and therefore, the same level of disclosure is not considered necessary.

2. Link of Environmental, Social, Governance and Firm Performance

2.1. ESG and Firm Performance

Social contract theory provides a basis for the theoretical social contract between firms and their stakeholders [16][17]. There are two aspects to this theoretical social contract. The first aspect is related to investors who wish to maximise their investment return while the second relates to the broader issues of operational sustainability and corporate governance [18]. These two aspects form the current norms and expectations of the broader community. That is, firms’ value system is perceived as being congruent with the value system of the larger social system of which the entity is a part and must conform to the terms of the social contract [19]. This conformity with social contracts consists of sets of formal and informal agreements that apply to the firms themselves and their various stakeholders, that is, social contracts comprising sets of formal and informal agreements between societal groups and obligations toward each other [20]. For example, firms’ theoretical social contract with the broader community includes banks and other large fund providers, institutional investors, employees, as well as customers [21][22]. These external and internal stakeholders also have a theoretical social contract with the broader community and are motivated to project their conformity with both aspects of the social contract. The fundamental association between parties to this social contract is a reciprocation legitimacy identified in legitimacy theory [17]. Here, the managerial branch of stakeholder theory [5] explains the motivation of managers to meet the ESG disclosure needs of dominant stakeholder groups that affect firms’ ongoing survival.
The managerial branch of stakeholder theory explains how managing the relationship with different stakeholder groups through corporate disclosure helps to improve firm financial performance [5][6]. Different groups’ needs are prioritised through mapping the salience of each group based on three criteria: power, authority, and urgency [23]. The highly salient stakeholders’ group is categorised as having a high rating for all three criteria. Therefore, firms are motivated to enhance ESG performance disclosure to improve reputation and accountability [24], which, according to scholars, leads to increased financial performance [9][10][25].
Although the most prevalent view of the relationship between ESG and firm financial performance is positive, there are some contrasting findings in the literature [26][27][28]. For instance, although the relationship is reported to be moderately positive in some literature [26][29][30], some report neither a significant relationship [31] nor a neutral one [32]. Environmental performance has been positively related to return on assets (ROA) [33][34], which is consistent with some meta-analysis studies [35][36][37].
From the stakeholder theory viewpoint, prior literature [6][38][39], and the mode posited recently by Fatemi et al. [40] responsible behaviour of a firm positively impacts a firm’s financial performance. It can also mitigate potential damage to a firm’s market value through a commitment to socially responsible behaviour [41]. Paredes-Gazquez et al. [42] reveal a positive association between corporate social engagement and financial performance, while numerous studies find a positive association between corporate governance and financial performance [43][44]. Corporate governance is the main driver of firm sustainability, and ESG investment is critical [45]. Rabaya and Saleh [46] found that ESG disclosure had a positive influence on the competitive advantage at the firm level over ten years, which led to increases in financial performance. For instance, within the strategy field, Lavie, et al. [47] suggest that ‘over time, repeated use of exploitation routines generates reliable feedback that enables organisations to refine their existing competencies further and evaluate better the likely success of exploitation efforts’. Regarding ESG and financial performance outcomes for SMEs, it is thus less likely that financial performance will be influenced over a shorter period after implementing ESG innovations. More likely, it takes longer periods to embed ESG capabilities such that there is a lag in performance. Also, for ESG studies thus far, a longitudinal research design with some exceptions (e.g., Drempetic, Klein and Zwergel [48]) has not been reported in prior research within an SME context.

2.2. Firm Characteristics and Performance

Another stream of the literature delves into the diverse components of ESG performance and its impact on financial performance. Cormier and Magnan [49] propose that the trade-off in relation to corporate ESG performance disclosure may vary, particularly in respect of large and SME firm characteristics [48][50]. Therefore, a firm’s characteristics, such as its size, management structure, reputation and media exposure, should be considered [51].
Friedman et al. [52] provide the most dissenting viewpoint, arguing that corporate ESG performance disclosure imposes costs higher than its benefits and causes a misallocation of corporate resources. Nevertheless, the literature focuses on the modest positive relationship between a firm’s ESG performance and profitability [26][27][53][54][55]. However, higher costs through implementing ESG initiatives and increasing ESG performance disclosure may be more achievable by larger firms. Extant research identifies the higher cost of implementing ESG [56] plus the higher cost of increasing the level of ESG performance disclosure [57]. Barauskaite and Streimikiene [58] conclude that ESG initiatives lead to both additional benefits and additional costs for businesses.
Some studies recommend that good ESG performance can enhance a firm’s reputation and operational performance [10][59]. Cornett et al. [60] argue that larger financial firms follow sustainable behaviours on a larger scale than smaller ones. This trend may be present for larger and smaller firms irrespective of industry. Moreover, a recent study by Drempetic, Klein and Zwergel [48] found that ESG scores do not realistically measure the sustainability performance of a company and that firm size—such as corporate firms—are more advantaged as they have access to data availability and the necessary resources for providing ESG data. Interestingly, these scholars found that ‘ESG scores [are] distorted in favour of large companies because ESG scores are dependent on resources for providing ESG data. In respect of the current study’s aims, more needs to be known about the influence of ESG on the financial performance of SMEs since these limited studies have mainly focused on ESG and sustainability as distinct from ESG and financial performance.
Rabaya and Saleh [46] dissected their analysis into large and small firms and found that although there is a percentage difference between the two firm sizes, both small and large firms experienced an increase between ESG implementation and firm performance. The efforts implemented to address ESG issues constitute a cost to a firm that may lead to lower profitability, but cost-effective improvements from reduced waste and energy-saving benefits tend to offset the initial costs [61]. In summary, large firms have the financial capacity to pursue sustainable business on a greater scale than smaller firms, and therefore, the large firms’ greater investment in ESG performance disclosure may result in these firms having a greater competitive advantage and subsequent profitability.

This entry is adapted from the peer-reviewed paper 10.3390/su14106019

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