The impact of ESG on corporate financial performance: Based on fixed effects regression model

2.1 Basic of ESG and financial performance

As early as the 1970s, concepts related to ESG emerged, spurred by a wave of protests in Europe and the United States against industrial activities that were detrimental to the natural environment. This period gave rise to a series of environmental protection movements, prompting countries to enact environmental protection policies. During this era, there was a growing recognition that the value of businesses extended beyond rapid growth and should also encompass factors such as environmental protection and social governance. In 2005, the Global Compact organization released the report “Who Cares Wins,” explicitly introducing the concept of ESG for the first time. It identified ESG as the integration of the concepts of environment, social, and governance. The report explained the content encompassed by environmental standards, social standards, and governance standards.

The Environmental (E) dimension of the ESG concept primarily addresses the impact of corporate activities on the natural environment. Among the three dimensions of ESG, the environmental dimension has received more attention [2]. The Social (S) dimension of ESG measures the external impact of corporate operations on society and the contributions made by companies to society. Given that the ESG concept originated from Corporate Social Responsibility (CSR), it emphasizes that businesses should not only pursue the achievement of established financial goals but should also prioritize long-term societal benefits and contribute to the sustained development of the economic and social environment [3]. The Governance (G) dimension of ESG focuses on ethical concepts, including principles of fair and transparent transactions, and the effectiveness of corporate boards. Some scholars argue that the three dimensions of ESG are interconnected and should be analyzed and evaluated as a whole. Ketter et al. suggests that the three dimensions of ESG can be represented through an ESG concept framework [4]. This framework enables companies to address specific societal issues by comprehensively considering all three dimensions. The widespread influence of the ESG concept is primarily attributed to the promotion of sustainable investment principles. The ESG concept framework plays a crucial role in observing and assessing the sustainability and applicability of different organizational structures.

Financial performance is the measure of a company’s operational outcomes over a specific period, encompassing the effectiveness of cost control, asset utilization, shareholder returns, and other factors. Financial performance indicators can be broadly categorized into three main types [5]: (1) Single Indicator Approach: a. Accounting Performance Indicators: Based on book values, including metrics like Return on Assets (ROA), Return on Equity (ROE), and Gross Profit Margin. ROA, due to its comprehensive nature, is often favored by scholars as it provides a more holistic reflection of a company’s financial condition. b. Market Performance Indicators: Based on market values, including commonly used metrics like Tobin’s Q and Earnings Per Share (EPS). Tobin’s Q is widely utilized in this category. (2) Composite Indicator Approach: This approach involves selecting and constructing a comprehensive indicator system based on certain standards. (3) Perception Indicator Approach: This approach considers factors such as the robustness and safety of a company’s finances, the efficient utilization of assets, the execution of operational strategies compared to competitors, and the achievement of financial goals. These indicators collectively serve as metrics for evaluating financial performance, providing insights into various aspects of a company’s operations, from accounting-based measures to market-based valuations and broader perceptions of financial health and strategic execution. The choice of which indicators to use often depends on the specific goals of the analysis and the nature of the industry or company being evaluated.

2.2 Relationship between ESG and financial performance

Regarding research on the relationship between ESG and financial performance, it can be primarily categorized into three main types: positive impact, negative impact, and no significant impact.

The majority of findings support the positive result. Kim and Li found that among 2200 individual studies from 1970 to 2015, approximately 90% of them indicate non-negative relationships between ESG and financial performance variables, while most report the positive impact of ESG factors on corporate financial performance [6]. Yoon et al. conducted a study on South Korean companies, revealing a positive and significant impact of ESG on corporate financial performance [7]. Ahmad et al. examined the impact of ESG on the financial performance of UK firms, indicating that high ESG firms show high financial performance as compared to low ESG firms [8].

However, many scholars have reached the opposite conclusion. Di Tommaso and Thornton concluded in their study that European banks with higher ESG scores exhibit lower performance, as ESG investments divert scarce resources [9]. Duque-Grisales and Aguilera-Caracuel using Latin American multinational companies as their sample, found a significant negative correlation between ESG scores and financial performance [10]. Ruan and Liu focusing on companies listed on the Shanghai and Shenzhen stock exchanges in China, reached a similar conclusion [11].

Additionally, many scholars believe that there is no necessary or fixed correlation between the two. Zhang et al. examined Chinese listed companies and argued that the corporate governance dimension is not correlated with financial performance, and the disclosure of relevant information does not necessarily enhance or diminish financial performance [12]. Meanwhile, Chen et al. argued that fulfilling ESG responsibilities would, in the short term, increase corporate costs and present a “substitution effect” on corporate performance, but in the long term, it would promote the accumulation of intangible assets and present a “promotion effect” on financial performance [13].

2.3 Literature summary

The research in this field is abundant in west countries, but there are some differences and even contradictions in the conclusions. This may be related to the different measurement methods of ESG and financial performance, as well as the diverse contexts of the studied companies in terms of countries and industries [14]. This implies that the impact of ESG on financial performance is influenced by various factors, and differences in sample selection, model construction, measurement methods, and the market environment can all affect the final results [15]. In contrast, in China, most related studies are limited to examining the impact of ESG as a whole. There is limited literature that investigates the correlation between the three dimensions and financial performance [12, 16], especially in studying the impact of ESG on financial performance in heavily-polluting industries. It is important to emphasize that heavily-polluting industries face greater environmental and social responsibility challenges. Strengthening ESG practices in heavily-polluting industries not only assists these sectors in managing environmental and social risks but also fosters sustainable development and creates long-term value for investors and society.

Based on the existing research, this study proposes improvements in the following aspects: This study treats environmental, social responsibility, and corporate governance as a comprehensive non-financial performance. It explores the relationship between ESG and financial performance using listed companies in heavily-polluting industries as samples. This approach, bolstered by two-way fixed effects regression model, aims to prevent partiality in ESG research, ensuring the completeness of the study results for accuracy and persuasiveness. The study further examines the impact on financial performance from three dimensions of ESG. Additionally, it underscores a thorough exploration of regional heterogeneity and employs variable replacement and IV-GMM approaches to assess the robustness of the research findings.

3.1 Theoretical foundation

The emergence of the theory of sustainable development is rooted in the gradual and in-depth research on environmental protection issues worldwide. In particular, the World Commission on Environment and Development (WCED) published the “Our Common Future” report in 1987, which is considered the starting point for establishing the concept of sustainable development. Of course, the introduction of any concept is an evolutionary process, subject to further modification and reshaping as different participants and environments come into play. Due to ethical concerns, there is a paradoxical and dialectical relationship between sustainability and development. The theory of sustainable development aims to reconcile this paradox and address the dialectical relationship between development and sustainability. The ideology of sustainable development requires the balanced and coordinated advancement of environmental protection alongside economic and social progress. This underscores the theory’s imperative for contemporary society to meet its developmental needs while ensuring the well-being of future generations [17].

Stakeholder theory emerged in the 1960s, asserting that businesses are responsible not only to shareholders but also to meet the demands of all stakeholders beyond shareholders. By balancing the interests of various stakeholders, effectively integrating and allocating resources, businesses can achieve their goals. Freeman, in “Strategic Management: A Stakeholder Approach”, defines stakeholders and identifies the groups involved: stakeholders are individuals or groups that can influence the achievement of corporate goals or be influenced by the processes through which corporate goals are achieved. Businesses can enhance environmental and social responsibility, improve corporate governance, and engage in ESG practices to provide feedback to stakeholders, meeting their interests and obtaining resources and support, fostering positive interactions between the company and stakeholders.

3.2 Research hypotheses

Based on the theories of sustainable development and stakeholder theory, ESG has a positive impact on financial performance. Regarding the environmental aspect, active investment in environmental protection by companies can create a positive corporate image, enhance investor confidence and public trust, accumulate reputation capital, and facilitate better corporate development. It also fosters trust from the government, reduces compliance risks, minimizes litigation and penalty losses, and increases the likelihood of obtaining government resources, leading to valuable resource advantages and enhanced competitiveness [18]. In terms of social responsibility, companies taking proactive steps to fulfill social responsibilities and genuinely meet the legitimate interests of various stakeholders contribute to building trust, enhancing confidence, and strengthening cooperation willingness and motivation. This, in turn, enables companies to sustainably provide the necessary capital and resources for long-term operations, promoting stable, healthy, and sustainable development. Regarding corporate governance, effective governance provides institutional safeguards for the continuous and smooth operation of corporate activities. Actively improving corporate governance and enhancing governance standards are conducive to making business decisions in a scientifically rational manner, thereby increasing operational efficiency and effectiveness. Building on this, the hypothesis proposed in this paper is as follows:

H1: ESG in heavily-polluting industries has a positive impact on corporate financial performance.

Fulfilling ESG responsibilities related to environmental protection by heavily-polluting companies may entail certain financial costs and disruptions to routine production and operations, such as the adoption of new energy-saving solutions or the implementation of more environmentally friendly production methods. Before being operational, these initiatives may generate minimal or no revenue, resulting in ESG responsibility fulfillment costs exceeding benefits. However, once in use and producing the “innovation compensation” effect, the costs become less than the benefits, ultimately enhancing financial performance. As the national green ecological civilization construction process continues to deepen, the increasing pressure from resource and environmental constraints encourages heavily-polluting companies in China to adopt more environmental measures to enhance their competitiveness [19]. In the current ESG paradigm, the concepts of corporate ethics and environmental protection have long been intertwined, with a greater emphasis on environmental responsibility compared to other dimensions. Investors are increasingly concerned about whether products are green and environmentally friendly, making companies that excel in environmental dimension more readily accepted by the market. Based on this, the hypothesis proposed is:

H2: For heavily-polluting companies, the Environmental (E) dimension has a more pronounced positive impact on corporate financial performance compared to the Social (S) and Governance (G) dimensions.

4.1 Data Source and sample selection

The specific scope of heavily-polluting industries is explicitly defined in documents such as the “Catalogue of Industries for Environmental Protection Inspection of Listed Companies” issued by the Chinese Ministry of Environmental Protection in 2008. This includes 16 categories: thermal power, steel, cement, electrolytic aluminum, coal, metallurgy, chemical industry, petrochemical industry, building materials, papermaking, brewing, pharmaceuticals, fermentation, textile, leather production, and mining. This paper selects A-share listed companies in China’s heavily-polluting industries with ESG scores available in the Bloomberg database as the research sample.

After excluding companies with incomplete financial or ESG data and removing companies with abnormal data, a total of 282 listed companies from 2018 to 2021 were obtained for the empirical analysis in this paper. ESG data is sourced from Bloomberg, while company financial data and other relevant information are sourced from the China Stock Market & Accounting Research (CSMAR) database. Stata 17.0 is used as the statistical analysis software.

4.2 Variables definitions

4.3 Model construction

Based on the previous analysis and to test the proposed hypotheses, a static panel regression model Eq. (1) is constructed using the selected variables:

TobinQ i , t = β 0 + β 1 ∗ ESG i , t + β 2 ∗ Controls i , t + μ i , t(1)

To further analyze the impact of the E , S , G dimensions on financial performance, the following model Eq. (2) is established:

TobinQ i , t = β 0 + β 1 ∗ ESG ⁢ _ ⁢ e i , t + β 2 ∗ ESG ⁢ _ ⁢ s i , t + β 3 ∗ ESG ⁢ _ ⁢ g i , t + β 4 ∗ Controls i , t + μ i , t(2)

Here, i represents the individual company, t represents the year; β represents the intercept and coefficients, and μ represents the random error term. Details of variables in the models are shown in Table 1.

5.1 Descriptive analysis

Table 2 presents the descriptive statistics of the variables. The minimum value of TobinQ is only 0.813, while the maximum value is as high as 9.794. This indicates significant variations in the financial performance of heavily-polluting companies across different regions in China. The variable ESG has a minimum value of 20.089 and a maximum value of 60.417. For the E dimension, the minimum score is 0, and the maximum score reaches 73.815. The S dimension has a minimum score of 3.204 and a maximum score of 51.391, while the G dimension has a minimum score of 47.622 and a maximum score of 96.117. These results suggest considerable differences in the overall ESG scores and scores for each dimension among different companies, indicating significant disparities in ESG awareness and practices.

The standard deviation of enterprise size is 1.201, indicating a noticeable variation in the sizes of heavily-polluting companies. The minimum value for growth is - 0.294, and the maximum value is 0.815, indicating substantial differences in growth among the sampled companies. The mean value of financial leverage is 0.451, suggesting good debt-paying ability among the companies. The minimum duration of company listing is 10 years, while the maximum reaches 38, revealing a significant disparity in the listing years of the sample companies. The minimum independent director ratio is 25%, and the maximum is 60%, indicating a considerable difference in the proportion of independent directors among the companies.

The correlation test results for the variables in the sample are shown in Table 3. The scores of ESG (Environmental, Social, Governance), total score, and the age of the enterprise are all positively correlated with the financial performance of the enterprise, showing a preliminary positive relationship, but the results did not pass the significance test. The variables of enterprise growth, the combination of dual roles and the proportion of independent directors show a significant positive correlation with Tobin’s Q. Additionally, enterprise size and financial leverage both exhibit a significant negative correlation with Tobin’s Q.

To avoid the occurrence of multicollinearity, we calculated variance inflation factors (VIF), which were significantly below 10. From Table 3, it can be observed that, except for the correlation between the total ESG score and the scores of environmental (E), social (S), and governance (G), which reaches around 0.8, it does not involve actual regression. The correlations between other variables are all less than 0.5, so it is judged that the model constructed does not have multicollinearity.

Fixed effects regression, treating individual characteristics as constant, it prevents biases in estimation results. This method enables a more accurate assessment of the relationship between independent and dependent variables, thereby improving model credibility and precision. Furthermore, two-way fixed effects regression involves considering both individual and time fixed effects simultaneously, effectively capturing variations and relationships by controlling for individual heterogeneity and time trends. To assess the model’s applicability, we initially conducted the Hausman test. The results indicated a p -value of 0.000, leading to the rejection of the null hypothesis and supporting the adoption of a fixed effects model. Consequently, a two-way fixed-effects model is employed for the regression analysis in this study.

From the regression analysis results in Table 4 column (1), it can be observed that, without including control variables, the R-squared value of the relationship between current ESG and financial performance (Tobin’s Q) is 0.067, and the F-value is 60.65. This indicates that using this model to explain the impact of short-term ESG score on financial performance has a certain explanatory significance. According to the empirical results, the coefficient of ESG is 0.043, and this variable is significant at the 1% level. After including control variables, as shown in column (2), the R-squared value in the fixed-effects model is 0.141, and the F-value is 15.23, indicating that the model can rigorously demonstrate the hypothesis. According to the empirical results, the coefficient of ESG is 0.018, and this variable is significant at the 5% level. Therefore, this result suggests that overall ESG performance has a positive impact on corporate financial performance. In summary, these results confirm the validity of Hypothesis 1.

In order to further explore the impact of ESG dimensions on corporate financial performance, we elaborate on the influence of E, S, and G dimensions on corporate financial performance. According to Table 4 column (3), the coefficient of ESG_e is 0.01, indicating that this variable is significantly positive at the 1% level. The result suggests that the Environmental (E) dimension has a significant positive effect on corporate financial performance. The Social (S) dimension exhibits a non-significant negative impact on Tobin’s Q, and the Governance (G) dimension is negatively correlated with Tobin’s Q but is also not statistically significant. In conclusion, these findings affirm the support for Hypothesis 2.

Given the uneven regional development in China, with significant differences in economic development levels and financial ecosystems [21], we conducted a heterogeneity analysis by dividing the country into three major regions: East, Central, and West, according to the classification provided by the National Bureau of Statistics. Table 5 presents the results of the grouped regression for the entire sample. The estimation coefficient for ESG in the East region is 0.02, which is similar to the overall sample result of 0.018 and statistically significant at the 5% level. However, in the Central and West regions, this impact is not significant. The result may be attributed to the relatively slower development pace of heavily-polluting companies in the Central and Western regions compared to the Eastern region. In these regions, companies may prioritize profitability concerns over social responsibility, leading to less emphasis on fulfilling corporate social responsibilities. In summary, the grouped regression by region reaffirms that corporate ESG has a positive impact on financial performance. This aligns with the previous regression results, indicating that a strong ESG performance can promote improvements in financial performance. Therefore, Hypothesis 1 is validated through the regional subgroup regression.