Environmental factors, social responsibility and corporate governance and financial performance of the company
This research analyzes the relationship between environmental, social and governance (ESG) factors and firm value. ESG strengths positively impact valuation, while ESG concerns impair the overall market value. ESG and value of the company: arguments.
| Рубрика | Менеджмент и трудовые отношения |
| Вид | дипломная работа |
| Язык | английский |
| Дата добавления | 10.12.2019 |
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Environmental factors, social responsibility and corporate governance and financial performance of the company
Yurchenko Julia Konstantinovna
Abstract
This research analyzes the relationship between environmental, social and governance (ESG) factors and firm value. While many articles attempted to explore the relationship between ESG performance and financial performance, the simultaneous influence of ESG performance and disclosure has been largely undiscovered. According to the results, stakeholders account for both ESG performance and ESG disclosure while valuing the company. ESG strengths positively impact valuation, while ESG concerns impair the overall market value. ESG disclosure taken solely also negatively impacts firm value. Together with ESG strengths, higher ESG reporting weakens the beneficial effect of firm's strengths on firm valuation, while ESG disclosure together with ESG concerns mitigates negative effects on firm value. The mitigating effect of ESG disclosure may signal that investors value ESG efforts positively when a company struggles with environmental, social or governance challenges, and vice versa, when a company performs well in terms of ESG, prioritizing ESG issues might negatively influence firm value, probably because investors may perceive wide ESG agenda to be a sign of inefficient spending. social value market
В данном исследовании проанализирована взаимосвязь между экологическими, социальными факторами, факторами корпоративного управления (ESG) и стоимостью фирмы. Хотя во многих статьях ислледовали взаимосвязь между эффективностью ESG и финансовыми показателями, одновременное влияние ESG показателей и ESG отчетности широко не рассматривалось. Согласно результатам, заинтересованные стороны учитывают как эффективность ESG, так и раскрытие ESG информации при оценке компании. Сильные стороны ESG оказывают положительное влияние на рыночную стоимость, в то время как ESG недостатки снижают стоимость компании. Раскрытие ESG информации негативно влияет на стоимость фирмы, если рассматривается отдельно от других факторов. Результаты показывают, что более высокий уровень ESG отчетности смягчает ESG недостатки, и снижает положительный эффект от ESG преимуществ на стоисоть фирмы. Смягчающий эффект от ESG отчетности может сигнализировать о том, что инвесторы положительно оценивают деятельность в сфере ESG, когда компания борется с экологическими, социальными или управленческими проблемами, и наоборот, когда компания имеет хорошие показатели ESG, приоритезирование ESG вопросов может негативно повлиять на стоимость фирмы - возможно потому, что инвесторы могут воспринимать излишний фокус на ESG как признак неэффективности инвестиций компании.
Table of contents
Introduction
Chapter 1. Literature review
1.1 Role of ESG in the modern world
1.2 ESG and value of the company: theoretical arguments
Chapter 2. Empirical research
2.1 Research design
2.2 Data and sampl
2.3 Empirical results of regression analysis
Conclusion
List of references
Appendix
Introduction
This study investigates the relationship between a firm's ESG performance, ESG-related disclosure and firm value. Recently, many efforts have been put to measure financial performance and valuation impact of ESG factors. Meanwhile, numerous articles addressed the determinants of ESG disclosure and the influence of disclosure on overall company performance and its value. However, the combination of ESG disclosure and ESG performance factors regarding impact on firm value seems to be largely undiscovered. Although the relationship between these factors is not well explored, the hypothesis suggests ESG disclosure mitigates the impact of ESG activities on value of the company. There are 2 views on effect of ESG disclosure: first one refers to decrease in information asymmetry that improves stakeholders' understanding of ESG strengths and weaknesses; second one regards the situation when companies use ESG disclosure to appear more socially responsible than they are - this tactic is also known as "greenwashing". On the one hand, weaker asymmetry should positively influence firm value, and on the other hand, if investors perceive ESG disclosure as "greenwashing", it might impair company value.
The similar ambiguity is true for ESG performance and firm value relationship. Voluntary ESG activities imply additional costs. The costs of a firm increase which inevitably result in reduced profits. Nevertheless, the strategies of many companies demonstrate that significance of implementing ESG activities increases. This implies that these policies should be beneficial to enterprises, for instance, they may be valued higher for reduced risks in the long term and thus increase valuation. Firms can also benefit from better efficiency appearing from better relationships with all stakeholders (e.g. better conditions from suppliers).
So far academic literature could not provide unanimous position. In early studies, it was universally accepted that environmentally or socially oriented investments that exceeded minimum legal standards bring about additional costs, decrease profitability and overall value. This concept is known as shareholder theory, first formulated by [Friedman, 1970]. Successors of this theory point out that the paradigm of legal constraints which bind organizations to stick to minimal environmental standards developed behind no payback of CSR activities [Kim and Lyon, 2015]. In contrast to this idea, more recent studies reveal versatile benefits and additional profits for companies integrating ESG activities into business, developing stakeholder theory (or resource-based theory) [e.g. Fatemi, Fooladi, Tehranian, 2015; Porter, Kramer, 2011; Malik, 2015]. For instance, according to this theory, ESG activities have potential to increase firm value by widening management team capability, improving reputation in eyes of business partners, customers and potential employees, as well as reducing reputation risks and accordingly cost of capital. All these factors can influence performance of the company and provide one of competitive advantages. [Jensen, 2002] concluded that long-term value maximization and winning position in the market is only possible when interests of all stakeholders surrounding the company are satisfied. However, equivocal vision of ESG factors importance has not been found yet. Although some studies reported a negative relationship or absence of any influence, a meta-analysis [Margolis et al., 2009] found the overall effect to be positive, though declining over time.
Despite absence of ultimate evidence in literature on how ESG activities affect financial performance, over past few decades a lot of companies invested in ESG, as well as provided sustainability reporting. According to KPMG study [KPMG international survey of corporate responsibility reporting, 2011], only 300 companies in the world had CSR reporting. By 2014 this number has increased to more than 7000 companies [Khan et al., 2016]. Meanwhile, ESG (CSR) disclosure standards were developed, and now are being implemented by more and more organizations - mostly acknowledged are Global Reporting Initiative guidelines and International Integrated Reporting Council. Nevertheless, still quality of ESG reporting remains heterogeneous, making it difficult to assess effect of ESG disclosure on a value of a company.
Besides, motives for ESG disclosure may vary significantly resulting in different valuation by the market. Apart from most evident reason for ESG transparency to emphasize strengths and play down weaknesses, firms can use ESG disclosure to recover its reputation after ESG-related scandals, or to be more transparent after adopting critical changes in internal ESG policies. It might also be "cheap talk" or "greenwashing" - the strategy when a firm wants to look socially responsible, but not to be one. There is a negative consequence of such a strategy: some businesses even understate their ESG activities and are less transparent for fear of alienating investors - it is called "brownwashing". Accordingly, literature analysis described in further parts revealed no empirically found dependency between ESG disclosure and value of the company.
This paper aims at answering the question whether the association between ESG activities and firm value is moderated by ESG-related disclosure. Empirical analysis of this study is based on 1358 firm-year observations for public US companies for 2015-2018 years. Several databases were used for this analysis: Bloomberg ESG database, Thomson Reuters Eikon. Bloomberg aggregates data on the level of ESG disclosure, while Thomson Reuters has wide package on ESG performance scores separated by 11 dimensions, as well as on other financial and non-financial data used for control variables. Taking into consideration the potential endogeneity of the company's disclosure strategy, 2SLS regression method has been chosen. The first stage of the regression analysis comprises 3 equations that perform the determinants of ESG reporting and cross variables of ESG disclosure with ESG strengths and ESG concerns. The second stage concerns the relationship between firm market value (proxied by Tobin's Q) and ESG performance, ESG disclosure. Moreover, 3 pillars of ESG performance - ecological, social and governance performance - are considered separately as an extension of the current analysis.
The purpose of the study is to determine the relationship between ESG performance, ESG disclosure and value of a company. The tasks of the research are the following:
1. to review the extant literature dedicated to the relationships of ESG performance and firm value, ESG performance and ESG disclosure, and ESG disclosure and firm value;
2. to conduct an empirical study investigating the relationship between ESG performance, ESG disclosure and firm value,
3. to test viability of the model and the significance of the obtained results,
4. to analyze results and conclude on the relationship between factors.
The subject of the study is the relationship between ESG performance, ESG disclosure and value of a company. The object is public US companies.
The main distinction from other articles on ESG-related topics in finance is that in this study the integration of ESG performance and ESG disclosure factors is considered regarding firm value. In previous studies either ESG performance and financial performance or firm value relationship is explored, or the impact of ESG disclosure on financial metrics. The main supposition is that relationship between ESG performance and market value is moderated by the extent of ESG disclosure.
The remainder of the paper has the following structure: in the first part, theory and literature overview is provided as well as hypotheses are proposed, and in the second part, data, method and empirical findings are shown. In conclusion, the summary, results and propositions for further research are described.
Chapter 1. Literature review
1.1 Role of ESG in the modern world
Nowadays, importance of ESG data has enhanced a lot. In the past few decades, the world has witnessed an exponential growth in the number of organizations which monitor and disclose environmental data (for instance, level of carbon emissions, waste production, water consumption), social data (for instance, employee composition, product information, customer-related data), and governance data (for instance, political lobbying, anticorruption programs, board diversity, etc.) - this is called ESG data. While fewer than 20 companies provided publicly available ESG data in the early 1990s, by 2016 the number of companies issuing sustainability or integrated reports had increased to approximately 9000 [Amel-Zadeh and Serafeim, 2018].
Display 1 Growth of sustainability reporting, 2000-2015 and Growth of Principles for responsible investment, 2006-2017. Source: [Morgan Stanley, ESG and the Sustainability of Competitive Advantage, 2017]
Indeed, the latest UN Global Compact study on sustainability covered more than a thousand CEOs from all over the world [Amel-Zadeh and Serafeim, 2018]. It showed that 93% of CEOs consider CSR as "important" or "very important" component in the future successfulness of their companies. Therefore, it does not surprise why the researchers have attributed so much attention to the issue of the economic and social outcome produced by the integration of ESG (CSR) policies.
The same trend is true for investor interest in ESG data. Investor signatories to the UN Principles for Responsible Investment, first presented in 2006, commit to incorporating ESG questions into their investment analysis and ownership practices. By 2017, the UN principles had reached about 1500 signatories, with total assets under management about $70 trillion.
The increased demand for firms with good ESG performance has driven significant changes in financial industries. Over the past several decades, investing in socially responsible companies (SRI - socially responsible investing) has become a major trend in mutual fund industry and one of the key topics in financial surveys around the globe. SRI is broadly defined as an investment process that involves recognizing the companies with high corporate social responsibility (CSR) accounts, while CSR is assessed on the environmental, social and corporate governance (ESG) metrics [Renneboog, Ter Horst, Zhang, 2008]. According to US SIF report in 2018 (US forum for sustainable and responsible investment), SRI only in USA have reached $12,0 trillion, up 38% percent from $8,7 trillion in 2016. This represents one quarter out of the $46,6 trillion in total assets under professional management in the United States.
Whether the fuss about ESG, CSR and SRI is justified with the concrete financial benefits for shareholders or it is just one of the popular topics with investors who strive for other non-financial utilities (such as consistency with their personal beliefs and values), the researchers all over the world still make efforts to consider this issue and provide a uniform solution.
1.2 ESG and value of the company: theoretical arguments
From theoretical viewpoint, link between ESG performance and valuation of the company is not evident. There are several effects of ESG activity which may influence firm's value in direct or indirect way. First and the most direct, ESG activity that exceeds minimal legal standards implies additional non-necessary costs for a company. Therefore, the early understanding of this relationship was uniformly negative [Vance, 1975; Wright, Ferris, 1997]. [Friedman, 1970] summarizes this position with claiming that there is the only one social responsibility of the firm that is to maximize shareholders' value. The supposition underlying this argument is that ESG investments could not pay off to exceed costs. However, ESG investments could generate several benefits for a company which could impact firm value in a positive way. Evaluating possible effects of ESG from strategic management perspective, [Porter and Kramer, 2006] affirm that ESG (CSP) "can be much more than a cost, a constraint or a charitable deed - it can be a source of opportunity, innovation and competitive advantage".
ESG, risk and cost of capital
Ecological, social and governance factors leave implications on both internal and external business environment. One of the externalities of ESG that supports a positive link between ESG performance and company valuation [Clarkson, 1995; Jones, 1995] is that improved ESG performance will lead to a persistent reduction in the risks it faces. [Godfrey, 2005] claimed that ESG (CSP) can provide a certain `moral capital' that is used as a reputational shield for a company in critical for survival times. In this sense, company has more chances to preserve its value and trust of stakeholders, and even prevent from bankruptcy.
Theoretically, ESG can influence level of risk of an organization for several grounds. First, proper ESG performance increases organization transparency, thus reducing negative effects of information asymmetry for all stakeholders. Second, good ESG performance allows to reduce specific risks, for instance, reputation losses due to ecological or governance (or fraud) hazards. Moreover, if an organization has fewer specific risks, it brings fewer financial risks for investors (downside risk) and creditors (credit risk). All in all, ESG performance can reduce firm's financial risk and cost of capital.
To illustrate the possible consequences of neglecting ESG risks, we can consider several ESG-related scandals in modern history that impacted firm value crucially, resulted in plummeting of market prices up to 99%. Shareholders suffered substantial losses following these ESG risk events (see Display 2). The negative environment and social consequences of oil spills, mining explosions and unsafe products can be critical for existence of the company, and the cost to investors can be enormous. Additionally, poor governance and accounting stewardship can undermine advantages of even highly successful businesses which are associated with sustainable competitive advantages and long-term growth perspectives. While it is impossible to fully hedge against such hazards, many investors believe that incorporating ESG analysis can mitigate these risks and minimize them.
Display 2 Stock price performance in 1 year following ESG risk event. Source: [Morgan Stanley, ESG and the Sustainability of Competitive Advantage, 2017]
Empirical analysis supports arguments for positive relationship between ESG and risk metrics. Researchers usually explore the effects of ESG performance on cost of capital. Many studies in this area used risk adjusted performance indicators to assess the financial impact of ESG, however, more interesting studies are those dedicated solely to risk, as the relationship with level of returns will be analyzed in further parts. [Orlitzky, Benjamin, 2001] conducted a meta-analysis that confirms a significant negative mean correlation between ESG performance and risk of ?0.21. In the past few decades, there were many efforts to address this issue with focuses on this relationship between ESG and financial risk from different sides. [Godfrey, Merrill, and Hansen, 2009] using event study for considering legal issues taken against firms found that firms with stronger ESG governance have better risk management. [Sharfman, Fernando, 2008] showed that proper environmental performance leads to a decreased cost of capital for different reasons, including a reduction in systematic risk. [Salama, Anderson, and Toms, 2011] reinforce these results: they found that in UK community and environmental responsibility rankings are negatively associated with market betas. [Oikonomou, Brooks, and Pavelin, 2012] provide details on the relationship of the ESG-systematic risk link. The authors conduct a research using both conventional and downside risk metrics - the latter is more indicative of actual investment risk rather than volatility. They found out that the negative implications of additional social and environmental controversies become stronger during periods of higher market volatility, for instance, downturns. [Luo and Bhattacharya, 2009] add to the above findings by concentrating on the effects of ESG performance on unsystematic risk. They also concluded a negative relationship between these factors. [Reverte et al., 2016] documented negative relationship of ESG practices and cost of equity capital on the sample of Spanish listed firms, justifying the idea of positive impact of CSR on company's financial metrics.
The same tendency is evident for debt markets. Part of the studies also dig into cost of debt evaluation and test the relationship between ESG and level of the credit risk. [Sun and Cui, 2014] demonstrated that an effective risk management and good ESG (CSR) standards are associated with lower costs of debt. Regarding bond market, [Bauer and Hann, 2010] and [Oikonomou et al, 2014] found out that corporate bonds of organizations with more ESG strengths, and particularly environmental strengths, have stronger credit ratings (or lower credit risk) resulting in lower yields; and vice versa, the more environmental/ESG concerns a company has, the higher is its cost of debt. [Ge and Liu, 2015] verified this relationship holds even for only new bond issuance. All these results are consistent with the pioneering work of [Goss, 2009], who first concluded ESG (CSP) to be a determinant of financial distress.
ESG performance and financial performance
More recently, the resource-based view on ESG activities was developed with a claim that socially responsible behavior may bring about net positive impact on firm performance. Within the framework of stakeholder theory [Freeman, 1984], it is stated that socially responsible activities better satisfy the interests of nonowner stakeholders, such as employees, customers, suppliers, debtors, regulators, etc. [Jones, 1995] pointed out ESG can ensure more efficient contracting conditions. [Fatemi, Fooladi, 2013] claimed that better ESG performance allows for opening new paths to further growth and risk reduction, probable by widening management capabilities.
From the empirical standpoint, a large body of literature dealt with the effects of ESG (CSP) factors. Different studies stated a positive association between ESG and nonfinancial performance measures, such as increased operational efficiency and lowered material and energy consumption [Aras and Crowther, 2008; Porter and van der Linde, 1995; Russo and Fouts, 1997]; better motivation for employees [Bhattacharya, Sen, & Korschun, 2008; Greening & Turban, 2000]; stimulation of customer loyalty [Albuquerque, Durnev, & Koskinen, 2015; Ramlugun & Raboute, 2015]; efficient advertising and brand reputation [Cahan, Chen, Chen, & Nguyen, 2015; Hsu, 2012; McWilliams & Siegel, 2001; Reverte, 2009]; decrease of regulatory burden [Freeman, 1984; Neiheisel, 1995]; product differentiation and reduction in price sensitivity [Boehe & Cruz, 2010; Flammer, 2015]; and customer satisfaction [Pйrez & del Bosque, 2015; Sen & Bhattacharya, 2001; Walsh & Bartikowski, 2013; Xie, 2014]. These above mentioned non-financial benefits have potential to increase financial performance metrics for a company, including firm value, if they exceed ESG-related costs. To tackle this issue regarding the profitability of ESG activities, further literature analysis is needed.
Empirical findings by most researchers demonstrate positive relationship between ESG performance and financial performance [e.g. Margolis et al., 2007; Alafi and Hasoneh, 2012; Shen and Chang, 2008; Erhemjamts et al., 2013; Wu, Tsai, Cheng, & Lai, 2006]. [Turban and Greening, 1996] found that ESG performance is positively associated with ROA. [Galbreath, 2006] revealed the positive results relative to Australian firms' reputation and financial performance metrics, such as ROA and ROE. [Guenster et al., 2011] studied the link between eco-efficiency scores and financial performance in the end of the 1990s and early 2000s and found a positive relationship of eco-efficiency scores to operating performance and market value. Another example of paper is [Erhemjamts et al., 2013] where also positive relationship is revealed; for this research the sample of nearly 17.000 firm-year observations over the 1995-2007 period was used. Other examples of positive association are [Bajic & Yurtoglu, 2017; Dimson, Karakas, & Li, 2015; Eccles, Ioannou, & Serafeim, 2014; Edmans, 2011; Fatemi et al., 2015; Ge & Liu, 2015; Krьger, 2015]. [AlTuwaijri, Christensen, Hughe, 2004] constructed model with structural equations within which economic performance is a function of environmental performance and controls. The authors found a positive influence of environmental performance on economic performance. [El Ghoul, Guedhami, Kim, 2015] estimated the link between ESG performance and firm value in 53 countries. They confirmed ESG performance to be positively related to firm value, especially in states with weaker institutions, explaining this difference by ESG mitigation effect for market failures related to institutional voids.
However, several studies documented either negative [Boyle, Higgins, Ghon Rhee, 1997; Vance, 1975; Brammer, Brooks, Pavelin, 2006] or a nonsignificant association between ESG performance and financial performance or market value [Alexander, Buchholz, 1978; Aupperle, Carroll, Hatfield, 1985; Horvathova, 2010; McWilliams Siegel, 2000; Renneboog, Horst, Zhang, 2008]. For instance, [Fisher-Vanden and Thorburn, 2011] suggested an unfavorable influence of ESG (CSP) on financial performance. The researchers found the possibility of the market reacting negatively to news of companies joining an environmentally friendly program. This might indicate negative expectations on its financial performance. There are also examples of U-shaped association as well: [Barnett and Salomon, 2012] found that firms with low ESG performance (CSP) have higher financial performance than firms with moderate ESG scores, but lower than firms with highest ESG performance.
Regarding studies which aggregate many results of previous analyses, positive association between ESG performance and financial performance seems to prevail. [Margolis et al, 2007] conducted a meta-analysis of 167 studies in terms of ESG-financial performance link and found that ESG engagement is related to the competitive advantage of a firm, except for 2% cases. The sample included studies for the period of 35 years. The authors pay much attention to the issue of causality, emphasizing that it is possible that firms with better financial performance invest more in ESG for some reasons. The sequential study by [Margolis et al, 2009] conducted for the period 1972-2007 also suggests the positive effect of ESG (CSP) on accounting- and market-based profits of a company. In fact, [Margolis et al, 2009] aggregated 251 individual empirical studies and noticed a small positive mean effect size of r = 0,133 (median = 0,09, weighted r = 0,11). For a subsample of 106 researches published since 1998, the mean effect size is only 0.090 (median = 0,063, weighted r = 0,092), meaning that the relationship between ESG performance and financial performance may weaken in recent times. [Wu, Tsai, Cheng, & Lai, 2006] also conducted a meta-analysis survey, and concluded that there is positive relationship as well.
ESG disclosure motives and link to financial performance
ESG disclosure is non-standardized, voluntary reporting that varies a lot in form and intensity. Nowadays, many firms stick to unified guidelines in this sphere, such as GRI [Vigneau, Humpphreys, Moon, 2015]. More recently, Initiative for Intagrated Reporting (IIR) proposed a new set of standards in terms of ESG for international usage, first published in 2013 [Cheng, Ioannou, Serafeim, 2014]. Additionally, apart from sustainability or combined reporting, firms more often use other non-traditional channels for ESG disclosure, such as websites and social media [Eberie, Berens, Li, 2013; Reilly, Hynan, 2014].
Most of the research on ESG reporting was based on manually constructed ratings and lists developed by individual researchers who collected data from annual reports and other publicly available data, on their own (for instance, [Aerts, Cormier, Magnan, 2008; Cho, Roberts, Patten, 2010]). The restricted access to ESG data and its non-systematic reporting put a constraint to many previous research studies. Currently, specialized commercial data providers collect and aggregate ESG data which provides new opportunities for analysis. For example, Bloomberg ESG database or Thomson Reuters ESG scores compile versatile information on ESG - these sources are also used in present research.
Before going further to consideration of ESG disclosure relationship with financial performance or company valuation, it is important to recognize there are different motives for ESG reporting in the first place. According to voluntary disclosure theory, developed by [Verrecchia, 1983; Dye, 1985], it is stated that companies with positive ESG performance would prefer to report extensively on their ESG activities, while firms with low ESG performance would choose to disclose minimum information. Under this framework, organizations signal about their good ESG performance because they want to be distinguished from poorer performers and thus avoid situations of adverse selection [Akerlof, 1970]. This claim is supported by study of [Cahan et al, 2015]; the authors state good ESG activities generate favorable image in public, and that firms with good ESG performance have a higher value (or lower cost of capital) only if they have wide media coverage.
In contrast to this argument, there are more motives why firms may intensify or weaken ESG disclosure. It is possible that a company would disclose more information about ESG to manage public perception by explaining going changes in its ESG-related policies. For instance, it may intensify its transparency to prevent or mitigate negative consequences of significant environmental damages or similar critical for society events on its reputation and market value fluctuations [Brown, Deegan, 1998; Cho, Patten, 2007], or to restore its legitimacy [Deegan, 2002; Campbell, Craven, Shrives, 2003]. Firms could also use ESG disclosure to look more socially responsible, irrespective of their true performance - "greenwashing" [Cho et al, 2015]. Furthermore, managers of the company may choose not to disclose their environmental, charitable or other socially responsible investments if they are worried that investors may not appreciate these actions finding them too costly and not coinciding with shareholders' interests. Therefore, a company with a good ESG performance may deliberately choose not to publish too much about ESG activities or even understate them - this is called "brownwashing" [Kim, Lyon, 2015].
Empirical evidence demonstrates mixed results regarding the relationship between ESG performance and level of ESG disclosure. Earlier articles found no significant relationship between these factors [Freedman, Wasley, 1990; Ingram, Frazier, 1980; Wiseman, 1982]. Other researchers concluded on no significant link between environmental performance and environmental disclosure [Hughes, Anderson, Golden, 2001; Patten, 2002]. More contemporary studies often brought about positive results between these associations [Al-Tuwaijri et al, 2004; Clarkson, Li, Richardson, Vasvari, 2008, 2011; Dhaliwal, Li, Tsang, Yang, 2011; Lyon, Maxwell, 2011; Gao, Dong, Ni, 2016]. The inconclusiveness of the results may be explained by the problems of methods employed and measurement problems relative to ESG disclosure, sample selection and failure to include all relevant factors in the model [Patten, 2002]. Accordingly, [Clarkson et al, 2008] pointed out that some additional effects included into disclosure metrics, which can be not discretionary - for instance, negative relationship found in some studies between ESG activities and extent of ESG reporting might be caused by the additional regulatory disclosure requirements provoked by arising environmental hazards.
The empirical findings regarding the extent of ESG disclosure and market value are not equivocal either. Some of the researches reported negative relationship [Villiers, van Staden, 2011; Ho, Taylor, 2007], while others had positive relationship results [Clarkson, Fang, Li, 2013; Gamerschlag, Mouller, Verbeeten, 2011; Gao et al, 2016; Middleton, 2015]. In further studies researchers hypothesized that there can be different forms of disclosure that carries "soft" or "hard" information, and consequently, it may have different motives for reporting and thus effects on firm value [Brammer, Pavelin, 2006; Bouten, Everaert, Roberts, 2012]. [Dhailwal, Li, Tsang, Yang, 2014] examined the relationship between ESG reporting and cost of equity on international sample of companies that covers 31 countries. They separated countries by principle of whether countries in the sample are more shareholder-oriented or less. Generally, the authors revealed negative relationship between extent of ESG reporting and equity cost of capital, and this relationship appeared to be stronger for more stakeholder-oriented countries. It was also found that ESG disclosures are associated with lower capital constraints [Cheng, Ioannou, Serafeim, 2014]. Finally, in the baseline research by [Plumlee, Brown, Hayes, Marshall, 2015] no significant association between the overall level of ESG reporting and market valuation of a company, its components (cash flows and cost of capital) was found; however, after controlling for ESG performance and separating ESG disclosure by its nature (positive, negative or neutral) and the type of ESG reporting (soft or hard), the authors noticed that the high-quality soft disclosure is significantly correlated with both increased cash flows and the decreased cost of capital components of firm market value. Relying upon findings and insights of the previous academic literature, the following hypotheses are proposed regarding ESG performance, ESG disclosure and firm value.
It may be expected that value of the firm is jointly affected by the level of ESG performance and level of ESG reporting. Moreover, ESG disclosure may serve as a moderator in this relationship between ESG activities and valuation of the company. Therefore, the implied relationship can be shown using the following mathematical formula:
Considering literature findings, the hypothesis of this study supposes a positive connection between firm value and ESG performance. As for ESG disclosure, the hypothesis of no relationship with firm value is tested, because of extant analysis' mixed findings and variety of managerial motives regarding disclosure policy. Thus, the following hypotheses are tested:
H1. There is a positive relationship between ESG strengths and firm value.
H2. There is a negative relationship between ESG concerns and firm value.
H3. There is no relationship between the extent of ESG disclosure and firm value.
Chapter 2. Empirical research
2.1 Research design
To study the relationship between 3 metrics - ESG performance, ESG disclosure and firm value, it is necessary to foresee possible endogeneity problem. Endogeneity can be caused by omitted variables or simultaneity. Thus, if level of ESG disclosure is affected by other factors (such as different motives for disclosure described in the first part) and these factors also influence firm value, then error terms of regular OLS regression will be non-independent, so the coefficients will be biased and inconsistent. Also, it is possible that firm value impacts ESG disclosure - in this case ESG disclosure will be correlated with error terms. To account for potential endogeneity, the instrumental variables method has been chosen and 2SLS regression analysis.
In the baseline model, 3 instrumental variables have been chosen for the potential endogenous variable of ESG reporting. The first instrumental variable is the presence of CSR committee as a part of board of directors. [Liao, Luo & Tang, 2015; Peters, Romi, 2014] noticed that companies that have CSR committees are prone to disclose information on gas emission and have better quality of this information. [Michelon, Parbonetti, 2012] found that organizations which have CSR committees report more information on social issues as well. Therefore, extant studies prove CSR committees to affect significantly the level and quality of ESG disclosure. Therefore, this instrumental variable should be significantly correlated with ESG reporting and suitable for 2-stage regression model. [Peters, Romi, 2015] found no relationship between CSR committee existence and firm value, therefore CSR committee dummy suits the exogeneity condition, because it is unlikely to have straight influence on a dependent variable.
The second instrumental variable used is analysts' earnings forecast surprise. It is taken from Thomson Reuters database and calculated by subtracting the consensus earnings estimate from the actual reported earnings and then dividing by the consensus earnings estimate. There is a wide range of studies providing evidence that extent of transparency and disclosure is negatively related to a dispersion of analysts' earnings forecast [Barron, Kile, O'Keefe, 1999; Lang, Lundholm, 1996; Hope, 2003]. It is clear that the more transparent a company is, the less information asymmetry arises, and the more precise forecasts are. Regarding ESG disclosure, [Dhaliwal et al, 2011; Dhaliwal, Radhakrishnan, Tsang, Yang, 2012] conclude that dispersion of analysts' earnings forecasts is negatively associated with mandatory ESG standards (by law) and positively associated with voluntary ESG activities. All in all, earnings forecast surprise should suit the relevance condition in our model. As for independency criterion, there is no comprehensive evidence on a relationship between earnings forecast accuracy and firm value. Some researches show that analyst forecast dispersion is positively correlated with current stock prices and negatively related with future returns [e.g., Diether, Malloy, Scherbina, 2002; Johnson, 2004]; other papers conclude on quite the opposite relationship [e.g., Anderson, Ghysels, Juergens, 2005; Barron, Stanford, Yu, 2009]. Other part of studies found no relationship: [Brennan, Chordia, Subrahmanyam, 1998; Hwang, Li, 2008; Li, Wu, 2014]. Considering these mixed findings, it is implied that analysts' earnings forecast surprise instrument satisfies exogeneity condition. However, postestimation exogeneity tests are needed to evaluate suitability of instruments.
Finally, ownership concentration is used as an instrument. Previous studies documented an adverse relationship between ownership concentration and the level of disclosure [Garcia-Meca, Sanchez-Ballesta, 2010]. Companies with several large shareholders might have less motivation to be transparent because the demand for public disclosure is weaker comparing to companies with much more dispersed ownership and stronger community of minority shareholders. Moreover, large shareholders may have insider access to company information; for instance, they can be related to board of directors. Regarding CSR/ESG disclosure, it is widely concluded that firms with more concentrated ownership have on average more modest ESG reporting [Brammer, Pavelin, 2008; Reverte, 2009; Bouten et al., 2012; Liao et al., 2015]. The evidence on the relationship between firm value and ownership concentration in inconclusive: part of papers found a positive link [Sraer, Thesmar, 2007; Villalonga, Amit, 2006], others documented a negative association [e.g., Anderson, Reeb, 2004]. Also, non-monotonic relationship was found in [Anderson, Reeb, 2003], and some studies report no relationship [Perrini, Rossi, Rovetta, 2008; Weiss, Hilger, 2012; Welch, 2003]. For this study we use largest shareholder's ownership share as a proxy. To understand whether this instrument fits exogeneity condition, postestimation tests will conclude.
Specification of first-stage regression should account for potential endogeneity of the interaction terms between ESG performance and ESG disclosure. In this study ESG performance is split into ESG strengths and ESG concerns. Adopting the methodology of [Wooldridge, 2002], interactions between ESG strengths/concerns and instrumental variables for ESG disclosure as instruments for cross-variables of ESG strengths/concerns and ESG disclosure. So, the first-stage regressions are as follows:
Disc = F (CSR_comm, Analyst_forecast, Own_conc)
Disc*Str = F (CSR_comm*Str, Analyst_forecast*Str, Own_conc*Str)
Disc*Con = F (CSR_comm*Con, Analyst_forecast*Con, Own_conc*Con)
All the instrumental variables must satisfy relevance and exogeneity conditions, and to check it the postestimation test statistics is examined. In the appendix (attachments 4-6) several statistics and tests for underidentification, weak instruments and overidentification are reported.
Firm value is proxied by Tobin's Q; level of ESG disclosure is proxied by ESG disclosure percentile score from Bloomberg ESG database, and ESG strengths/concerns data is provided by respective scoring in Thomson Reuters ESG database.
To finalize regression models, several control variables are added in accordance with previous literature [e.g., Cho, Patten, 2007; Clarkson et al., 2008; Jiao, 2010; Peters, Romi, 2014]. There are several metrics which are traditionally used as control variables for firm value. These variables comprise profitability proxy (ROA), ROA growth, firm size (natural logarithm of sales - lnsales), asset intensity (assets to sales ratio - assetsales), leverage (debt to equity), advertising intensity (advertising expenditures to sales - advert), research and development intensity (R&D spendings to sales - rd), asset age (net PPE to gross PPE - ppe_ntg). Also, dummy variables for absence of advertising and R&D expenditures are added (advert_missing, rd_missing), as well as industry and year effects.
All in all, 2SLS regression models used in this study are as follows:
First stage models with instrumental variables:
Disc = a + B1*CSR_comm + B2*Analyst_forecast + B3* Own_conc + B4* Str + B5* Con + controls + e,
Disc*Str = a + B1*CSR_comm*Str + B2*Analyst_forecast*Str + B3* Own_conc*Str + B4* Str + B5* Con + controls + e,
Disc*Con = a + B1*CSR_comm*Con + B2*Analyst_forecast*Con + B3* Own_conc*Con + B4* Str + B5* Con + controls + e,
Second stage model:
TobinQ = a + B1*Disc + B2*Str + B3*Str*Disc+ B4*Con+ B5*Con*Disc+ controls+ e,
where controls are: ROA, ROAgr, ln_sales, assetsales, leverage, advert, advert_missing, rd, rd_missing, ppe_ntg, year, industry.
2.2 Data and sample
ESG data is versatile and non-standardized; earlier studies often referred to CSR reports and researchers manually collected data. Nowadays the main sources for ESG information are aggregated in major financial databases which opens new opportunities for research. In this study 2 ESG databases are used: Bloomberg ESG and Thomson Reuters ESG databases.
Bloomberg ESG provides data on level of ESG disclosure. The database was launched in 2009, and by 2019 it has aggregated data for nearly 11,000 companies in 63 countries [Bloomberg website]. Bloomberg analyzes over 700 environmental, social and governance indicators for disclosure from company-sourced filings, such as CSR reports, annual reports, official websites; and other third-party information, covering practically all the available information for investors. Depending on the data points obtained, and adjusting reports to the industry, Bloomberg provides disclosure scores ranging from 0.1 (lowest) and 100 (highest).
Thomson Reuters ESG provides ESG performance scores for more than 7,000 companies in the world across 10 main topics: emissions, environmental product innovation, resource use, human rights, shareholders, and others. ESG data is based on company-reported data, covers more than 400 different ESG metrics and dates back to 2002 (178 comparable measures are used in ESG scoring). Scores are also based on percentile scale from 0.1 to 100 and adjusted to industry.
The sample consists of 340 US companies from S&P 500 for 2015-2018 years. Initially, financial services and IT industries were excluded from the sample due to its specifics regarding factors influencing market value or ESG performance [Auer, Schuhmacher, 2016]. Then outliers were determined and excluded, as well as companies for which ESG disclosure or ESG performance was unavailable, and only 1358 firm-year observations were left. As for industry break-down, 47% of the sample are manufacturing companies, 12% are transportation and utilities, 11% are wholesalers and retailers, services have 23% and mining and construction companies - 7%.
To construct a model according to the approach of other researchers [e.g. Cornett, Erhemjamts, Tehranian, 2016; Plumlee et al., 2015], ESG data is divided into ESG strengths and ESG concerns. Thomson Reuters reports ESG data in 10 categories and 1 additional controversy category. ESG categories include such pillars as emissions, resource use, workforce, management, human rights, etc. (Display 3), while controversy score covers many ESG topics. If ESG scandals, court procedures or other controversial events happen and get coverage in media, then controversy score assigned for a firm is low, decreasing ESG combined score. Thus, 11 ESG categories scores are transformed into ESG strengths and concerns with a following rule: if ESG pillar's percentile is above 50, then it adds up to ESG strengths; otherwise, it is captured in ESG concerns. This logic is applicable since Thomson Reuters ESG data is presented in percentiles from 0 to 100. Afterwards, total ESG strengths and concerns are calculated based on 11 categories.
Display 3 Thomson Reuters ESG scores structure Source [Thomson Reuters ESG scores, 2019]
Display 4 presents the results of descriptive statistics of the variables. The mean value for Tobin's Q is 2.29 (1.21). ESG disclosure average value is 34 for the sample, which means that S&P 500 companies on average do not disclose half of possible ESG information according to Bloomberg. ESG score is on average 64 out of 100 possible. ESG strengths and concerns have values in between of 0 and 100, as well as combined ESG scores. On average, firms from the sample have much more ESG strengths than ESG concerns, with mean scores 57.8 and 23.8, respectively. 60.8% of companies have CSR committees in terms of Board of directors. Earnings surprise' average is 0.01 meaning EPS forecasts for S&P 500 companies are on average quite accurate and a bit understated. Ownership concentration values reflect a dispersed ownership model which is typical for USA and other Anglo-Saxon markets. Control variables (ROA, ROA growth, logarithm of sales, leverage, assets to sales) are in reasonable limits: average ROA is 6.9%, average logarithm of sales is 23.0 ($9.5 billions), average assets to sales 2.3, average debt-to-equity 1.0. Average advertising expenses and R&D expenses are 2.3% and 3.3% of sales, respectively; while for 81.5% of sample advertising expenses are unavailable, and for 56.1% of sample R&D expenses are not reported.
Display 4 Descriptive statistics
Further correlations matrix is provided. Tobin's Q is negatively correlated with disclosure and ESG concerns, leverage, logarithm of sales, asset intensity, asset age; and positively correlated with ESG strengths, ROA, ROA growth, advertising and R&D expenses. ESG disclosure is significantly positively correlated with ESG strengths, leverage, log of sales and R&D expenses and negatively correlated with ESG concerns. Positive link between ESG disclosure and leverage possibly means that banks take into consideration ESG risks. ESG strengths are negatively connected with ESG concerns, meaning that usually firms with strong ESG advantages have less ESG weaknesses. All in all, initial correlations seem reasonable, as it is hypothesized that ESG strengths/concerns should positively/negatively influence on a firm value, while ESG disclosure can be a mitigator in this relationship. Also, there is no strong correlation observed (more than 0.7 or less than -0.7), however some ESG metrics and ROA with Tobin's Q have rather high pair correlation coefficients.
Display 5 Cross-correlations of variables (star refers to 95% significance level)
2.3 Empirical results of regression analysis
In this section the results of 2SLS regression model are presented. At first, the output of 3 first stage regression models is described; the results are shown in appendix (attachments 1-3). Then the results of second-stage regression, examining the relationship between ESG performance, ESG disclosure and firm value, are summarized in display 6. The analysis is based on panel data, and the year and industry dummy variables are included into the model. Also, robust standard errors are used to control for heteroskedasticity [White, 1980].
Before going further to the results, it is important to check for overidentification, weakness of the instruments and exogeneity. According to Durbin-Wu-Hausman test, hypothesis of exogeneity of variables is rejected (p=0.0014, 0.0016). The same is true for strength and relevance test (attachment 6): F-statistics is more than critical value (p=0.0002), and Shea's partial R-squared is 11% which means that significant part of variation of ESG reporting is explained by instrumental variables. Finally, Sargan and Basmann overidentification test shows insignificant results (p=0.2370, p=0.2426), meaning that there is no overidentification in the model.
First-stage regression results are presented in attachments 1-3. All 3 models are significant and adjusted R-squared is 52-75% meaning significant part of disclosure metrics is explained by independent variables' variance. Control variables (firm size, asset intensity, leverage, R&D intensity, industry dummies) are significant at least at one regression model. All 3 instruments are significant at least in 1 first-stage regression model. Presence of CSR committee at Board of directors is an instrument significant in all first-stage regression models - for disclosure, disclosure*ESG strengths and disclosure*ESG concerns. It is seen that presence of CSR committee positively impacts ESG disclosure in accordance with expectations. Earnings surprise is significant only in a regression for ESG disclosure*ESG concerns, providing a negative influence on disclosure; while ownership concentration is significant and positive in 2 first-stage regressions: with dependent variable disclosure and ESG strengths*disclosure. Taken together postestimation results and significance of instruments, it is allowed to move to the discussion of second-stage regression model with instrumented disclosure and cross variables.
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