ESG and firm performance: do stakeholder engagement, financial constraints and religiosity matter?

Recent years have witnessed a burgeoning interest among regulators, managers, academics and society in the environmental, social and governance performance (ESG) of firms. As Artiach et al. (2010) explain, ESG relates to the extent to which a firm simultaneously incorporates issues related to economic growth, environmental protection, social responsibility and corporate governance into its business operations ^[1]. A central question that has long been discussed in the relevant literature is whether ESG performance matters for firm performance. Earlier studies in this field have yielded mixed results; that is, the ESG-firm performance relationship can be positive, negative, or neutral (Margolis and Walsh, 2003; Salzmann, 2013; Ye and Zhang, 2011). Specifically, several studies regard ESG performance as a manifestation of agency problems inside a firm, which can be detrimental to firm value (Lahouel et al., 2021; Tenuta and Cambrea, 2022). An opposing view, however, holds that firms with superior ESG performance may gain stakeholder support, which is an intangible benefit for firms to improve their performance (Cahan et al., 2016; Nguyen et al., 2020, 2023). The inconsistent empirical findings on the ESG-firm performance relationship in the extant literature, as noted in Pham and Tran (2020), may be attributed to incomplete research models that fail to include appropriate intervening variables.

This study attempts to fill this gap in the literature by re-examining the relationship between ESG performance and firm performance, with a particular focus on important intervening factors that have not received adequate attention in previous studies. Specifically, we investigate whether the ESG-firm performance linkage is moderated by stakeholder engagement, financial constraints and religiosity.

We test our hypotheses using a comprehensive dataset for firms from 31 countries between 2002 and 2018. Our empirical results confirm that ESG performance significantly and positively affects firm performance. Moreover, this positive relationship is more pronounced in firms with a higher level of stakeholder engagement but becomes weaker in firms with more financial constraints. Additionally, religiosity is found to negatively moderate the relationship between ESG performance and firm performance. We check the robustness of the baseline results using different dimensions of ESG performance, an alternative measure of firm performance, an alternative estimation technique and re-estimating the baseline model with different subsamples. To identify the causal effect of ESG performance on firm performance, we adopt the propensity score matched difference-in-differences (DiD) approach with country-level mandatory ESG disclosure regulations as the exogenous regulatory shock. Our results remain valid in the above tests. Interestingly, we find that the positive impact of ESG performance on firm performance is driven primarily by environmental and social factors rather than by governance performance.

Our paper makes important contributions. First, our research findings help resolve the long-standing debate about the value impact of ESG performance. This debate centers on the claim that ESG engagement may have a detrimental effect on shareholder wealth. Our empirical findings assert that ESG, in fact, enhances rather than diminishes firm performance. Second, while previous studies have largely neglected intervening factors in the relationship between ESG performance and firm performance, our paper investigates relatively new contingencies of this relationship by demonstrating that the value influence of ESG performance varies with stakeholder engagement, financial constraints and religiosity. Third, our study offers more insight into the ESG literature by showing that not all ESG dimensions equally impact firm performance, thereby suggesting that individual ESG components, in addition to overall ESG, should be adequately investigated.

A large body of literature employs stakeholder theory and a resource-based view to explain the linkage between ESG performance and firm performance.

Stakeholder theory (Freeman, 1984) suggests that a firm needs to take into account the interests of its stakeholders, defined as any individual or group who can influence or is influenced by the actions of the firm. A firm’s legitimacy is obtained in the eyes of stakeholders by conforming to their expectations about corporate social responsibility (Zheng et al., 2015). Drawing on this theory, previous empirical studies show that ESG initiatives help firms improve their relationships with their stakeholders, which in turn enhances firm performance (Waddock and Graves, 1997; Preston and O'Bannon, 1997). For instance, Vishwanathan et al. (2020) show that ESG performance can increase stakeholder cooperation and increase firm productivity, thereby influencing firm performance. Ashrafi et al. (2020) demonstrated that firms can build legitimacy through the integration of ESG practices into business strategic decisions and operation processes, thus improving firm performance even in the long run.

Additionally, a resource-based view (Wernerfelt, 1984) complements stakeholder theory in explaining the positive effect of ESG on firm performance. Proactive engagement in ESG initiatives enables firms to develop new resources and capabilities critical to their competitive advantage (Branco and Rodrigues, 2006). In particular, ESG positively influences employees’ motivation, their job satisfaction and commitment to their organizations (Brammer et al., 2007), which in turn significantly contributes to firm performance (Huang et al., 2015). Moreover, firms with superior ESG can reduce the costs of recruiting and training new employees because of their higher employee retention (Jones et al., 2014). Moreover, firms with good ESG reputation are more likely to gain support from external stakeholders such as suppliers, customers and capital providers (Malik, 2015), thereby maintaining their competitive advantage over competitors to achieve financial success. Consistent with these arguments, we propose our first hypothesis as follows:

However, there are counterarguments that suggest a negative impact of ESG performance on firm performance. Friedman’s (1970) agency theory considers ESG to be a manifestation of the agency problem whereby shareholders’ wealth is misallocated to social and environmental projects in pursuit of managers’ personal interests, such as building a positive reputation for sustainability initiatives in the job market. Such projects can be implemented at the expense of other competing projects that have positive net present values. Furthermore, ESG engagement, such as investing in environmental initiatives, incurs additional costs for a firm, which may compromise its profitability (Derwall et al., 2005). A number of recent studies also provide empirical evidence supporting a negative impact of ESG performance on firm performance (Lahouel et al., 2021; Tenuta and Cambrea, 2022). As such, the impact of ESG performance on firm performance is still an empirical question.

Greenwood (2007) defines stakeholder engagement as the practices undertaken by firms to involve stakeholders in their organizational activities. Previous studies provide evidence on the important role of stakeholder engagement in value creation (Freudenreich et al., 2020), strategic decision-making (Ramus and Vaccaro, 2017), innovation (Bendell and Huvaj, 2020), corporate reporting (Pucheta-Martínez et al., 2020) and the ESG practices of firms (Dobele et al., 2014). Consistently, Cheng et al. (2014) maintain that stakeholder engagement is likely to temper managerial short-termism and is regarded as a superior form of contracting with essential stakeholders, thereby enhancing firm profitability. Choi and Wang (2009) note that by improving their ESG performance, firms with high levels of stakeholder engagement have greater financial performance. In a related vein, Ho et al. (2021) indicate that by enhancing stakeholder engagement, ESG positively impacts firms’ speed of adjustment to target leverage, thereby increasing firm value. Additionally, superior stakeholder engagement can help firms accumulate social capital (Smith and Lohrke, 2008), which is helpful for achieving the financial benefits of ESG programs and for absorbing the costs associated with them. Consistent with Girard and Sobczak (2012), who argue that stakeholder engagement leads stakeholders to believe in the norms, values and objectives of the firm, we expect that ESG activities in firms with superior stakeholder engagement are perceived to be more credible and thus are associated with better financial outcomes. Consequently, we propose the second hypothesis as follows:

Financial constraints refer to frictions that prevent a firm from funding all desired investments, such as inability to borrow, inability to issue equity, dependence on bank loans, or illiquidity of assets (Lamont et al., 2001). Previous studies show that financial constraints negatively impact firm’s prospects. Hovakimian (2011) shows that firms facing fewer financial constraints perform significantly better than those facing more financial constraints. Consistently, Campello et al. (2010) find that financially constrained firms reduce their corporate investment in technology, employment and capital spending. Additionally, these firms bypass potentially profitable investment projects. Musso and Schiavo (2008) report that the likelihood of exiting the market is greater for firms facing financial constraints. Given that ESG implementation is not without costs, financial constraints may cause firms to pass up ESG investments or selectively engage in ESG activities as impression management tactics that may be value irrelevant. This leads us to our third hypothesis:

Religiosity is defined as the intensity of adherence to prevailing religious beliefs, codes, values, practices and promulgation (Abdelsalam et al., 2021). Religion has been shown to have a significant impact on individuals’ and communities’ behaviors and on firms’ decision-making (Hilary and Hui, 2009; Gundolf and Filser, 2013) and is viewed as an inseparable part of economic thought (Al-Khazali et al., 2017). The recent literature has particularly focused on the association between religious beliefs and firms’ environmental and social performance. Du et al. (2016) note that firms located in a stronger religious atmosphere normally show a greater level of ESG than others. This is because ESG practices are valued more by stakeholders with higher religiosity (Angelidis and Ibrahim, 2004). Consistently, Deng et al. (2013) indicate that religious stakeholders assign more value to ethical conduct. Wu et al. (2016) revealed that religious stakeholders request more ESG-oriented activities and are less tolerant of behaviors that are likely to raise environmental and social concerns. Similarly, Ozkan et al. (2023) noted that religiosity influence individuals’ consumption preferences or their intention to adopt environmentally friendly products. These authors also note that people with strong religious beliefs are likely to have more moral intentions and are unlikely to be involved in ethically questionable practices. Cao et al. (2019) view religiosity as an informal institution and argue that it improves enforcement by increasing nonpecuniary costs such as feelings of guilt and reducing risk-taking. Their empirical analysis suggests that religion can act as an effective alternative mechanism for facilitating informal finance decision-making. These discussions suggest that ESG performance should be more value relevant in countries with higher degrees of religiosity. We therefore hypothesize the following:

Nonetheless, one can also express an alternative view on the impact of religiosity on the relationship between ESG performance and firm performance. ESG engagement in societies with higher levels of religiosity is commonly regarded as a social norm, so stakeholders are likely to pay less attention to firms’ social responsibilities than to their irresponsible behaviors. Consequently, firms may be less motivated by adhering to ESG practices in countries with stronger religiosity but more motivated by doing something outside the scope of social norms. Given that religiosity discourages risk-taking behaviors, corporate managers may forgo risky projects with positive net present values, thereby reducing firm value (Zolotoy et al., 2019). Firms located in countries with higher levels of religiosity are more likely to have better performance through improvements in workplace safety (Amin et al., 2021), earnings quality (Abdelsalam et al., 2021) and lower debt costs (Chen et al., 2016); hence, there is an upper bound for the increase in firm performance. This may lead to the possibility that firms operating in stronger religious environments find it difficult to improve their financial performance by enhancing their ESG performance. Therefore, an alternative hypothesis is proposed as follows:

We utilize a sample of 13,020 firm-year observations from 31 countries from 2002 to 2018 to test our hypotheses. The financial data of the firms were obtained from Thomson Reuters Worldscope. ESG and religiosity data were collected from the Thomson Reuters ESG database and the World Values Survey database, respectively. Firms with special features, such as warrants, trusts, funds and nonequity stocks, financial firms (SIC codes from 6000 to 6999), and regulated utilities (SIC codes from 4900 to 4999), are excluded. To reduce short panel bias, we eliminate firms that do not have data for at least two consecutive years. Both the dependent and continuous independent variables are winsorized at the 1st and 99th percentiles to mitigate the potential impact of extreme values.

Since ESG activities promote firm performance in the long run, a firm’s long-term expected value is a better proxy than its current economic performance (Kanter, 2011). Following prior literature (e.g., Cahan et al., 2016; Lahouel et al., 2021), we use Tobin’s Q as a measure of the market’s assessment of a firm’s long-term expected value. Tobin’s Q incorporates the market’s assessment of a firm’s future cash flow and the riskiness of those cash flows. We measure Tobin’s Q as the market value of assets scaled by the book value of total assets.

We obtain ESG performance score data from the Thomson Reuters ESG database (Cheng et al., 2014; Ho et al., 2021). Based on information from diverse sources, including annual reports, corporate social responsibility reports, company websites and global media sources, Thomson Reuters obtains more than 400 ESG metrics and establishes ESG scores. These scores evaluate a firm’s ESG performance across three pillars: environment (E), social (S) and governance (G). In our main analyses, we employ the annual ESG score for each focal firm as a proxy for our key independent variable.

The three moderating variables employed in the current study are stakeholder engagement, financial constraints and religiosity. Stakeholder engagement data are obtained from the Thomson Reuters ESG database, which measures the extent to which a focal firm explains the formal processes in place for engagement with its stakeholders (Cheng et al., 2014; Ho et al., 2021). The higher the score is, the stronger the firm’s stakeholder engagement.

The Kaplan-Zingales (KZ) index (Kaplan and Zingales, 1997) is used as a proxy for financial constraints and consists of a linear combination of five accounting ratios, namely, cash flow to total assets, the market-to-book ratio, debt to total assets, dividends to total assets and cash holdings to total assets (Baker et al., 2003). Higher values of the KZ index imply that the firm faces more financial constraints.

We follow the literature (e.g., Chen et al., 2016) and utilize the religious orientation results from the World Values Surveys (WVS) to measure religiosity at the country level. We obtain three items in the WVS that capture such elements of religiosity: membership in religion, religious importance and religious services. Following Chen et al. (2016), we extracted the first principal component of these three elements to develop a comprehensive religiosity variable, denoted as REL.

We control for a number of factors that can potentially affect the relationship between ESG performance and firm performance (Cahan et al., 2016). Specifically, firm size (SIZE) is measured as the natural logarithm of total assets. Tangibility (TANG) is the ratio of net property, plant and equipment to total assets. The sales growth rate (GROWTH) is measured as current sales divided by sales of the previous year minus one. R&D intensity (RDINT) is R&D expenditures scaled by total assets. Asset return (RET) is income before extraordinary items scaled by total assets. Capital expenditure (CAPEX) is capital expenditure scaled by total assets. Firm leverage (the LEV) is measured as total debt divided by total assets. Dividend payout (DIV) equals 1 if the firm pays a dividend and 0 otherwise.

The descriptive statistics for the whole sample and for the individual countries are reported in  Table A1 ^[2] and  Table A2 ^[2], respectively.

The following equation is used to examine whether ESG performance affects firm performance:

where $Qi,j,t$ is Tobin’s Q of firm i from country j in year t; $ESGi,j,t$ measures the ESG performance of firm i from country j in year t; $α$ and $Ϭ$ are coefficient vectors; and $Yi,j,t$ is a set of control variables. In addition, we control for country (⁠$μj$⁠), industry (⁠$θk$⁠) and year (⁠$δt$⁠) fixed effects to capture the unobserved heterogeneity across countries, industries and time.

We further examine whether stakeholder engagement, financial constraints and religiosity exert intervening effects on the relationship between ESG performance and firm performance. We include the interaction terms (ESG*MOR) between ESG performance and these three moderating variables in Eq. (1):

We report the results of Eq. (1), which estimates the impact of ESG performance on firm performance, using pooled OLS with industry, year and country fixed effects (Column (1)) and a firm fixed-effects model (Column (2)) in Table 1. The results show that all the coefficients of the ESG variable are positive and significant at the 1% level across the models. This finding supports our Hypothesis H1, which indicates that there is a positive association between ESG performance and firm performance. This finding is consistent with previous empirical research showing that ESG performance increases customer loyalty, decreases systematic risk, improves sales capacity or product price and attracts more resources that are essential determinants of firm performance (Cheng et al., 2014; Huang, 2022). More interestingly, this impact is economically significant. As shown in Column (1), a one standard deviation increase in ESG performance will lead to an increase of 4.6%, on average, in firm performance measured by Tobin’s Q.

The results in Column (3) of Table 1 show that the coefficient of the interaction term ESG*STAKE is positive and significant at the 1% level, indicating that stakeholder engagement enhances the positive relationship between ESG performance and firm performance. Therefore, our Hypothesis H2 is supported. This result is consistent with the idea that fostering long-term relationships with stakeholders enables firms to develop valuable intangible resources that are helpful for implementing ESG projects, which in turn can improve firm value (Cheng et al., 2014; Bai and Ho, 2022).

Column (4) of Table 1 reports that the coefficient of the interaction term ESG*FINCONST is negative and significant at the 1% level. This finding is consistent with the notion that financial constraints impair a firm’s ability to invest (Campello et al., 2010), especially in ESG projects, which often require a large amount of initial investment without any immediate payoff for the firm. Consequently, the financial impact of ESG performance becomes weaker for financially constrained firms, thereby supporting our Hypothesis H3.

Column (5) of Table 1 presents the results of analyzing the moderating impact of religiosity on the association between ESG performance and firm performance. The results show that the coefficient of the interaction term ESG*REL is negative and significant. This finding suggests that ESG performance can serve as a substitute for religiosity in impacting firm performance. Put differently, compared with their peers located in countries with higher levels of religiosity, firms in countries with lower levels of religiosity can gain greater financial benefits by actively engaging in ESG activities (El Ghoul et al., 2012; Su, 2019). This result supports Hypothesis H4b and rejects Hypothesis H4a.

In this section, we perform several tests to ensure the reliability of our results. First, establishing the causal effect of ESG performance on firm performance is a challenging task due to the potential endogeneity inherent in ESG research. To address this issue, we use mandatory ESG disclosure regulations at the country level as an exogenous shock to firms’ adherence to ESG practices (Gibbons, 2023; Krueger et al., 2023) and employ DiD analysis with a propensity score matching (PSM) procedure. Specifically, we follow Krueger et al. (2023) to identify the effective years of country-level mandatory ESG disclosure for our sample countries over the period 2002–2018. Our sample firms were divided into treatment and control groups. We estimate a logistic model to generate propensity scores. We then use the predicted probabilities calculated from the logistic regression to match all treatment firms with the control firms. This results in 2,059 pairs of matched treatment and control firms.  Table A3 ^[2] compares the mean values of the characteristics of the treatment firms with those of the control firms before and after the PSM. The results show that most firm characteristics differ significantly between the two groups before matching. However, after matching, all the firm characteristics are not significantly different between them, which satisfies the balancing assumption.

Based on the PSM sample, we employ DiD approach to re-examine the effect of ESG performance on firm performance as follows:

where POST_ADOPTION indicates whether a country has adopted a mandatory ESG disclosure regulation. The other variables are identical to those in Eq. (1). The results are reported in  Table A4^[2]. In particular, the coefficient of the variable of interest, POST_ADOPTION, is significantly positive, confirming that ESG performance enhances firm performance, which is consistent with our main results.

We next investigate which components of ESG performance contribute to the positive link between ESG performance and firm performance. The results reported in  Table A5 ^[2] suggest that the overall positive influence of ESG performance on firm performance is driven by a firm’s environmental and social performance rather than by its governance performance. This result is consistent with the view that corporate governance is not necessarily related to future cash flows and performance (Cheng et al., 2014).

In addition, we check the robustness of our baseline results using the natural logarithm of ESG scores to proxy for ESG performance (Ho et al., 2021), ROA as an alternative measure of firm performance (Tenuta and Cambrea, 2022), and the system GMM as an alternative estimation technique (Lahouel et al., 2021) ^[3] and dividing the sample into G7 countries and non-G7 countries (Cheng et al., 2014). These empirical analyses presented in  Table A6 ^[2] (using the natural logarithmic transformation of ESG),  Table A7 ^[2] (using ROA) ^[4],  Table A8 ^[2] (using the system GMM),  Table A9 ^[2] (using Oster’s (2019) advanced approach to address concerns about omitted variable bias) and  Table A10 ^[2] (using G7 and non-G7 subsamples) confirm the robustness of our baseline results.

Using a large international sample of 13,020 firm-year observations from 2002 to 2018, we find that superior ESG performance is associated with greater financial rewards. Interestingly, the positive relation between ESG performance and financial performance is driven by environmental and social performance rather than governance performance. We further provide empirical evidence that this positive relationship is more pronounced in firms with higher levels of stakeholder engagement. This finding indicates that firms that simultaneously invest in ESG activities and engage stakeholders in their business can produce a complementary effect on firm value. It also supports the notion that superior stakeholder engagement provides firms with critical resources to undertake ESG projects with positive net present values. However, the positive ESG–firm value relationship becomes weaker in firms with more financial constraints. This can be explained by the fact that financially constrained firms are disincentivized from making ESG investments given that ESG activities are not essential to their business but are costly and unlikely to offer benefits in the short run, thereby alleviating the value-enhancing effect of ESG engagement. We also document that the positive relationship between ESG performance and firm value is less pronounced for firms located in countries with a stronger religious atmosphere. This finding is consistent with the view that ESG engagement is a social norm in stronger religious societies; thus, its impact on firm value is weaker than that in societies with lower levels of religiosity, where ESG initiatives are less likely to coincide with a social norm.

Our findings have specific implications for practitioners and policy-makers. First, firms should proactively engage in ESG initiatives to increase firm value in the long run. Additionally, corporate managers should take into account the intervening influences of stakeholder engagement, financial constraints and religiosity in making decisions to invest in ESG activities. Moreover, our findings can inform policy-makers of the financial consequences of ESG performance, which can be helpful in designing new policies to further promote corporate sustainability.

We appreciate the constructive comments and suggestions from the Editor, the Associate Editor and three anonymous reviewers. We also thank conference participants at the 7th Vietnam International Conference in Finance (VICIF-2023), the members of the UE-UD Teaching and Research Team in Corporate Finance and Asset pricing (TRT-CFAP) for their helpful comments and suggestions. This research is funded by Foreign Trade University (No. FTURP02-2020-13). All remaining errors are our own.

Supplementary material for this article can be found online.