Sustainable Technology and Entrepreneurship 1 (2022) 100004

Sustainable Technology and

Entrepreneurship
h t tp s : // w w w .j ou r na l s . el s e v ie r . c o m /s us t ai na bl e - te c h no lo gy - a nd -e n tr ep r e ne ur s hi p

Full Length Article

Understanding the effects of Environment, Social, and Governance

conduct on financial performance: Arguments for a process and
integrated modelling approach
Michael T. Leea,1,*, Ikseon Suhb,2
a
SKEMA Business School − University Co ^te d’Azur, SKEMA Business School, 920 Main Campus Drive, Venture II, Raleigh, NC, 27606, USA
b
University of Nevada, Las Vegas, Lee Business School, 4505 Maryland Parkway, Las Vegas, NV, 89154, USA

A R T I C L E I N F O A B S T R A C T

Article History: To date, an overwhelming number of research findings on Environment, Social, and Governance (ESG) con-
Received 30 November 2021 duct and financial performance remains inconclusive. Furthermore, research has not identified nor explained
Accepted 4 January 2022 the “underlying mechanisms” behind this relationship. To encourage future research, we discuss the mecha-
nisms by identifying the first-order, mediating, and moderating variables. We synthesize recent studies for
Keywords: emerging themes and implications; argue for a process and integrated approach for modelling causality
causality
between ESG conduct and financial performance variables; and suggest methods to analyze the models. We
ESG
also advocate for researchers to explore the idea that balancing corporate conduct among the E, S, and G
evaluation
greenwashing
components may provide revelations about financial performance. We also discuss how incorporating
integrated “greenwashing” in a process and integrated model may explain the ESG conduct and financial performance
process link, or more than likely the lack of it.
Published by Elsevier España, S.L.U. on behalf of Sustainable Technology and Entrepreneurship. This is an
open access article under the CC BY-NC-ND license (http://creativecommons.org/licenses/by-nc-nd/4.0/)

Introduction lobbying, corruption, donation, and even their visions and strategies
are scrutinized under this component.
Corporate actions in social welfare have received an increasing Corporate ESG conduct integration with investment practices and
amount of attention from fund managers and investors (Gillan et al., its impact on risk-adjusted financial returns have become the fabric
2021). These actions, known as Environment, Social, and Governance of ethical or socially responsible investments, and the number of
(ESG) or corporate social responsibility, are viewed as financially socially responsible fund options abound in Wall Street and world
material to investment performance (Bofinger et al., 2022; Gillan et financial markets (Bofinger et al., 2022; Eccles & Viviers, 2011). In
al., 2021). The environmental component (E) evaluates how firms 2020, investments into ESG open-ended and exchange-traded funds
take actions to protect and minimize damage to the environment. reached $51.1 billion, doubling more than 2019 funds ($21.4 billion)
This component involves climate change, natural resources, pollution and increasing ten-times over 2018 funds ($5.4 billion). By the end of
and waste, and environmental opportunities. The social component 2020, the ESG funds included 369 portfolios, and the U.S. ESG funds
(S) evaluates how firms treat its employees and the communities reached $236.4 billion, up by more than 70% from those of 20191. The
that they serve. Key focal elements encompass employee relations, surge in socially responsible investment alternatives has driven pub-
working conditions, organizational diversity, human rights, licly-traded companies to disclose the economic effects of ESG activi-
employee equity and justice, inclusion, product responsibility, and ties voluntarily, improving information transparency to investors
community health and safety. The governance component (G) evalu- qualitatively (Mervelskemper & Streit, 2017). According to the 2020
ates how firms’ management leads and oversees their organizational report released by the Governance & Accountability Institute, 90% of
authority. Board functions, structure, firm policies, compensation, Standards & Poor’s (S&P) 500 firms have published an ESG report in
2019, up from 86% in 2018, 75% in 2014, 53% in 2012, and just 20% in
20112.

* Corresponding author at: SKEMA Business School, 920 Main Campus Drive, Ven-
1
ture II, Raleigh, NC, 27606, U.S.A. https://www.morningstar.com/articles/1019195/a-broken-record-flows-for-us-
E-mail addresses: michael.lee@skema.edu (M.T. Lee), ikseon.suh@unlv.edu (I. Suh). sustainable-funds-again-reach-new-heights
1 2
Telephone: +1 919 535 5710 (M.T. Lee) https://www.ga-institute.com/research-reports/flash-reports/2020-sp-500-flash-
2
Telephone: +1 702 895 1551 (I. Suh). report.html

https://doi.org/10.1016/j.stae.2022.100004
2773-0328/Published by Elsevier España, S.L.U. on behalf of Sustainable Technology and Entrepreneurship. This is an open access article under the CC BY-NC-ND license
(http://creativecommons.org/licenses/by-nc-nd/4.0/)
M.T. Lee and I. Suh Sustainable Technology and Entrepreneurship 1 (2022) 100004

Increased availability of corporate ESG information for investors investors, and researchers, and may derail the link between ESG con-
also captivate academic interests in expanding ESG research. Accord- duct and financial performance.
ing to Friede et al. (2015), researchers published approximately 2,250 In the discussion and conclusion section, we embrace the incon-
empirical studies on the link between ESG conduct and financial per- clusive findings and the gaps in existing research, and propose three
formance from the early 1970s to 2014, 70% of which has been pub- under-explored themes and ideas for future studies. Not only will
lished during the last 15 years. Since 2015, more than 1,000 research these themes motivate further research on the ESG conduct and
papers investigating the impact of ESG on financial performance financial performance relationship, they will more than likely offer
have been released (Whelan et al., 2021). Despite the explosive other perspectives and evidence for firm stakeholders, fund manag-
growth in ESG studies, the ESG conduct and financial performance ers, investors, and researchers to consider when making investment
relationship findings remain rather inconclusive (Whelan et al., decisions. First, we argue for a process and integrated approach to
2021; Gillan et al., 2021; Friede et al., 2015). Furthermore, ESG modelling causality between ESG conduct and financial performance
research has not identified nor explained the mechanisms, processes, at the ESG conduct level of analysis that includes non-financial and
and workings, known as the “black-box”, between ESG conduct, financial first-order variables, mediating variables, and moderating
scores, and/or disclosures and financial performance. variables that are directly impacted by ESG conduct. We suggest ana-
On this point, Whelan et al. (2021, 5) calls for researchers to gain a lytical methods to support this modelling. Second, we advocate for
better understanding of “the mechanisms behind the relationship researchers to explore the idea that balancing conduct between the
between ESG and financial performance”. Our study evaluates ESG E, S, and G components may enhance understanding between ESG
literature to propose a process and integrated modelling approach conduct and financial performance. Third, we present the concept of
that addresses this research gap. With extensive literature reviews “greenwashing”, and how this conduct in a process and integrated
pre-2015 (e.g., Friede et al., 2015), we focus our evaluation on ESG model may influence financial performance, or more than likely the
papers post-2015 that address our main research question: What var- lack of it.
iables can explain today’s inconclusive link between corporate ESG con-
duct and financial performance? Evaluating ESG conduct and financial performance
To this end, we evaluate 43 studies to gain insights into the
mediating variables and moderating variables that account for and ESG conduct
alter the direction of the relationships between reported ESG con-
duct and financial performance. We identify the first-order varia- Peloza (2009) reviews prior research spanning 36 years between
bles, mediating variables, and moderating variables in studies that 1972 and 2009 that show some 63% with a positive relationship
locate ESG conduct across different geographical locations and between ESG conduct and financial performance, 14% with a negative
industry contexts. We also propose arguments for a process and relationship, and 22% with a neutral or mixed relationship. Friede et
integrated modelling approach with emerging themes that can al. (2015) combines the findings of some 2,200 individual studies,
spearhead future research with implications for firm stakeholders, and they report some 90% of studies with a “non-negative” relation-
fund managers, investors, and researchers. We also discuss prior ship, with the majority of studies showing positive findings. The posi-
ESG literature review papers that include Whelan et al., (2021), Gil- tive relationship appears stable over time, and the results vary
lan et al. (2021), Friede et al. (2015), and Peloza (2009) to augment between portfolio and non-portfolio studies, regions, sectors, and
our evaluation and proposal for process and integrated model speci- asset classes (e.g., equities vs. bonds vs. real estate). Friede et al.
fications. (2015) also discusses the ambiguity in individual E-, S-, and G-specific
The 43 studies evaluated are overwhelmingly archival, and they findings in the many studies they review (e.g., Endrikat et al., 2014;
are published in the following relevant scholar databases and pub- Dixon-Fowler et al., 2013; Love, 2010; Gillan & Starks, 2007).
lisher sites: Cogent, Center for Sustainable Business (NYU-Stern), Elsev- Even research findings post-2015 are somewhat unsure about ESG
ier, Emerald Group Publishing, IACSIT Press, Institute for Operations conduct and financial performance relationship (e.g., Ahmad et al.,
Research and the Management Sciences, IUP Publications, John Wiley & 2021; Whelan et al., 2021; Petitjean 2019). We discuss below this
Sons, MDPI Publications, Palgrave Macmillan, Portfolio Management considerable doubt, especially among mainstream firm stakeholders,
Research, Routledge, Routledge Taylor & Francis, SBS Swiss Business fund managers, investors, and researchers, whether firms that engage
School, Springer, Universal Publishers, and Wiley-Blackwell. The key- in high levels of ESG conduct would succeed in producing competi-
words used to search papers that address our research question are tive returns. ESG conduct is not always associated with high returns,
environment, social, governance, ESG, financial performance, media- and these recent studies have shown that the superior performance
tion, and moderation. Some 60 financial performance variables are of ESG-conscious firms may be concentrated in certain industries
utilized by the 43 studies we evaluate: 34 variables represent market with certain kinds of customers and employees (Kotsantonis et al.,
performance (56.7%), 25 correspond to reported firm performance 2016). Furthermore, studies are warning against confusing associa-
(41.7%), and 1 serves as a perceptual performance by measuring con- tion with causal relationships between ESG conduct and above-mar-
sumers’ responses to a survey (1.7%). The Appendix lists the studies ket shareholder returns (Cappucci, 2018).
evaluated in our paper. Post-2015 studies have tried to explain the inconclusive findings
Fig. 1 depicts the structure of our literature evaluation section. We by the lack of ESG reporting standards which impact ESG disclosure
commence with a synthesis of recent studies that examine the rela- consistency, comparability, transparency, and the evaluation of firm
tionship between various ESG conduct and financial performance ESG conduct. For example, Tamimi and Sebastianelli (2017) provides
variables. We then evaluate the relatively few papers that specify an descriptive statistics that reveal S&P 500 firms differ in their level of
appropriate level of analysis and discuss the role of the first-order disclosures across E, S, and G; the highest level of transparency is
variables in attempts to explain how ESG conduct yields a “direct” set found on G, and the lowest on E. Moreover, there is much variability
of immediate performance effects before translating into financial in the percentage of S&P 500 firms disclosing information about S.
performance. We then appraise the rather small number of studies The authors also find significant differences in transparency on the S
that analyze mediating and moderating variables, which provide and G components among industry sectors, as well as adding that
insights into the link between ESG conduct and financial performance large-capitalization firms have significantly higher ESG disclosure
variables. We also pay special attention to ESG “controversies”. This scores than mid-capitalization firms. Understanding the transparency
notion emerges in recent literature to represent one-off firm actions in disclosures can help stakeholders assess practices and policies for
that raise ESG concerns among firm stakeholders, fund managers, better ESG evaluations (Almeyda & Darmansya, 2019).
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M.T. Lee and I. Suh Sustainable Technology and Entrepreneurship 1 (2022) 100004

Fig. 1. Literature evaluation structure.

Virtually all post-2015 studies use ESG data from rating agencies ESG disclosure scores and sub-scores from Bloomberg as a proxy for
to measure the extent to which firms are ESG-oriented. Drempetic et Asian firms’ transparency in reporting their ESG score. The aim is to
al. (2020) employs neo-institutional theory to explain that firms need understand how firm-level ESG disclosures are associated with ESG
to remain legitimate to survive, and this depends on their acceptance scores in the Thomson Reuters Asset 4 database. They find evidence
by society. Because firm stakeholders, fund managers, investors, and that disclosing E and S strategy implementation in an effective sys-
even researchers are unable to assess company ESG conduct on their tem of corporate governance can strengthen ESG conduct. Similarly,
own, they depend heavily on ESG scores reported by rating agencies. Shakil et al. (2019) indicates a positive association of emerging mar-
These scores may reduce information asymmetry along with financial ket banks’ E and S performance with their financial performance, but
information for making analytical, investing, and research decisions. G performance does not influence financial performance.
However, it is not often discussed what rating agencies ESG scores Of the 43 studies we evaluate in the Appendix, 34.7% used ESG
really measure, nor what firm stakeholders, fund managers, invest- data from Thomson Reuters, 30.6% from Bloomberg ESG database,
ors, and researchers want the scores to measure. and the remaining 34.7% from other sources (e.g., RobecoSAM data-
Drempetic et al. (2020) also argues that the current ESG scores do base, KLD Stats database, Eikon DFO database, WISEfn database, MSCI
not realistically measure firm ESG conduct either. Rather, ESG scores ESG database, World Bank Statistic, Sustainalytics database). Reliance
depend on firm size, and firm size is the main determinant of data on various rating agencies and lack of consistency of ESG ratings, in
availability and resources that generate ESG information. The authors particular heterogeneous ESG measurement concepts, across differ-
suggest that it may be better for firms to invest in reliable and consis- ent agencies seem to explain, in part, the inconclusive findings on the
tent ESG reporting rather than ESG conduct itself. Rating agencies link between ESG conduct and financial performance (Chatterji et al.,
only provide as much information as firms report, and this does not 2016; Dorfleitner et al., 2015). In addition, utilizing a wide range of
reduce the entire asymmetrical distribution of ESG information for financial performance variables adds another layer of complexity
users. Therefore, firm stakeholders, fund managers, investors, and that may explain unconvincing evidence on ESG conduct.
researchers should be cautious when using ESG scores because they
can lead to a misallocation of investment funds with respect to idyllic Financial performance
ESG conduct.
To understand the impact of ESG information disclosures on eco- The majority of studies measure financial performance using a
nomic, environmental, and social conduct, Alsayegh et al. (2020) uses combination of three measurement approaches: (1) market
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M.T. Lee and I. Suh Sustainable Technology and Entrepreneurship 1 (2022) 100004

performance, (2) reported firm performance, and (3) perceptual per- the G component is positively related to ROA and Tobin’s Q but nega-
formance. Market measurement approaches, which rely on financial tively related to ROE.
performance information from the Wall Street and other financial Cek and Eyupoglu (2020) examines the overall and individual
markets, are the most commonly used across studies (Peloza, 2009). influences of corporate E, S, and G conduct on economic performance
Share price and its variations, including abnormal daily stock returns in S&P 500 firms. Economic performance was measured as client loy-
(e.g., de Franco, 2020; Capelle-Blancard & Petit, 2019; Landi & Sciar- alty, shareholder loyalty, and overall performance, which imply firms’
elli, 2019), annual stock returns (e.g., Khan, 2019), and market- abilities to general long-term shareholder value and sustained finan-
adjusted return (e.g., Farooq, 2015), dominate financial performance cial wealth, which was measured based on ROA, market value, and
variables. It is because market-based variables are publicly-available share price. The authors reveal mixed evidence: Corporate E conduct
which enables investors to evaluate, monitor, and compare firm per- does not have any significant effect on firm economic performance,
formances and their link to ESG conduct over time, within the indus- while S and G conduct significantly influence firm economic perfor-
try, across different sectors, and/or geographical locations. More mance.
recently, Tobin’s Q, also known as the Q ratio, has become an increas- As a result, the lack of coherent results in post-2015 studies may
ingly popular measure for investors and academics to evaluate also be attributed to the adoption of firm-level analysis and variables
whether ESG conduct impacts a firm’s market value to be under or within the three financial performance approaches. While all
over its assets’ replacement cost (e.g., Gillan et al., 2021; Alareeni & approaches use somewhat comparable variables that are publicly-
Hamdan, 2020; Ajour El Zein et al., 2020). available, these are “capture-all” measures that are inappropriately
Reported firm performance variables are also widely used, and used to understand ESG conduct, which is an activity or initiative
often accompany market variables (e.g., Gillan et al., 2021; Batae et level of analysis. Therefore, many questions still arise with inconclu-
al., 2020; Cek & Eyupoglu, 2020; Ajour El Zein et al., 2020). Under this sive findings between ESG conduct and financial performance includ-
approach, the variables are calculated from firms’ financial reports ing: (1) that market variables capture more than just ESG conduct;
such as earnings per share (EPS), return on assets (ROA), return on (2) that both market and accounting variables arguably reflect on his-
sales (ROS), return on equity (ROE), return on capital (ROC), and torical performance; (3) the timing in the causality between ESG con-
return on capital employed (ROCE). These variables show how effi- duct and financial performance; and (4) whether accounting
ciently firms use their assets to create profit margins and firm value variables are appropriately applied at the correct level of analysis
from their assets. While the definitions of these variables are well because they measure firm-level performance rather than ESG con-
known, the calculations are inconsistently applied and rely on the duct performance. In the following sections, we draw on the rela-
period-end timing and the firms’ decisions to report specific compo- tively few non-archival studies to make a case that appropriate
nents of these measures. Some ESG studies rely on both market and variables should be chosen to focus at the ESG conduct level, and as
reported firm performance variables in analyzing financial perfor- close as possible to the ESG activities or initiatives to demonstrate
mance. Examples of composite variables are operational performance causality.
(Alareeni & Hamdan, 2020; Buallay, 2019), economic performance
(Ionescu et al., 2019; Tarmuji et al., 2016), and corporate efficiency Exploring causality links
(Alsayegh et al., 2020).
Perceptual variables include third-party reputational rankings, First-order variables
and/or survey responses from firms’ management, employees or con-
sumers to assess financial performance (Starks et al., 2017). For Rather than firm-level or a higher-order financial performance
example, Starks et al. (2017) considers the investment horizon of variables, specifying first-order variables can focus research studies
fund managers and institutional investors in relation to their appetite on analyzing the “direct” or immediate performance effects of the
for ESG conduct in more than 3,300 actively managed U.S. domestic ESG conduct. This approach is used in the economics, management,
mutual funds. Investors with longer horizons tend to prefer higher marketing, and psychology literatures to understand causality by
ESG firms significantly compared to short-term investors. Investors explaining the influence of employee and firm behavior, and firm
also have more patience toward high ESG firms in their portfolios as decision-making as they relate to financial phenomena (e.g., Lee et
compared to their other holdings, selling relatively less after negative al., 2022; He et al., 2020; Lee & Raschke, 2020). In an ESG context, the
earnings surprises or poor stock returns. In a variation on the finan- two main approaches to selecting first-order variables that roll up
cial performance dependent variable, Ajour El Zein et al. (2020) into firm-level or higher-order financial performance variables
examines the impacts of sustainable investment in the financial sec- include cost-based and revenue-based variables (Peloza, 2009). Cost-
tor by modeling and testing relationships between ESG scores and based variables assess the extent to which ESG conduct changes the
firms’ brand value. Analyzing sectoral and regional effects, the cost structure of the firm such as human capital investments, waste
authors observe a positive relationship between ESG scores and reduction, and energy conservation; reduces the firm’s risk profile;
brand equity value as measured by consumers’ willingness to spend and improves the firm’s cost of capital (He et al., 2020; Sharfman &
money on one branded product versus another one. Fernando, 2008). While these immediate effects are important, cost
Currently, research has under-utilized perceptual variables as variables have an inbuilt potential for bias as firms focus on cost sav-
proxies for financial performance because of the dominance of mar- ings which overlooks the investment side associated with ESG con-
ket and/or reported firm performance variables (El Khoury et al., duct (Bofinger et al., 2022).
2021; Cek & Eyupoglu, 2020; Dalal & Thaker, 2019; Velte et al., 2017; On the other hand, revenue-based variables for ESG conduct show
Han et al., 2016), and because of “perceived lack of credibility or changes in firm revenues by, for example: (1) garnering loyalty
rigor” compared to market and/or firm performance variables among current customers, (2) generating new market opportunities,
(Peloza, 2009). Not surprisingly, recent ESG studies show that the and (3) trading carbon emissions (Lee et al., 2022). While professional
trend towards using both market and reported firm performance var- consultants and research institutes have directed studies into reve-
iables or composite variables continues relative to perceptual-based nue effects, research academics have yet to examine the revenue out-
performance variables. For example, Alareeni and Hamdan (2020) comes from ESG conduct in detail.
investigates S&P 500-listed firms’ ESG component disclosures repre- We evaluate below a handful studies examining the impact of ESG
sented by component scores and their impact on ROA, ROE, and conduct on the first-order cost-based or revenue-based variables. Ng
Tobin’s Q. The authors find that E and S disclosures are negatively and Rezaee (2015) investigates KLD database firms from 1991 to
associated with ROA and ROE but positively related to Tobin’s Q, and 2013 and show that E and G conduct significantly reduces cost of
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M.T. Lee and I. Suh Sustainable Technology and Entrepreneurship 1 (2022) 100004

capital, while S initiatives do not result in a reduced cost of capital To date, ESG research with mediating variables is underexplored.
unless economic sustainability performance is taken into account. Only a few studies have used publicly-available integrated reporting
Ellili (2020) looks into 30 publicly-traded companies in UAE and - defined as firm disclosures about social, employee, and leadership
report similar results to those of Ng and Rezaee (2015). This study performance in ESG reports and financial reports - to introduce medi-
reveals that weighted average of cost of capital is significantly ating variables when examining ESG conduct and financial perfor-
decreased by E and G activities but not by S activities. Lee and mance.
Raschke (2020) analyzes 15 U.S.-listed automotive firms that account For example, Mervelskemper and Streit (2017) investigates the
for more than 95% of the U.S. market share and find that organiza- effectiveness of ESG stand-alone and integrated reporting as a media-
tional ambidexterity in green innovations, employee satisfaction, and tor of ESG performance, measured by ESG combined and individual
emission performance are antecedent conditions for maintaining scores, on firm market valuation. The authors find that that ESG per-
high ESG ratings. formance is more highly valued when firms publish an integrated
Feng et al. (2016) examines the effects of ESG conduct on brand ESG report. Fatemi et al. (2018) analyzes 1,640 firm-year observations
value creation and report that G conduct has a significant impact on for publicly-traded U.S. firms and show that the link between ESG
brand value creation, while E and S conduct have no or mixed effects conduct (its reported strengths and weaknesses complied by KLD
on brand value creation, respectively. The authors measure brand Research and Analytics) and firm valuation (accounting and market
creation based on financial performance of branded products and measures) is mediated by firm disclosures (measured Bloomberg).
services, consumer-purchasing decisions associated with brand, and Xie et al. (2019) demonstrates that the effects of 209 listed Chinese
competitive strength of branded products and services. Loh and Tan firms’ green process innovation on financial performance are through
(2020) investigates ESG conduct of 74 Singapore publicly-traded green product innovation, and that firms’ green image moderates the
companies and find that the presence of sustainability reporting on relationship between green product innovation and financial perfor-
firms’ economic, E, and S activities, and the quality of the report have mance. Similarly, Chouaibi et al. (2021) uses UK and Germany panel
significantly positive effects on brand value. Alour El Zein et al. data and report that green innovation is part of the relationship
(2020) also shows that higher overall ESG scores lead to higher brand between ESG conduct and financial performance.
equity in 1,100 companies in the S&P 500 and EURO 600-Bloomberg. Overall, incorporating mediating variables in future studies may
Lee et al. (2022) demonstrates that emission performance, employee reveal the underlying causality between ESG conduct and financial
satisfaction and automotive firms’ historical financial performance performance. ESG conduct creates non-financial effects that manifest
precede brand valuation. These results indicate that E (i.e., emission in leadership, employees, and organizational culture. The impact of
reduction) and S (i.e., employee training and equal compensation) these effects will likely flow through and reveal themselves in the
conduct as well as investment activities in both tangible and intangi- first-order variables and ultimately higher-order firm-level financial
ble assets significantly enhance consumers’ perception of brand qual- performance variables.
ity.
Collectively, findings on the link between ESG conduct and the Moderating variables
first-order cost-based or revenue-based variables suggest that first-
order variables at the ESG conduct level of analysis can provide a bet- Currently, there are a small number of studies examining the
ter understanding of financial performance that might not be visible changes in the ESG conduct and financial performance relationship
in higher-order or firm-level variables that include market-based and contingent upon moderating variables, particularly in the presence of
accounting-based performance measures. Higher-order or firm-level “ESG controversies”. Aouadi and Marsat (2018, 1027) defines ESG
variables are “capture all” measures that offer limited guidance about controversies as “. . . news stories such as suspicious social behavior
ESG performance because they do not specifically provide insights and product-harm scandals that place a firm under the media spot-
into how and why the ESG conduct leads to or does not lead to a light . . .”, causing firms to come under a significant level of scrutiny
change in financial performance. Firm stakeholders, fund managers, and criticism by fund managers, investors, and academics. ESG con-
investors, and researchers may benefit from the first-order variables troversies can cause unintended negative effects on stakeholders’
that are applied much closer to the ESG conduct level for investment interest, inclusive of firm reputational risk, potentially raising doubts
decisions. about a firm’s future financial prospects and negatively affecting
share prices (Stevens, 2020). Consistent with this view, de Franco
Mediating variables (2020) shows that European and the U.S. publicly-traded firms
embroiled in ESG controversies experience adverse reactions from
In addition to the first-order variables, mediating variables can fund managers and investors in the form of abnormal negative stock
improve our understanding between ESG conduct and financial per- returns, and face slower recovery from losses compared to Asian-
formance. The mediating effects help to demonstrate cause and effect Pacific-listed firms.
through associations and correlations with a system of non-financial In contrast, Aouadi and Marsat (2018) analyzes an international
and financial variables that eventually flow into firm-level financial dataset of 4,312 firms associated with more than 3,000 ESG contro-
performance variables, explaining the ESG value-enhancing process. versies reported between 2002 and 2011, and find that corporate
That is, the how and why ESG conduct affects the first-order varia- social performance (CSP) scores and ESG controversies have positive
bles, and in turn, higher-order firm-level financial performance varia- effects on firm value after controlling for firm size and other market
bles. There are generally three classes of mediating variables, and value predictors (i.e., ROA, research and development expenses, sales
these classes involve organizational behaviors in leadership and growth). The strong positive impact of ESG controversies dissipates
employees that support financial performance (Lee et al., 2022; Nir- when the authors include the CSP interaction, yet the positive effect
ino et al., 2021; Tamimi & Sebastianelli, 2017; Peloza, 2009). of CSP on firm value still remains. These results suggest that ESG con-
The first involves employee retention, which reduces hiring costs troversies do not affect the CSP firm value relationship negatively,
and turnover costs and enhances productivity. The second relates to and may play an important role in gaining significant attention from
employee motivation and organizational culture, which can stimulate fund managers, investors, and academics. In fact, this study demon-
innovation, and product and service leadership. The third concerns strates that high-attention firms, larger firms located in countries
firm reputation and branding, which benefit from firm leaders that with greater press freedom, benefit from ESG controversies because
are able to successfully retain employees and manage their firm cul- their CSP scores lead to improved firm value relative to low-attention
ture in pursuit of enhancing its brand portfolio and firm reputation. firms.
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Wong and Zhang (2021) investigates ESG controversies by exam- performance, while financial slack and geographic diversification
ining the value relevance of corporate reputation risks from adverse mitigate negative effects of ESG conduct on firm performance. Future
media coverage of ESG issues on share price performance. Investors research can broaden our understanding of the role that context-spe-
perceive corporate reputation as a valuable intangible asset and that cific and/or firm characteristic variables play in explaining the link
ESG controversies via media channels have a significant negative between ESG conduct, first-order variables, mediating variables, and
effect on firm valuation. Analyzing industry classifications reveals financial performance.
that ESG controversies do not significantly affect share price perfor-
mance of firms in the alcohol, tobacco, and gaming industries.
Discussion and conclusion: Research themes
Instead, firms in the candy and soda, steel works, banking, and insur-
ance industries are the most susceptible to investors’ repercussion
Overall, prior research shows that engaging in ESG as a business
from ESG controversies. As a result, firm characteristics, corporate
model has more positive effects on financial performance than nega-
reputation status, and industry explain differences in investors’ reac-
tive effects, and that the effects are context-dependent. What is evi-
tions to ESG controversies.
dent from our literature evaluation is that there is no clear consensus
In addition to ESG controversies, prior studies document the
and definitive understanding about how ESG conduct leads to finan-
effects of ESG conduct on firm performance moderated by the type of
cial performance, and that the link is not straightforward. In light of
board representation (Nekhili et al., 2019; Nekhili et al., 2021), firm
these complexities in ESG performance research, we discuss three
size (Minutolo et al., 2019), environmentally-sensitive industries
important themes below that aim to fill in the existing research gaps
(Yoon et al., 2018), and geographic location (Duque-Grisales & Agui-
and spearhead future studies with implications and conclusions for
lera-Caracuel, 2019; Ortas et al., 2015). For example, Nekhili et al.
fund managers, investors, and researchers.
(2019) reports that ESG conduct has a negative influence on firm
First, we describe the importance of model specification using a
value when employees represent part of the board of directors. These
process and integrated approach because it forces researchers into
results reveal that fund managers and investors perceive the pres-
thinking about the ESG conduct level of analysis, first-order variables,
ence of employee board representation as being value destructive, as
mediating variables, and moderating variables that impact financial
employee directors are potentially maximizing the interests of
performance. Second, we propose a new idea that ESG conduct
employee stakeholders to the detriment of shareholders’ interests.
should be centered around the possibility that all of its components
On the other hand, Nekhili et al. (2021) shows that the effect of ESG
need to be balanced in harmony in order to achieve financial perfor-
conduct on firm value is positively moderated by employee share-
mance. Using extensions of established management theory, we out-
holder representation in the presence of employee directors, but neg-
line the motivation for considering balanced ESG components when
atively moderated by labor representation where the presence of
building process and integrated models that test the relationships
employee directors is elected by the right of employment. Both
between ESG conduct and financial performance. Third, we discuss
Nekhili et al. (2019, 2021) also suggest that fund managers and
future research relating to greenwashing, an emerging issue that is
investors react sensitively to the type of board representation when
becoming increasingly important for fund managers, investors, and
evaluating ESG conduct.
academics.
Minutolo et al. (2019) examines 467 firms in the S&P 500 from
2009 to 2015 and demonstrate that the influence of ESG conduct
Model specifications
(measured by ESG score) on firm performance (measured by Tobin’s
Q) is greater for larger firms than smaller firms (measured by sales
or total employees). Yoon et al. (2018) analyzes 7,056 Korean firms Process and integrated models
between 2010 and 2015 and find that the value-enhancing effect of We propose that researchers examine the link between ESG con-
ESG conduct diminishes when firms operate in environmentally duct and financial performance using a value-enhancing process and
sensitive industries such as in the energy, materials, and utilities integrated modelling approach that encompass our analysis above of
sectors. first-order variables, mediating variables, and moderating variables.
Duque-Grisales and Aguilera-Caracuel (2021) reports that the ESG Value creation commences with the ESG conduct that directly affects
conduct to financial performance relationship is significantly nega- first-order non-financial and/or financial firm variables such as orga-
tive in the Latin American businesses, with evidence of financial slack nizational culture, employee motivation, employee retention, reputa-
and geographic international diversification having a moderating tion, and branding. These variables, in turn, mediate the link between
effect. Ortas et al. (2015) also demonstrates that firms’ geographical ESG conduct and the first-order cost variables and revenue variables
locations serve as a moderator between firms’ ESG conduct and at an operational level, which in turn, influence financial performance
financial performance. Japanese firms have higher E effects on firm at a higher-order firm-level of analysis. Moderating variables may be
value, but lower E effects on ROA compared to Spanish and French considered in the model specification to evaluate whether the value-
firms. Firms in Spain report greater S effects on firm value than enhancing process varies by context (e.g., ESG controversies, environ-
French and Japanese firms. The authors attribute these results to dif- mental sensitive industries, geographic locations) and/or by firm
ferences in culture: a “Christian versus a Confucian cultural back- characteristics (e.g., firm size, board representation).
ground may lead to a different emphasis on social versus Our literature evaluation reveals that firm location and industry
environmental priorities [and a different impact on firm value or per- contexts serve not only as moderating variables, but also as a means
formance]” (Ortas et al., 2015, 1949). to introduce control variables that explain differential ESG conduct
In sum, research on moderating variables suggests that the effects and financial performance. Control variables have featured in many
of ESG conduct on financial performance vary by context (e.g., coun- recent ESG studies, where various regulations, policies, and operating
tries with greater media coverage/freedom, cultural differences cultures in different locations and/or industry sectors provide explan-
between Christian and Confucian countries, investors’ sensitivity to ations for financial performance outcomes. Of the 43 ESG studies we
specific industries, geographic location) or by firm characteristics evaluated since 2015, the majority utilize ESG panel data associated
(e.g., firm size, corporate reputation, types of board of director repre- with firm located in Asia (11), Europe (13), North America (10), and
sentation). Countries with greater media coverage and media free- worldwide (9), while a few use data in firms operating in Africa (1),
dom and investors’ insensitivity to specific industries diminish the Middle East (1), and South America (1). As for industry sectors, the
negative impact of ESG controversies. Labor representation on the majority of studies (28) rely on cross-industry data to evaluate the
board of directors magnify positive effects of ESG conduct on firm changing effects of ESG conduct on financial performance. Modelling
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M.T. Lee and I. Suh Sustainable Technology and Entrepreneurship 1 (2022) 100004

Fig. 2. A process and integrative model for ESG conduct and financial performance

location and industry differences can provide further insights into a Methodological approaches
value-enhancing process and integrated modelling approach. A majority of ESG studies use archival data from ESG rating agen-
Fig. 2 depicts the general value-enhancing process and integrated cies (e.g., Bloomberg, MSCI, Sustainalytics, Thomson Reuters) to char-
approach, and provides research guidance for future ESG conduct acterize ESG conduct and its effects on firm performance. Of the 43
and financial performance model specifications. papers evaluated post-2015, only one study utilizes a survey to mea-
We propose that researchers identify a particular ESG conduct sure portfolio managers’ opinions about integrating ESG conduct into
and specify a process and integrated model that examines the their investment decisions (van Duuren et al., 2016). We do not find
link between a particular ESG conduct and financial performance any papers using case studies, interviews, and experiments. Future
while considering first-order variables, mediating variables, and studies could expand on the available research methods to supple-
moderating/control variables. Employing relevant theory and ment the insights gained from existing archival studies (Huarng et
empirical evidence on ESG can inform researchers about the al., 2021). Surveys and experiments can add detailed dimensionality
appropriate variables and their related relationships in the model by examining the behavioral influence of ESG conduct on stakeholder
specification. Take for example an automotive brand’s E conduct judgement and decision-making as the firms pursue financial perfor-
when the firm introduces a new range of electric vehicles (EVs) mance. These stakeholders may be internal (e.g., firm executives,
to their product lineup. The E conduct is at the EVs level of analy- board of directors, controllers, employees), external (e.g., auditors,
sis. Researchers can connect the production of new EVs directly customers, suppliers), and lateral (e.g., competitors, government and
to increases in E performance and E scores, and the combined non-profit organizations) (Sirgy, 2002; Morgan & Hunt, 1994).
ESG score by way of reduced emissions and increased fuel econ- Larcker et al. (2019) uses a survey to understand how CEOs and
omy (e.g., Lee & Raschke, 2020; Lee et al., 2022). This model may CFOs in S&P 1500 firms incorporate ESG conduct into their strategic
be empirically tested with non-financial mediating variables (e.g., planning and investment decisions, which affects firm value. Survey
corporate culture, employee satisfaction) and/or financial mediat- responses from over 200 participants reveal that: (1) 89% of firm
ing variables (e.g., corporate reputation/branding; brand valua- executives already consider stakeholders’ ESG interests very impor-
tion) to show the indirect path from E conduct (introduction of a tant or important for management to pursue business goals; (2) 40%
new range of electronic vehicles to the production lines) to E per- of firm executives perceive both shareholders’ and stakeholders’
formance (reduced emissions and increased fuel economy), and interests as equally important in long-term firm management; (3)
the first-order performance variables. Often, firms track the cost, 96% of firm executives are very or somewhat satisfied with the job
revenue, profit margins, and earnings related to these EV model their firms do in meeting stakeholders’ interests; (4) 37% of firm
lines at the operational level. These first-order variables ulti- executives view the cost of meeting stakeholders’ interests have a
mately affect reported financial performance variables (e.g., ROA, high or moderate impact on firm value; and (5) 43% of firm execu-
ROI, ROE) and market performance variables (e.g., share price, tives believe that their largest institutional shareholders really care
Tobin’s Q). Gaining insights into the first-order cost variables or about stakeholders’ interests including ESG conduct because they
revenue variables can broaden our understanding of the direct know that it is central to firm success.
and indirect impacts of E conduct on financial performance. It can The Larcker et al. (2019) study illustrates that future ESG research
also offer opportunities to examine the role of context-specific could use case studies, surveys, interviews, or experiments to gain
variables (e.g., countries with greater media coverage/freedom) insights into stakeholders’ judgements and their decision-making
and/or firm characteristic (e.g., corporate reputation/branding) processes involving ESG conduct. New studies can use a mixed
variables in moderating the relationship between E conduct and research method combining survey, interviews, experiments, and/or
the first-order performance variables and its relationship between archival to develop compelling models that show a process and inte-
first- and higher-order performance variables. grated approach between ESG conduct, employees’ organizational
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M.T. Lee and I. Suh Sustainable Technology and Entrepreneurship 1 (2022) 100004

commitment, job performance, and financial performance. Future a negative impact. Uotila et al. (2009) uses 15 years of archival
research could also use experimental designs to identify situational data for 279 manufacturing firms in the S&P 500 companies to
context in which internal stakeholders such as the board of directors show the tradeoff between exploitation and exploration, and that
and/or employees respond more or less sensitively to ESG conduct, the optimal balance depends on environmental conditions. An
potentially leading them to make judgements and decisions that may inverted U-shaped curve was shown between the relative share
influence financial performance. of exploration and financial performance which was moderated
Various analytical tools are available for evaluating archival, case by firms’ research and development intensity. Furthermore, Stett-
study, interview, and experimental data. Finding definitive results ner and Lavie (2014) finds that balancing exploitation and explo-
can depend on the rigor of the statistical tools chosen (Woodside, ration through internal organization, alliance, or acquisition
2016). Theory-building analysis is often undertaken using qualitative modes enhances financial performance.
comparative analysis (QCA) (Huarng et al., 2021). QCA and its exten- From an ESG perspective, firms should have the ability to continue
sion fuzzy-set qualitative comparative analysis (fsQCA) analyze sys- its current ESG activities while simultaneously developing new ESG
tems or sets of conditional variables using Boolean algebra and fuzzy capabilities for the future. Scholars may consider this ambidextrous
set theory to identify recipes for outcome variables (Lee & Raschke, approach to ESG because corporate leaders see ESG as part of their
2016; Woodside, 2013). QCA and fsQCA generate causal complexity strategic management and as a source of innovation (Husted & Allen,
from data analysis and supports complex theory-building (Woodside, 2006). Extending the evidence demonstrated by organizational ambi-
2014). dexterity theory to ESG raises the compelling question of whether
Where the theoretical foundation is more established, multiple firms that equally focus their attention on E, S, and G conduct are
regression analysis (MRA) is commonly used to test and validate rela- most likely to maximize financial performance. Therefore, while
tionships in subsets of the systems or sets of conditional variables emphasizing individual conduct components may lead to financial
and outcome variables (Huarng et al., 2021). By analyzing the correla- performance, balancing the three components may provide maxi-
tions between hypothesized dependent and independent variables mum levels of financial performance. Future research should exam-
using strong theory, researchers confirm or deny the causality among ine these relationships as firm emphasis shifts between E, S, and G to
sub-groups of variables about a particular phenomenon (Lee & determine whether there are levels that maximize financial perfor-
Raschke, 2016). MRA tools extend to structural equation modelling mance.
(SEM), which utilizes similar but more powerful MRA to measure and The major challenge with examining ESG ambidexterity, and one
analyze complex relationships involving observed and latent varia- that warrants discussion, is how ESG balance can be measured. We
bles or constructs. SEM analyzes linear, mediating, moderating, and previously observed that ESG combined and individual ratings are
interactions in causal relationships among latent constructs while provided by third-party agencies. These agencies provide limited and
simultaneously accounting for construct measurement error (Hoyle, quite ambiguous explanations about what they really measure with
1995). Factor analysis can also supplement MRA or SEM to explore individual and combined ESG scores. Currently, ESG ratings agencies
and incorporate items underlying stakeholders’ perceptions of ESG (e.g., Refinitiv/Thompson Reuters/ASSET4) compiles a combined and
dimensions into an integrated model specification while controlling individual score based on data collected from annual reports, com-
for the industry sector and/or geographical locations (Gyonyorova et pany websites, non-governmental organization websites, stock
al., 2021; Huarng et al., 2021). exchange filings, company ESG reports, and news sources. While rat-
ings agencies provide the weights that each individual component
ESG balance contributes to the combined score, they do not provide details about
how they derive the weights for their combined score. At the same
One area where researchers have yet to explore is whether the time, it is not helpful that fund managers, investors, and researchers
concept of ESG balance, the equal emphasis placed by firms on E, S, do not clearly articulate what they want the scores to measure. There
and G components, mediates, moderates, and impacts financial per- are opportunities to undertake future research on a measure repre-
formance. Current studies using combined ESG scores do not ques- senting ESG balance.
tion the given E, S, and G weightings assigned by ratings agencies. So
far, we highlight that the findings related to financial performance ESG greenwashing
are inconclusive because it is dependent on relatively under-explored
model specifications. We have not really considered whether the ESG Greenwashing is the act of intentionally misleading consumers
component weights used in the combined ESG scores may explain with false claims about firms’ environmental practices and impacts.
differential financial performance. What if the balance among firms’ Greenwashing is characterized by poor ESG performance and positive
ESG components in model specification impacts financial perfor- communication about ESG performance (Delmas & Burbano, 2011).
mance? Consumers are becoming discerning and cynical of firms as they
The idea of ESG balance and financial performance is based on an claim to protect the environment, but fail to demonstrate their
extension of organizational ambidexterity theory, which refers to the actions (Torelli et al., 2020). Greenwashing can have quite a negative
premise that organizational “adaptation requires both exploitation effect on consumer and investor confidence, especially in claimed
and exploration to achieve persistent success” (March, 1991, 205). green products, and this green marketing tactic can scar, erode, and/
Exploitation is innovation that makes improvements in existing com- or damage the consumer market for these products and the participa-
ponents and build on the existing learning trajectory, whereas explo- tion of investors in capital markets (Bofinger et al., 2022). Further-
ration is innovation that shifts to a new or next generation learning more, firms engaged in greenwashing are often embroiled in
trajectory (Benner & Tushman, 2002; Gupta et al., 2006). lawsuits, sometimes class actions, for false advertising (Torelli et al.,
In the research literature, continuous improvement and the 2020).
acquisition of new knowledge are central to exploitation, explora- There are a small number of papers studying the effects of green-
tion, and ultimately long-term performance (Lee & Raschke, 2020; washing, but research is making inroads in three areas. First, there
Lee & Gaudioso, 2020). He and Wong (2004) are the first to test are studies that have only begun defining greenwashing (e.g., Szabo
the ambidexterity hypothesis in a sample of 206 manufacturing & Webster, 2020; Marquis et al., 2016; Delmas & Burbano, 2011).
firms. They found that interaction between exploitation and Szabo and Webster (2020) uses two case study interviews to show
exploration has a positive association with sales growth, while that greenwashing not only relates to ESG perceptions, but also to
the relative imbalance between exploitation and exploration has consumers’ happiness while interacting with firms’ websites. In
8
M.T. Lee and I. Suh Sustainable Technology and Entrepreneurship 1 (2022) 100004

contrast, Marquis et al. (2016) shows that firms that are more misleading advertising about the environmental features of products
environmentally unfriendly, especially those in countries where affect how consumers perceive advertising and brands. False claims
there is more exposure to scrutiny, are less likely to engage in selec- harm consumers’ attitudes toward advertising and brands, although
tive greenwashing. Delmas and Burbano (2011) defines greenwash- vague claims do not seem to have a significant effect. Berrone et al.
ing in terms of environmental performance versus positive/no (2017) collects longitudinal data about 235 publicly-traded U.S. firms
communications about environment performance. Greenwashing in polluting industries to show that E activities help firms gain ESG
refers to poor environmental performers who provide positive com- legitimacy. However, some conduct can damage this legitimacy if
munications about environmental performance. Green firms are ESG performance deteriorates and the firm comes under intense pub-
good environmental performers regardless of communications, while lic and media scrutiny.
brown firms are poor environmental performers who provide no More research is required under these three streams of green-
communications about environmental performance. washing research. Once a unified definition and standard measure is
Second, there are studies that empirically demonstrate the inci- defined, researchers can draw on meaningful theory and ask ques-
dence of greenwashing (e.g., Du, 2015; Parguel et al., 2015). Using tions about whether greenwashing explains the negative or lack of
Chinese companies, Du (2015) provides evidence that greenwashing significant findings between ESG conduct and financial performance.
is negatively and significantly associated with cumulative abnormal The greenwashing variable may be incorporated into a process and
returns (CAR) around greenwashing exposure, but is positively and integrated model as a mediating or moderating variable to under-
significantly associated with CAR in environmentally-friendly firms stand its effects on the first-order and the higher-order financial per-
via contagion effects. Paraguel et al. (2015) examines the use of formance variables.
nature-evoking elements in advertising to artificially enhance a
brand’s ESG image by conducting three experiments on French con- Funding
sumers. They find that these elements mislead consumers in their
evaluation of a brand’s ESG image especially in a low knowledge situ- This research did not receive any specific grant from funding
ation.
agencies in the public, commercial, or not-for-profit sectors.
Third, there are studies that examine the effects of greenwashing
on consumers and firms (e.g., Pimonenko et al. 2020; Schmuck et al.
2018; Berrone et al. 2017). Pimonenko et al. (2020) demonstrates Declaration of Competing Interest
that a one-point increase in greenwashing is associated with a 0.56-
point decline in a firm’s green brand, and that website and social The authors declare that they have no known competing financial
media information was the culprit for greenwashing. Schmuck et al. interests or personal relationships that could have appeared to influ-
(2018) utilizes an affect-reason-involvement model to show that ence the work reported in this paper.

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M.T. Lee and I. Suh Sustainable Technology and Entrepreneurship 1 (2022) 100004

Appendix. Summary of ESG conduct and financial performance papers evaluated

Journal title 2015 2016 2017 2018 2019 2020 2021

(alphabetically)

1 Accounting and Manage- Batae et al. 2020

ment Information
Systems
2 Asian Journal of Sustain- Han et al.
ability and Social 2016
Responsibility
3 Business Strategy Mervelskemper Minutolo et al.
Environment & Streit 2017 2019
4 Centre for Sustainable Whelan et al.
Business, NYU-Stern (2021)
5 Cogent Business & Ahmad et al.
Management, 2021
6 Corporate Governance Alareeni &
Hamdan 2020
7 Corporate Governance: Nekhili et al.
An International 2021
Review
8 Energy Economics Petitjean 2019
9 EuroMed Journal of Chouaibi et al.
Business 2021
10 Financial Analysts Journal Khan 2019
11 Global Finance Journal Fatemi 2018
12 International Journal of Tarmuji et al.
Trade, Economics and 2016
Finance
13 IPTEK Journal of Proceed- Almeyda & Dar-
ings Series mansya 2019
14 IUP Journal of Corporate Dalal & Thaker
Governance 2019
15 Journal of Advertising
16 Journal of Applied Busi- Farooq 2015 Velte 2017
ness Research (JABR)
17 Journal of Asset Dorfleitner
Management et al. 2015
18 Journal of Business Ethics Du 2015 van Duuren Berrone et al. Aouadi & Duque-Grisales Drempetic et al.
et al. 2016 2017 Marsat 2018 & Aguilera- 2020
Caracuel
2019;
Capelle-Blan-
card & Petit
2019
19 Journal of Business Xie et al. 2019
Research
20 Journal of Corporate Gillan et al.
Finance 2021
21 Journal of Global Velte 2017
Responsibility
22 Journal of Sustainable Friede et al. 2015 El Khoury et al.
Finance & Investment 2021
23 Management of Environ- Buallay 2019;
mental Quality: An Shakil et al.
International Journal 2019
24 Social Responsibility Landi & Sciarelli
Journal 2019
25 Strategic Management Chatterji et al.
Journal 2016
26 Sustainability Ortas et al. 2015 Yoon et al. 2018 Ajour El Zein et
al. 2020;
Alsayegh et
al. 2020
27 Technological and Eco- Ionescu et al.
nomic Development of 2019
Economy
28 Technological Forecasting Nirino et al.
and Social Change 2021
29 The British Accounting Wong & Zhang
Review 2021
30 The International Journal Nekhili et al.
of Human Resource 2019
Management
31 The Journal of Investing de Franco 2020
Total: 43 5 4 4 3 13 7 7

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