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A non-linear assessment of ESG and firm

performance relationship: evidence from China

Ganlin Pu

To cite this article: Ganlin Pu (2023) A non-linear assessment of ESG and firm performance
relationship: evidence from China, Economic Research-Ekonomska Istraživanja, 36:1, 2113336,
DOI: 10.1080/1331677X.2022.2113336

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ECONOMIC RESEARCH-EKONOMSKA ISTRAŽIVANJA
2023, VOL. 36, NO. 1, 2113336
https://doi.org/10.1080/1331677X.2022.2113336

A non-linear assessment of ESG and firm performance

relationship: evidence from China
Ganlin Pu
School of Economics and Management, Wenzhou University of Technology, Wenzhou,
Zhejiang, China

ABSTRACT ARTICLE HISTORY

The main objective of this paper is to assess the non-linearities Received 26 March 2022
between the ESG activities and firm performance in case of an Accepted 6 August 2022
emerging market. China is identified as a case study for the pre-
KEYWORDS
sent examination. Even though this research objective has been
ESG; firm performance;
explored by past researcher, the evidence presented in literature emerging economy; China
is not conclusive. The paper hypothesizes that such conflicting or
inconclusive results can potentially be attributed to wrong model- JEL CODES
ing, datasets that include both developing and the developed C32; E44; G12
markets, and the prevalent endogeneity issue in corporate gov-
ernance literature. For the purpose of this paper, the author uses
the dynamic panel approach of First difference and the System
Generalized Method of Moments. The findings from the analysis
of 232 Chinese listed firm show a positive association between
ESG activities and the firm performance. However, the relationship
is nonlinear. In other words, the relationship between ESG activ-
ities and the firm performance is inverted U-shaped. This indicates
the relationship is positive up to a certain threshold and once the
ESG activities cross that threshold it start to have negative effect.
The key insight from this research is that the firm has to find their
threshold of ESG activities to gain maximum benefits from
such activities.

1. Introduction
Sustainability themed investing is a subset of principle-based investing which pays
close attention to issues related to environment, governance and society. The overall
movement towards sustainable investing seeks to ensure that all stakeholders are
taken care of while making investment decisions. This is a deliberate move towards
an approach commonly referred to as ‘Triple Bottom Line’ or 3 Ps (People, Planet
and Profit). The idea is to move and expand outward from the sole objective of
‘Shareholders’ Wealth Maximization’ to maximizing the benefits of 3 Ps.

CONTACT Ganlin Pu [email protected]

ß 2022 The Author(s). Published by Informa UK Limited, trading as Taylor & Francis Group.
This is an Open Access article distributed under the terms of the Creative Commons Attribution-NonCommercial License (http://
creativecommons.org/licenses/by-nc/4.0/), which permits unrestricted non-commercial use, distribution, and reproduction in any
medium, provided the original work is properly cited. The terms on which this article has been published allow the posting of the
Accepted Manuscript in a repository by the author(s) or with their consent.
2 G. PU

The surge in sustainability investing over the past decade is encouraging for vari-
ous stakeholders including advocates of sustainability investing. In fact, the total sus-
tainability assets are estimated to be USD 37.9 trillion in December 2020 and as per
the projections, are estimated to reach USD 53 trillion. The total sustainability assets
are expected to reach USD 140 trillion by 2025 and this would make them one-third
of the total assets in the industry. More than half of these assets are in Europe but
US has also shown remarkable growth in the past couple of years. In Asia, Japan
leads the way in the sustainability industry. As per the reports of the Global
Sustainable Investment Alliance (GSIA) and McKinsey, a significant proportion of
sustainability assets are based on the negative religious based screening criteria
(mostly Islamic finance) amounting close to USD 20 trillion.
Sustainability is a broader term denoting the ethical dimension of investment deci-
sion-making. For instance, Islamic finance investing is one of the types of sustainabil-
ity investing. In this paper, the focus is on the Environmental, Social and Governance
(ESG) type of investing definition. The ESG is one of the crucial subsets of sustain-
ability investing and has garnered global response from investors, policymakers,
industry players, regulators and other market players (Escrig-Olmedo et al., 2013; Hill
et al., 2007). The onslaught of COVID-19 seems to be a critical turning point for the
ESG industry as the global health crisis has led to heightened interest in the ESG
industry. Many institutional and even retail investors are pushing asset managers and
firms to incorporate ESG criteria in their investing and business approach. As per the
report of Morningstar, the ESG compliant Exchange Traded Funds (ETFs) witnessed
total fund inflows worth USD 38 billion in space of space of months that is from
January 2020 to July 2020. The total fund inflows are approximately twice of what
these ETFs received during the same time in 2019. In fact, Amundi, one of the largest
fund managers in the EU region, has made a claim that the ESG principles have
become a screening criterion for fund managers in Europe. The ESG screening crite-
ria use a mix of negative and positive filters to create their portfolios (Klepek &
Bauerov
a, 2020). The interest in the ESG industry has also forced the lawmakers to
start creating regulations and guidelines at the national level. For instance, Nasdaq
US has already issued reporting guidelines on ESG (‘ESG Reporting Guide 1 and 2’).
The objective of these reporting guidelines is to provide a framework to listed firms
on the reporting of ESG related matters (Dhiman & Arora, 2020). The guidelines are
also intended to encourage and motivate small businesses or SMEs to start engaging
in ESG disclosure reports (Ruan & Liu, 2021). Some of the regions have gone a step
ahead and made it mandatory for firms to either disclose ESG-related information or
explain the reason for not disclosing ESG related information. In other words, EU
has made it mandatory by issuing a guideline—comply or explain indicating that fail-
ure to comply or explain can result in high penalties. Along the same lines, China
has made significant progress towards regulating the ESG-related disclosures
(Gudanowska et al., 2020). For instance, the securities commission of China has
revised the guidelines related to governance of listed firms. The revised guidelines
now require the listed firms to disclose environment related information in the
annual report (Goettel, 2021). Additionally, it also requires the firm to disclose the
social responsibility they are carrying out throughout the year (Aghmiuni et al.,
 ECONOMIC RESEARCH-EKONOMSKA ISTRAŽIVANJA 3

2020). For instance, the firms can share information as to how they are tackling the
issue of poverty as part of their social responsibility (Ruan & Liu, 2021). Similarly, at the
macro front, the concept of ESG is compatible with China’s five development concepts.
These concepts are; innovation, coordination, open, green and inclusiveness.
With so much at stake, academics and the policymakers have examined the effect
of sustainability on the performance, especially at the corporate level. However, there
is no definite answer to this question and the evidence so far on this issue is mixed
(see for instance, Kitzmueller & Shimshack, 2012; De Lucia et al., 2020).
In this paper, the debate on performance effect of ESG is revisited using data per-
taining to China. The case of China provides a good example as the Chinese have
made significant progress over the past few years in terms of policy initiatives and
effectively regulating the industry. Moreover, China is an emerging country and has
unfortunately become one of the most polluted countries in the world. However, they
have been rapidly increasing the forest cover to combat environmental issues
(Sokolov Mladenovi
c et al., 2020). With national policies like increasing forest cover,
adoption of renewable energy resources and mandating environmental related disclo-
sures for listed firms, China has been taking practical measures in becoming a good
role model for the ESG benchmark. Therefore, it is interesting to examine how these
policies and the ESG disclosure by firms are affecting firm performance (Lee &
Brahmasrene, 2020).
To achieve this objective, the ESG and other financial data pertaining to Chinese
listed firms is collected from 2015 to 2020. The findings, based on dynamic modelling
of First differenced and the system GMM, reveal a non-linear relationship between
the ESG disclosure and the firm performance. More precisely, the ESG disclosure at
the initial level is rewarding for the firms but beyond a certain point, disclosure starts
affecting performance through the increase brought about in the cost of such disclo-
sures. In other words, as the stakeholders are the ultimate cost bearer of such disclo-
sures, ESG spending beyond a threshold may be viewed as unnecessary and hence
start affecting performance negatively. These stakeholders are consumers, employees,
etc. The non-linear association could be the reason as to why the results of extant lit-
erature on ESG and firm performance is so far conflicting and inconclusive.
To conclude, it can be argued that ESG disclosure is good for firm performance.
However, excessive disclosure may reverse the benefits of disclosure. The firms have
to ensure that they do not go beyond a threshold or cross a certain cut-off in order
to protect themselves from being affected negatively by excessive disclosure. In other
words, every firm needs to assess as to how much ESG related information or disclos-
ure is enough to make informed decisions as this will help the firm reap full benefits
of ESG disclosure.
The study findings are an indication to Chinese policymakers that the policy initia-
tives and measures that have been undertaken over the recent years are generating
positive effects. However, they need to ensure that the listed firms only include rele-
vant ESG related information so that firms do not incidentally end up affecting their
performance negatively.
This paper extends the extant literature in several ways. First, it adds to the overall
understanding of ESG and firm performance nexus by modelling and showing the
4 G. PU

existence of a non-linear relationship between ESG and firm performance. The cor-
rect modelling of relationship is necessary and therefore constitute a major contribu-
tion of the present study. Future researchers can take cue from the findings of this
paper and build on present study outcomes by exploring more non-linearities in the
ESG and firm performance nexus (Saeidi et al., 2021).
Second, it significantly adds to the literature on the determinants of firm perform-
ance in an emerging market like China. In other words, the paper adds to the work
of Fatemi et al. (2015), Price and Sun (2017) and others by examining this relation-
ship in case of China and that too in a non-linear context.
Finally, it is generally understood that the ESG and the corporate governance lit-
erature is marred by endogeneity issues.
One of the issues the governance/ESG literature suffers from is endogeneity. The
issue of endogeneity could arise due to multiple factors but one of the key reasons is
the omitted variable bias. The omitted variable bias is essentially a correlation
between the independent variables and the error term. It arises because of the omis-
sion of some of the variables related and important to the equation that is being esti-
mated. Additionally, the issue of endogeneity can arise due to the possibility that
some of the independent variables are affected by the dependent variables. This is
commonly referred to as reverse causality in econometrics literature. For instance, in
our case, it is possible that firm performance is influenced by ESG disclosures. Last
but not the least, the equation can also suffer from dynamic endogeneity (Abdallah
et al., 2015). From econometrics perspective, this paper is improvement over the
extant literature on CSR, ESG and corporate governance as the paper uses dynamic
first differenced and the system GMM to address the critical issue of endogeneity.
The adoption of dynamic GMM is highly rare and has only started being employed
recently in the literature on ESG and corporate governance (see for instance,
Bennouri et al., 2018; Price & Sun, 2017; Sila et al., 2016).
The rest of the paper is organized as follows. The next section provides an over-
view of the existing literature on ESG and firm performance. Data and the method-
ology are outlined in Sec. 3 followed by an overview of the key findings and their
discussion in Sec. 4. Finally, the paper concludes in Sec. 5.

2. Literature review
There is a vast amount of literature on ESG and firm performance. The onslaught of
Covid-19 pandemic has intensified the debate further. As per the traditional view,
managers work towards or at least pretend to work towards maximizing shareholders’
wealth. This is the only Key Performing Indicator (KPI) for the managers and it is
based on this that they get paid and promoted. However, more recently, the corpo-
rates are moving towards a stakeholder approach to profitability as opposed to a
mere shareholder approach (Myskov
a & H
ajek, 2020). In other words, more and
more business owners are adopting an approach that takes care of the stakeholders
rather than just focusing on shareholders. The proponents of the stakeholder
approach argue that for the long-term survival of the firm, it is essential for the firm
to avoid any future conflict between the shareholders and other stakeholders. This is
 ECONOMIC RESEARCH-EKONOMSKA ISTRAŽIVANJA 5

only possible if the firm aligns their interest with those of the stakeholders. Hence,
adopting a stakeholders’ approach to firm operation is considered to be value creation
for a firm, especially in the long run (Lassala et al., 2021).
The literature on corporate governance has written a lot on the possible benefits of
aligning the interest of stakeholders with the firms’ objective. There are several ways
as to how the stakeholder approach translates into better performance. First and fore-
most, the alignment of the objectives of all the stakeholders indirectly implies more
information disclosure on the financial as well as non-financial front. This increased
disclosure is expected to go down well with the increasing trend of demanding more
information from the corporates. This is closely linked with the empirical evidence
suggesting that the more diverse the information, the better price in formativeness it
would be (Goldstein & Yang, 2015). On the other hand, more information, especially
non-financial would reduce the information asymmetry between the firm and the
external stakeholders (Daniel, 2021). These disclosures reveal a number of insights
about the firm’s operational activities and if people think that a certain aspect of the
firm is socially responsible then they my wish to buy their products or services, hence
directly impacting operating firm performance (Li et al., 2020). A higher level of dis-
closure also means higher level of scrutiny from researchers, analysts, investors and
other stakeholders. One of the positive aspects of such scrutiny is that it helps the
firm identify its strong and weak points and can expect to get good recommenda-
tions, especially on reducing the risk of stock price crash. Moreover, higher disclosure
also means higher transparency. Higher level of transparency has been shown to
improve efficiency and hence result in improved operating performance (Vilanova
et al., 2009). This is commonly referred to as the ‘Social Impact View’.
These views are supported by numerous empirical works (see for instance, Aboud
& Diab, 2019; Al-Najjar & Anfimiadou, 2012; Beretta et al., 2019; Cek & Eyupoglu,
2020; Cornett et al., 2016; Evans & Peiris, 2010; Gangi et al., 2020; Lins et al., 2019;
Manrique & Mart
ı-Ballester, 2017; Yu et al., 2018).
On the opposite end, a significant number of past studies have shown financial
and nonfinancial disclosures to be a complete waste of money (Shen et al., 2016). In
other words, the relationship between ESG disclosures and firm performance is found
to be negative. For instance, it has been argued that additional disclosures lead to
inefficient use of resources (Friedman, 2007). In other words, ESG activities put
unnecessary pressure on the firm to donate for charitable causes and also provide aid
for national and international social causes (Ullmann, 1985). As the firms have lim-
ited resources, using it for ESG activities would imply that those resources cannot be
used for more productive uses such research and development or projects with posi-
tive Net Present Values (NPVs). In this sense, ESG activities or disclosures can des-
troy firm value (Bhardwaj et al., 2018). This view of ESG is known as the ‘Trade-off
View’. Some of the literature has also referred to a Shift of Focus view. These views
are supported by many empirical studies (see for instance, Barnea & Rubin, 2010;
Brammer et al., 2006; Di Tommaso & Thornton, 2020; Hillman & Keim, 2001; Lee
et al., 2009).
Additionally, there is limited but growing literature that suggests that ESG activ-
ities are irrelevant to investors in that they neither place any value on it nor consider
6 G. PU

it as cost or value destroying (Griniuk, 2021). In other words, some of the more
recent works have argued in favour of there being no relationship between ESG activ-
ities and firm performance (see for instance, Friede et al., 2015; Shakil et al., 2019).
Such diverse results in the existing literature could be due to several factors. First,
filters across ESG screens vary across countries, regions and the industries or sectors
(Almeyda & Darmansya, 2019; de Silva Lokuwaduge & de Silva, 2020; Del Giudice &
Rigamonti, 2020). So, within the context of a country or a region, some of the ESG
filter may be more important than the other, hence producing conflicting results on
the association between the two.
Along similar lines, the industry is also sensitive to specific dimension of ESG
activities. For instance, some may gain more from disclosing environmental related
information, especially firms operating in environmentally sensitive industries such as
mining (De Klerk et al., 2015; Garcia et al., 2017). Similarly, firms operating in other
sectors may gain from engaging in activities other than environmental activities.
Finally, the dynamics of developing and developed markets are markedly different
from each other. For instance, stakeholders in developed markets are more informed
about the ESG issues and hence tend to demand and appreciate disclosure and activ-
ities (Ali et al., 2017).

3. Data and methodology

3.1. Data
The ESG data of Chinese listed firms is still not provided by many service providers.
The data on ESG activities is only maintained by SynTao Green Finance, MSCI and the
China Corporate Responsibility Institute (CCRI). Among them, SynTao Green Finance
is one of the major sources of ESG data. The database covers ESG related information
of listed companies more comprehensively than any other database. In this paper, the
data of ESG is collected from Wind database. The sample period is from 2015 to 2020.
The total sample consists of 232 firms with 1,312 firm year observations. The other firm
level data such as firm size, financial leverage and sales growth is collected from
CSMAR database. Macroeconomic data such as GDP growth and financial development
is collected based on the World Development Indicators (WDI). Following the previous
literature, the collected data excludes financial and utility firms as they have different
capital structure and are regulated by other regulatory entities. To control for the out-
liers in the database, the variables are winsorized at 1% and 99%.

3.2. Econometric specification and methodology

To achieve the objective, following econometric specification is assessed:

Profitabilityi, t ¼ a0 þ b1 Profitabilityi, t1 þ b2 ESGi, t1 þ b3 ðESGi, t1 Þ2

(1)
þ b4 Xi, t1 þ b5 Zi, t þ ei, t
In Eq. (1) presented above, Profitability is the performance measure proxied by
Tobin’s Q. As a robustness, Return on Assets (ROA) is also used. The lagged depend-
ent variable is also used in the equation as there is enough empirical evidence to
 ECONOMIC RESEARCH-EKONOMSKA ISTRAŽIVANJA 7

indicate that performance is persistent and hence, also dependent on its past values.
The inclusion of lagged dependent variables makes the specification dynamic in
nature. ESG in Eq. (1) are the ESG scores of listed Chinese firms. X and Z are the
firm level and macroeconomic control variables, respectively. These control variables
are based on the extant literature on the ESG and firm performance. The firm level
variables are firm size (measured by total assets), financial leverage (measured by total
long-term debt to total shareholders’ equity) and sales growth (measured as change in
operating profit as compared to past year). Macroeconomic variables are economic
growth (measured as GDP growth) and financial development (measured as private
credit to domestic sector as a percentage of GDP).
As rightly pointed out by Abdallah et al. (2015), the governance literature suffers
from endogeneity issues, and therefore the current paper uses an approach that is suited
to tackle such issues. The issue of endogeneity usually arises due to dynamic interactions
among the variables. The other reason for endogeneity is the omission of key variables.
There are various approaches used in the econometrics field to address the issue of
endogeneity. For instance, the traditional and most common methods are instrumental
variable approach or stage least squares (2SLS) approach. However, there are inherent
issues with such an approach. For instance, Garc
ıa-Meca et al. (2015) argues that the
instruments used in the 2SLS tend to produce inefficient and biased estimates. More
importantly, it is difficult to find instruments that are closely related with the instru-
mented variables and not correlated with the error term. However, this paper overcomes
the issue by using First difference and the System GMM. The main advantage with the
GMM approach is that it uses its own lag as instruments.
This is paper uses System GMM instead of First difference GMM. The System
GMM is proposed by Arellano and Bover (1995) and Blundell and Bond (1998)
whereas the approach of First difference GMM approach is proposed by Arellano and
Bond (1991).
The traditional approaches to estimate the coefficients of an equation can lead to
various econometric issues. One of the major issues associated with the panel
approaches, especially with the dynamic panels, is the correlation between the lagged
dependent variable and the individual fixed effects. Hence, in this paper, the issue of
correlation between lagged dependent variable and individual fixed effects is
addressed by issuing System GMM. The approach of First difference GMM address
endogeneity by removing the individual fixed effects (in our case, Chinese listed
firms). It further employs lag variables as instruments to overcome the endogeneity
issue. On the other hand, System GMM uses level and first differenced estimations as
instruments. The approach of System GMM does not filter out the information con-
tains in the level form of variables. Along the similar lines, the System GMM
approach overcomes the issue of biasedness and the imprecisions attached with the
First differenced GMM approach. The downward bias associated with the Two Step
System GMM is corrected by the approach of Windmeijer (2005). The diagnostics
test suggested by the Hansen and Sargan is used to test the validity of instruments.
The GMM approach is considered to be asymptotical normal in nature.
Additionally, the approach is efficient as well as consistent in comparison to methods
that do not make use of additional information. The consistency, efficiency and the
8 G. PU

normality associated with the GMM can be attributed to the fact that it uses existing
information available in the moment conditions.
The prerequisite conditions of using GMM is the moment conditions. In other
words, the vector value function of g(Yt,h) should be known beforehand:

m ðh0 Þ ¼ E½g ðYt , h0 Þ ¼ 0, (2)

In Eq. (2), E refers to expectations whereas Y is more of a generic component.

Additionally, function of m(h) should be different from ‘0’ so that the condition of
h 6¼ h0 is met.
The fundamental idea behind the approach of GMM is that it substitutes the the-
oretical expectation of E[] with that of sample average:

1 XT
^ ðh0 Þ ¼
m gðYt , hÞ (3)
T t¼1

and then to minimize the norm of this expression with respect to h. The minimizing
value of h is our estimate for h0.
After the substitution, the next step is following the procedure of minimizing the
expression (with regards to h). Finally, the minimized expression of h becomes the
estimate of h0.

4. Findings and discussion

The descriptive statistics are provided in Table 1. The main results based on the ana-
lysis are presented in Table 2. There are three columns in Table 2.
The first column represents the baseline estimations. The estimation equation of
the column 1 is following:

Tobins Qi, t ¼ a0 þ b1 Tobins Qi, t1 þ b2 ESGi, t1 þ b3 ðESGi, t1 Þ2 þ ei, t (4)

In the above equation, the firm and macro level controls are excluded. The firm
level variables are used in their lagged form. This will help ensure that reverse causal-
ity issue does not arise in the econometric specification.
The findings presented in Column 1 suggest that the ESG affects firm profitability,
measured as Tobins Q positively. The coefficient of ESG activities is significant and
positive indicating a positive influence of ESG on firm performance. More precisely,
a 1 per cent increase in ESG activities lead to an increase in firm performance by
0.94 percent. The findings indicate that the stakeholders do value the ES activities
and reward the firm accordingly. In other words, the firm adopting stakeholder
approach is going to benefit from such activities. There can be several ways or chan-
nels through which ESG have a positive effect on firm performance. For instance,
more ESG activities could lead to increased trust in the organization’s policies and
hence lead to more public aids and contributions (Li et al., 2018; Zhang et al., 2010).
Additionally, ESG activities also increase the brand awareness and enhance the brand
 ECONOMIC RESEARCH-EKONOMSKA ISTRAŽIVANJA 9

Table 1. Descriptive statistics.

Variable Mean Std. dev. Min Max
TOBINS Q 1.214 6.119 0.973 185.290
ROA 1.665 3.414 26.227 27.16
ESG 12.176 13.309 2.838 92.004
Firm size 6.202 7.998 11.876 78.337
Firm size 9.417 2.003 4.696 27.762
Financial leverage 0.328 0.041 0.004 0.830
GDP growth 3.219 2.991 0.771 13.451
Financial development 83.419 28.007 6.126 183.991
Source: authors.

Table 2. ESG and firm performance.

(1) (2) (3)
Tobin’s Qt1 0.027 0.987 0.003
(0.026) (0.000) (0.000)
ESG 0.094 0.026 0.087
(0.090) (0.000) (0.010)
ESG2 0.119 0.039 0.281
(0.001) (0.000) (0.000)
Size 0.006 0.054
(0.000) (0.060)
Sales growth 0.001 0.000
(0.039) (0.048)
Leverage 0.000 0.000
(0.000) (0.000)
Economic growth 0.067
(0.029)
Financial development 0.031
(0.000)
Constant 0.019 0.003 0.001
(0.000) (0.000) (0.000)
AR (1/2) 0.31/0.29 0.41/0.54 0.28/0.91
Sargan/Hansen test (p-val) 0.31/0.27 0.11/0.54 0.00/0.72
p-values in parentheses. p < 0.1, p < 0.05, p < 0.01.
Source: authors.

image. This in turn gives the firm a competitive edge and hence, leads to an increase
in sales (Lambertini & Tampieri, 2015).
On the other hand, the square of ESG activities is not only significant but negative.
An analysis of the significant and the negative term indicates that the relationship
between ESG activities and the firm performance is non-linear. More specifically, the
relationship between the two is inverse U-shaped.
The economic meaning of such a coefficient is that there is a certain cut-off and if
the firm continues to engage in ESG activities after that cut-off, this would affect the
firm performance negatively. In other words, the findings suggest that the firm
should not involve in ESG activities after a certain threshold. The findings provide a
fresh perspective on the ESG and firm performance relationship by showing that the
non-linear modelling is the more appropriate way to assess the relationship between
ESG activities and firm performance.
In column 2, the equation is regressed with the inclusion of additional variables.
Equation (5) is an extension of Eq. (4). More specifically, Eq. (5) also consists of firm
level variables and can be written down as follows:
10 G. PU

Tobins Qi, t ¼ a0 þ b1 Tobins Qi, t1 þ b2 ESGi, t1 þ b3 ðESGi, t1 Þ2

(5)
þ b4 Xi, t1 þ ei, t

In the above equation, Xi is the set of firm level variables used in the previous lit-
erature on ESG activities and firm performance. These variables are firm size, finan-
cial leverage and sales growth.
The coefficient of ESG activities is still significant and positive. More importantly,
the squared term of ESG is significant and negative indicating a non-linear relation-
ship. These findings suggest that the ESG and firm performance is stable even when
the firm level controls are included in the analysis.

Tobins Qi, t ¼ a0 þ b1 Tobins Qi, t1 þ b2 ESGi, t1 þ b3 ðESGi, t1 Þ2

(6)
þ b4 Xi, t1 þ b4 Zi, t1 þ ei, t

Finally, in column 3, equation is regressed with the inclusion of macroeconomic

variables. More specifically, the results reported in column 3 are based on Eq. (6).
The findings indicate that the coefficients of ESG and the ESG squared are positive
and negative, respectively. These results indicate that the findings reported in the first
two columns are not subject to omitted variable bias. More importantly, the findings
indicate that the ESG and the firm performance is non-linear. Moreover, the macro-
economic variables are significant and positive. More specifically, economic growth
and financial development positively affect firm performance.
The diagnostic tests such as autocorrelation (AR 1/2) and the instruments validity
tests are also conducted (Saragan and the Hansen test). The result of diagnostic tests
is provided at the bottom of the table. All the tests confirm the suitability of System
in the paper. Moreover, the significance of the lag dependent variable reinforces the
decision to use dynamic modelling. The insignificance of autocorrelation and the
Sargan/Hansen tests indicate no autocorrelation and the validity of instruments.
It is particularly important to test the robustness or the stability of results in order
to ensure that the reported findings are robust and not sensitive to different specifica-
tions. The results are provided in Table 3 below. Similar to the main findings pre-
sented in Table 2, Table 3 has three columns. In the first column, this research only
includes ESG and the ESG squared variables. In column 2, the paper includes firm
level variable similar to the main findings. Finally, the paper includes macroeconomic
variable such as economic growth measured in terms of GDP growth and the finan-
cial development measured as private credit to domestic sector as a percentage
of GDP.
More specifically, following three equations are estimated for the findings reported
in Table 3. In this robustness test, the paper uses the alternate measure of firm per-
formance—Return on Assets (ROA). Though ROA is also a performance measure
and frequently used as a profitability proxy similar to Tobins Q, it is not sensitive to
the non-fundamental values of the firm.

ROAi, t ¼ a0 þ b1 ROAi, t1 þ b2 ESGi, t1 þ b3 ðESGi, t1 Þ2 þ ei, t (7)

 ECONOMIC RESEARCH-EKONOMSKA ISTRAŽIVANJA 11

Table 3. Robustness tests.

(1) (2) (3)
ROAt1 0.191 0.033 0.018
(0.006) (0.091) (0.000)
ESG 0.006 0.002 0.022
(0.019) (0.000) (0.010)
ESG2 0.067 0.001 0.287
(0.000) (0.021) (0.000)
Size 0.001 0.017
(0.049) (0.070)
Sales growth 0.016 0.000
(0.039) (0.041)
Leverage 0.282 0.098
(0.000) (0.000)
Economic growth 0.000
(0.039)
Financial development 0.021
(0.000)
Constant 0.003 0.073 0.023
(0.000) (0.000) (0.000)
AR (1/2) 0.29/0.46 0.09/0.83 0.19/0.33
Sargan/Hansen (p-val) 0.99/0.36 0.73/0.58 0.11/0.85
p-values in parentheses. p < 0.1, p < 0.05, p < 0.01.
Source: authors.

ROAi, t ¼ a0 þ b1 ROAi, t1 þ b2 ESGi, t1 þ b3 ðESGi, t1 Þ2 þ b4 Xi, t1 þ ei, t (8)

ROAi, t ¼ a0 þ b1 ROAi, t1 þ b2 ESGi, t1 þ b3 ðESGi, t1 Þ2 þ b4 Xi, t1

(9)
þ b4 Zi, t1 þ ei, t

In other words, the main advantage of using ROA is that it is not subject to specu-
lation. Therefore, it might be more reflective of firm performance. However, it is
important to acknowledge that a book measure such as ROA is subject to manipula-
tion internally and its use may be discouraged in certain cases. The results of Eqs.
(7), (8), and (9) are presented in column 1, 2 and 3 of Table 3 below. The findings
indicate that the ROA are positively affected by the ESG activities. Moreover, the
squared term of ESG activities is significant and negative, hence indicating an inverse
U-shaped relationship between ESG activities and firm performance measured as
ROA. These findings are similar to the ones presented in Table 2. The results indicate
that the reported findings are similar irrespective of whether the market measure
(Tobins Q) is used or a book measure (ROA) is used. As far as the diagnostics are
concerned, all the tests pass the diagnostic test.
As an additional robustness test, the paper utilizes the Fixed effect models. In these
models, the coefficients or the parameters are not random. The fixed effect models
allow the unobserved effects to be created with the observed variables. The Fixed
effect model can be represented in an equation form as follows:

Yit ¼ bi Xit þ qi þ lit (10)

In Eq. (10) above, Y is the dependent variable whereas X is a series of independent

variables. In the above equation is considered to be the unobserved fixed effects. In
12 G. PU

Table 4. Robustness test.

(1) (2) (3)
Tobin’s Qt1 0.029 0.298 0.006
(0.043) (0.001) (0.000)
ESG 0.067 0.033 0.045
(0.098) (0.075) (0.010)
ESG2 0.028 0.049 0.769
(0.029) (0.000) (0.000)
Size 0.017 0.087
(0.000) (0.000)
Sales growth 0.981 0.054
(0.000) (0.001)
Leverage 0.008 0.017
(0.000) (0.000)
Economic growth 0.037
(0.091)
Financial development 0.029
(0.001)
Constant 0.033 0.031 0.007
(0.000) (0.000) (0.000)
R-squared 0.14 0.26 0.36
Adj. R-squared 0.09 0.11 0.15
p-values in parentheses. p < 0.1, p < 0.05, p < 0.01.
Source: authors.

the above equation, q is the unobservable fixed effect which is different for each firm
but fixed across time. As these are unobservable fixed effects, they cannot be con-
trolled for and hence such estimations suffer from omitted variable bias.
In the fixed effect modelling, the unobserved firm characteristics are removed by
demeaning each variable. Equation (10) is transformed by demeaning as shown
below:
 
Yit  Yi ¼ bi Xit  Xi þ ðqi  qi Þ þ ðlit  li Þ (11)

The final equation can be written as follows:

Y€it ¼ bi X€it þ l€it (12)

As the series is now demeaned and the unobserved heterogeneity is removed, the
above equation (Eq. (12)) can be estimated by employing Ordinary Least
Squares (OLS).
The analysis reported in Table 4 below is same as in Eqs. (4)–(6). The only difference
between the results reported in Tables 2 and 4 is that of econometric approach. More
precisely, the results reported in Table 2 are based on the System GMM whereas the
results provided in Table 4 are based on the analysis of Fixed effect modelling. Not sur-
prisingly, the results reported in table are similar to the ones presented in Table 2. The
signs and the significance of coefficients are similar to that of Table 2.

5. Conclusion
Milton Freidman once famously said that ‘there is one and only one social responsibil-
ity of business—to increase its profits’. The statement can be considered highly
 ECONOMIC RESEARCH-EKONOMSKA ISTRAŽIVANJA 13

contentious as documented empirical evidences do indicate the positive effect of ESG

on firm performance. Although it is not a settled issue as to whether ESG activities
translate into better firm performance or not but there is considerable evidence in lit-
erature to nullify Freidman’s statement.
In the recent years, there has been a surge in more sustainable approaches towards
investing. This trend signifies a noteworthy movement towards sustainability inves-
ting, especially in the wake of Covid-19 pandemic. There is a strong push not just
from the institutional investors but also from retail investors to include sustainability
filter as a key screening criterion to build portfolios. One of the most important sub-
sets of sustainability investing is ESG investing. The segment of ESG is adopted glo-
bally with certain varying degrees of filters. The ESG criterion uses a best of class
approach to screen the stocks and debt instruments globally. A heightened interest in
ESG investing has led policymakers at the global level to draft policies around the
ESG filters. Most countries in the world are now moving towards mandating disclo-
sures, especially for listed firms. In that sense, China has made considerable efforts to
establish reporting guidelines for ESG disclosures and activities. As one of the most
polluted countries in the world, China has made it mandatory for listed firms to dis-
close their environmental activities. The country has been planting trees to increase
the forest cover in order to tackle the growing issue of CO2 emission in the country.
In this paper, the debate on ESG and firm performance is revisited. More precisely,
the current investigation poses the following question—‘Do ESG activities matter?’ As
mentioned above, the question has been investigated before but the findings, though
slightly tilted towards the positive effect of ESG on performance, are not so clear and
equivocal. In other words, the evidence on the effect of ESG on firm performance is
not a settled issue. There could be several reasons for these conflicting results. One
potential issue could be the wrong modelling and econometric specifications. In this
paper, the extant literature is extended by modelling the non-linear relationship
between ESG activities and firm performance. Moreover, the paper also addresses the
long-standing criticism of endogeneity that a corporate governance literature suf-
fers from.
To contribute to the existing body literature on the subject, the paper models the
relationship between ESG activities and firm performance. The findings reveal a num-
ber of interesting insights. First, ESG activities are found to positively influence firm
performance. This is in line with a number of past studies literature and a strong
piece of evidence against Freidman’s claim.
Second and more importantly, a key insight of this paper is that the relationship
between ESG activities and the firm performance is non-linear. In other words, the
findings indicate that the ESG activities are rewarding only up to a point and start to
affect the performance negatively after that. In other words, the relationship between
ESG activities and firm performance is inverse U-shaped. These findings indicate that
stakeholders consider ESG activities after a point as something which is unnecessary
or something which can be avoided. This is viewed by stakeholders as a cost. As the
resources that are diverted to ESG activities can be used for research and develop-
ment, and enhancement of products and services. The key takeaway from this
research is that the firms have to find their thresholds so as to limit their ESG
14 G. PU

activities at that point. Moreover, firms have to find more cost effective ESG activities
so as to avoid any negative shock to their profitability.
There are several limitations of the present research. First, in this research, the
paper only explores nonlinear modelling without paying attention to the specific
dimensions of ESG investing. Future researchers should explore the individual dimen-
sions of ESG filters. This is necessary as there could potentially be a case that only a
specific dimension of ESG filter has positive effect whereas other dimensions may be
either insignificant or even negative. The assessment of specific dimensions could
reveal the source of impact. For instance, as China is batting with unprecedented lev-
els of pollution, it may be possible that only environmental factors amongst the ESG
filters have a positive effect whereas social and governance dimensions are either
insignificant or negatively related to firm performance.

Disclosure statement
No potential conflict of interest was reported by the author.

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