Abstract

     This study examines the association between firms’ ESG reputational risk and financial performance under the EU regulatory policy changes and the COVID-19 period. Analyzing a panel of 1,816 European listed firms during the period 2007–۲۰۲۱, we document evidence that firms with lower ESG reputational risk have reduced information asymmetry, are less financial constrained and perform better. To establish causality, we design a quasi-natural experiment focusing on the 2014/95/EU directive of non-financial disclosing and the COVID-19 exogenous shock. Our findings are robust to several estimation techniques that address endogeneity, self-selection, and model sensitivity.

Introduction

     In recent years, the concept of environmental, social, and governance (ESG) has attracted considerable interest (Stroebel and Wurgler, 2021; Krueger et al., 2020), however, its potential impact on firm financial performance is ex ante unclear. Today, modern companies follow ESG strategies not only to boost their performance but also to reflect their values and contribute to a better world (Ferrell et al., 2016; Starks et al., 2017, Dyck et al., 2019, Hartzmark and Sussman, 2019). Moreover, there is an escalated demand from consumers for high ESG standards (Godfrey, 2005) and increased pressure on regulators and policy makers to address environmental pollution, workplace diversity and firms’ transparency (Yan et al., 2019). In this direction, the COVID-19 pandemic crisis has amplified the sensitivity to social issues, human capital, health, safety, and responsible practices more than ever before.

     According to Reuters,1 ESG-focused funds received a record $649 billion in investments in 2021, making over 10% of all assets globally. These assets have done better than market benchmarks. ESG due diligence involves managing both a financial opportunity as well as risk. For instance, Volkswagen’s participation in the Dow Jones Sustainability Index was confirmed just a few days before the US public learned about the 2015 US emission crisis.

Conclusion

     This study examines the impact of ESG reputational risk on European firms’ financial performance. Using different econometric techniques, we document a causal negative and statistically significant relationship between ESG reputational risk and financial performance. Our findings also have economic significance. In line with asymmetric information theory, we argue that in the presence of ESG reputational risk, there is increased information asymmetry between stakeholders and managers, which leads to adverse selection and increased cost of equity and financial underperformance. In addition, the market may interpret ESG reputational exposure as a negative signal. We draw insights from the literature’s distinction between “good” and “bad” firms considering their environmental, social, and governance performance. Consistent with agency costs theory (Friedman, 1998, Jensen, 2001, Benabou and Tirole, 2010, Cheng et al., 2013, Kim and Lyon, 2015, Kruger, 2015, Siano et al., 2017), we document that ESG-responsible firms align better with managers’ and stakeholders’ interests and decrease managerial myopic decisions (Eccles et al., 2014, Albuquerque et al., 2019); therefore, these firms have comparatively better financial performance and market value.

     We further explore the relationship between ESG informational risk and firms’ financial performance under the EU regulatory policy changes arising from the 2014/95/EU directive and the COVID-19 global pandemic. We show that ESG reputational risk, both in the presence of lower informational asymmetries (2014/95/EU directive) as well as high informational asymmetries (COVID-19 global pandemic), negatively predicts firms’ financial performance. This evidence supports our argument that lower ESG reputational risk increases financial performance by transmitting important information to investors and signaling firms’ true protentional dynamics, thus reducing ex ante uncertainty.