How uncertainty can determine corporate ESG performance?

Environmental, social, and governance (ESG) performance is a measure of how well a company manages its impacts and responsibilities on the environment, society, and its stakeholders. ESG performance has become increasingly important for companies and investors in the global economy, as it reflects the sustainability, resilience, and competitiveness of a company in the long term. It is widely recognized that ESG performance can have a significant impact on a company’s financial performance and long-term sustainability. Literature has shown that ESG performance can enhance the reputation and legitimacy of companies among their stakeholders, such as shareholders, regulators, customers, employees, and society at large. Companies that demonstrate high ESG performance can attract more investors, customers, and talent, as well as avoid regulatory sanctions and social backlash. ESG performance can improve the operational efficiency and innovation capacity of companies by reducing costs, risks, and waste, as well as fostering creativity, learning, and collaboration. Companies that adopt ESG practices can benefit from lower energy consumption, higher resource productivity, better quality management, and more opportunities for new products and markets.

Existing research on the topic

Previous studies have examined the relationship between EPU and corporate social responsibility (CSR), which is a broader concept that encompasses ESG performance. CSR refers to the voluntary actions that a firm takes to address its social and environmental impacts beyond its legal obligations. Previous studies have found mixed results regarding the impact of EPU on CSR. Some studies have found that EPU has a negative impact on CSR, suggesting that firms are less likely to engage in CSR activities when faced with an uncertain environment. Other studies have found that EPU has a positive impact on CSR, implying that firms use CSR as a strategic tool to cope with uncertainty and enhance their reputation. However, these studies have some limitations, such as using qualitative and self-reported measures of CSR, ignoring the heterogeneity of ESG dimensions, and neglecting the potential moderating and mediating factors that may affect the relationship between EPU and CSR.

Previous studies have found mixed results regarding the impact of EPU on CSR.

ESG performance is also important for investors, regulators, customers, employees, and society at large, who demand more transparency and accountability from companies on their ESG practices. However, achieving better ESG performance is not easy for companies, especially in emerging markets such as China, where they face various challenges and uncertainties. One of the major sources of uncertainty is economic policy uncertainty (EPU), which refers to the unpredictability of future economic policies and their effects on the economy. EPU can arise from various sources, such as political instability, policy changes, trade disputes, and global events. EPU can affect the decisions and behaviors of economic agents, such as consumers, investors, firms, and governments. China is a major economy that faces significant levels of EPU due to its rapid development, political system, and international relations. China is also a key player in the global ESG landscape, as it has made ambitious commitments to achieve carbon neutrality by 2060 and to improve its social and governance standards. However, China also faces many challenges and gaps in its ESG performance, such as environmental pollution, social inequality, human rights issues, and corporate governance problems.

The motivation of companies to tackle EPU to perform better their ESG performance in China can be explained by two main theories: the real options theory and the stakeholders’ theory. The real options theory suggests that firms may delay or defer their irreversible investment decisions under uncertainty until they receive more information or clarity about future outcomes. This implies that firms may postpone or reduce their ESG activities under high levels of EPU due to their irreversibility and sunk costs. However, this may also create an opportunity for firms to invest in more flexible and adaptable ESG activities that can cope with changing scenarios. The stakeholders’ theory suggests that firms may respond to their stakeholders’ expectations and demands under uncertainty by adopting proactive or reactive strategies. This implies that firms may increase or decrease their ESG activities under high levels of EPU depending on their stakeholder orientation and pressure. However, this may also create a challenge for firms to balance the conflicting interests of different stakeholder groups.

Firms may postpone or reduce their ESG activities under high levels of Economic Policy Uncertainty due to their irreversibility and sunk costs. However, this may also create an opportunity for firms to invest in more flexible and adaptable ESG activities that can cope with changing scenarios.

The Chinese framework

China is a developing country that faces significant environmental challenges due to its large population, rapid economic growth, and severe pollution. Therefore, ESG performance, which measures the sustainability and ethical impact of a company’s activities, is crucial for China’s long-term development. China has implemented various policies and regulations to encourage ESG performance and reduce environmental uncertainty, which refers to the unpredictability of future environmental conditions and policies. ESG-related research is also advancing and providing a more theoretical basis for the sustainable development of companies and society in China. However, there is a gap in the existing literature on how environmental uncertainty affects ESG performance at the micro level, that is, from the perspective of individual firms. Most studies have focused on the macro-level factors, such as economic policy uncertainty, or the firm-level factors, such as capital structure, earnings, and governance structure, that influence ESG performance. However, few studies have explored how environmental uncertainty, which varies for each firm depending on its industry, location, and strategy, affects ESG performance. Therefore, this study uses a sample of China’s A-share companies listed from 2008 to 2020 to analyze the impact of environmental uncertainty on ESG performance at the micro level, while controlling for corporate financial factors and corporate governance characteristics.

Findings of the paper

The main finding of this paper is that firms reduce their ESG investments when facing higher environmental uncertainty. During higher environmental uncertainty firms preferred to invest in real options as compared to ESG activities. Firms with less financing constraints have more real option investments; therefore, environmental uncertainty significantly reduces the ESG investments of these firms as compared to the firms with higher financing constraints. However, the firms operating in low-competitive industries also have more real option investments, but these firms keep investing in ESG activities even during high environmental uncertainty to enhance their reputation. Furthermore, the paper finds that the negative impact of firm-level environmental uncertainty on ESG performance dilutes during periods of high macro-level (economic policy) uncertainty.

Methodology

Panel data regression techniques

Applications and beneficiaries

The study has some practical implications for firms, regulators, and investors. For firms, it is important to improve their ability to quickly identify and respond to environmental uncertainties and to flexibly adjust their business decisions. They should also choose appropriate ESG investment strategies at different stages, taking into account their actual situation. For regulators, they should formulate differentiated policies to encourage ESG under different environmental uncertainties. They should implement different incentive policies according to the micro characteristics of firms, such as increasing subsidies for firms with high environmental uncertainty to promote sustainable development. They should also avoid frequent fluctuations in macroeconomic policies to create a prudent policy environment. For investors, this paper’s research can help them judge the value of ESG performance, and the rationality of ESG decisions, and select an appropriate investment portfolio based on environmental uncertainty and ESG performance.

Reference to the research

Bin‐Feng, C., Mirza, S. S., Ahsan, T. and Qureshi, M. A. (2024). How uncertainty can determine corporate ESG performance? Corporate Social Responsibility and Environmental Management, 31(3), 2290-2310.

Consult the research paper