CSR and FP
From the earliest classic studies by Bowen (1953), Eells and Walton (1961), McGuire (1963), Carroll (1979), the importance of CSR and its impact on society has been explored from various viewpoints. However, their opinions are divided on the need for corporate CRS. Some studies with a positive appraisal of CSR argued that ‘a corporation has a duty to society’ (Andrews 1973; Davis and Blomstrom 1975; Carroll 1979; Drucker 1984; Epstein 1987), whereas others reported that ‘a corporation only has the duty to maximize its benefit within the fence of law and minimum ethical restrictions’ (Levitt 1958; Friedman 1970).
Nonetheless, in the 2000s, various studies identified CSR as a source of competitive advantage (e.g. Russo and Fouts 1997; McWilliams and Siegel 2011). Donaldson and Preston (1995) and Porter and Kramer (2006) investigated whether a strategic CSR activity enhances the competitive advantage of the firms. Baron (2008) argued that CSR activities could be a productive investment. He concluded that CSR helps firms to attract consumers who value CSR expenditures but do not mind paying more for the corporate executives or the employees whose personal values are aligned with CSR. Baron (2008) suggested that some investors might value CSR more, even though it could lower financial profit in the short-run, because they are satisfied by owning such a firm that makes socially responsible expenditures. On the other hand, Besley and Ghatak (2007) found that breaking CSR promises will result in lower profits, whereas more responsible firms will earn higher profits due to their reputational premium. In this regard, Benabou and Tirole (2010) raised the question as to whether CSR helps the firm in the long run. Margolis et al. (2007) found that CSR engagement helps firms to gain a competitive advantage. They reported a positive relation between CSR and performance except in two percent of cases. The role of governance in CSR is also important. Several studies found the importance of sustainable development issues, such as stakeholder dialogue and core values, and of embedding these issues into the firm’s strategy. The study of Beltratti (2005), as well as that of Jamali et al. (2008), found a positive relationship between CSR and corporate governance. Beltratti (2005) concluded that by ensuring the protection of the stakeholders, firms are more likely to survive in the long term. Jamali et al. (2008) found that CSR and corporate governance strengthen each other. Furthermore, Aras and Crowther (2008) stressed the significance of the corporate governance and the subsequent sustainability of firm.
Meanwhile, empirical analysis has been inconclusive as to whether adopting CSR has a positive or negative effect on a firm’s FP. This is because the empirical findings were divided. The first group of literature finds a positive relationship between CSR and FP. The works of Orlitzky et al. (2003), Wu (2006), and Margolis et al. (2007) in management studies found a significant positive relationship between CSR and FP (Peiris and Evans 2010). The study of Barnett and Salomon (2006, 2012) in finance also suggested that firms with a higher CSR index score have better performance compared to those with a lower CSR score. The longitudinal study by Margolis et al. (2009) conducted from 1972 to 2007 also suggests the positive effect of CSR on accounting and market-based profits.
On the contrary, the second literature group argues that CSR has a negative effect on FP. Fisher-Vanden and Thorburn (2011) suggested the unfavorable effect of CSR. They found the possibility of the market reacting negatively to news of companies joining an environmentally friendly program, for instance, the Environmental Protection Agency’s Climate Leaders program, due to the anticipated negative effect on its financial performance.
Lastly, the third group of Brammer and Millington (2008) argued that a positive or negative relationship can occur depending on the level of CSR. They also provided some empirical evidence for the existence of a U shaped relationship between CSR and FP. Although they did not specifically hypothesize a U shaped relationship, they found evidence that the highest and lowest levels of CSR were associated with the highest levels of FP based on the firm-level data. However, in their study, CSR was represented by only one variable (i.e. corporate charitable), which is one of its limitations.
In light of the third group, Mittal et al. (2008) provided the rationale for a negative CSR-FP relationship. That is, when the expected relationship between CSR and FP is U shaped, the negative relationship could be observed at an earlier stage of CSR effort because the cost of CSR caused the initial downward slope of the U curve. Supporting the conjecture of Mittal et al. (2008), Nollet et al. (2016) empirically proved the existence of a U curve shaped relationship between corporate governance and FP in US corporations, and this is the first empirical finding of a U curve relationship in the CSR literature up until now.
Summarizing the above literature shows that the literature findings have been mixed until now, and so further research is needed. On this basis, our study examines the relationship between CSR and FP in Korean corporations. In Korea, recently, various studies of CSR have been conducted on cultural orientation, ownership structure and CSR, and on financial reporting quality, corporate governance and CSR. However, none of them analyzed the relationship between CSR and FP. Thus, we attempt to determine the effect of CSR on FP in Korean firms listed on the Korea (KOSPI) stock markets. For the analysis of Corporate Social Responsibility (CSR), the activities dataset of the individual ESG disclosure scores from Bloomberg in the period of 2008 to 2014 was used as its proxy.
Environmental, Social and Governance (ESG) overview
Most of the analyses of CSR appear in corporate sustainability reports. However, relying on the individual corporate CSR report has intrinsic shortcomings, such as a biased disclosure problem due to the deficiency of the firm’s revelation mechanism, viz. revealing only the firm’s favorite interpretation of its CSR and its operationalization (Butz and Pictet 2008). Thus, to investigate the relationship between CSR and FP unbiasedly, several studies examined the relationship based on third party ratings of environmental, social and corporate governance.
Practically, the ESG disclosure score is used as one of the major indexes in the identification of CSR effort. It is used to gain an understanding of the overall CSR activities; how corporations develop CSR issues with respect to their objectives and strategies for long-term growth, how they manage risks and other organizational characteristics in terms of general management practices, and so on. Originally, ESG terminology first appeared in the United Nations Principles of Responsible Investment and then in a number of companies’ CSR reports (Davis and Stephenson 2006). Although there is no clear understanding of this concept yet, ESG score has been practically used by major business consulting firms. Bassen and Kovacs (2008) argued that ESG score monitoring is important to implant CSR practically, as well as delivering ESG information in order for investors to assess a corporation’s risks and opportunities. Particularly, scoring indicators such as the environment activity (environmental scores and environmental factors), social responsibility (number of employees, employee turnover ratio, employee unionized, women in management, women in employees) and governance mechanisms (size of the board, independent directors, board duration, board meetings per year, women on board) is important.
Meanwhile, because ESG issues are extra-financial attributes, ESG scores could lack the consistency and standardized definitions (Peiris and Evans 2010) necessary for their comparison. Even with quantified data, it is difficult to compare them with the information delivered by peers and across periods. The ESG disclosure scores used in other studies faced the problem, particularly in terms of their objectivity. As a matter of fact, there are companies which are uncooperative in providing the information necessary to assess the impact of their ESG factors on FP (financial performance) or cases where the ESG score provided by the company lacks consistency. In order to resolve these problems or minimize the ESG measurement bias, this study use the ESG scores provided by Bloomberg, which is a third-party data collecting institution that cares very much about its own reputation for accumulating accurate data.
As shown in the literature review, there are no consistent findings on the relationship between overall CSR and FP yet. We suspected that using the combined ESG score might result in mixed findings or non-significant test results. Thus, we consider the effects of the three individual ESG scores on FP separately, instead of the overall ESG score. As a matter of fact, Nollet, Filis, and Mitrokostas (2016) conducted their study in the same way as ours. They tested for the effects of GDS, SDS, and EDS on FP separately.
We describe the individual ESG score in more detail below. Firstly, the Environmental Disclosure performance Score (EDS) is designed to address the business environment and the relationship between business and society. EDS is known to cover the corporation’s disclosure policy issues on their CO2 emissions, energy consumption, total waste, energy efficiency policy, and emissions reduction policy. Secondly, the Social Disclosure performance Score (SDS) covers the company’s disclosure policy on the number of employees, employee turnover ratio, number of unionized employees, percentage of women in management, percentage of women employees, and so forth. Both of these scores (EDS and SDS) are likely to be affected by the firm’s CSR spending. Thirdly, the Governance Disclosure performance Score (GDS) is designed to reflect the corporate governance structure.Footnote 1
Given the above CSR literature and description of ESG, our research questions the following two hypotheses.
-
Hypothesis 1. There is a linear and positive effect of Corporate Social Responsibility performance (EDS, SDS, GDS) on Corporate Financial Performance.
-
Hypothesis 2. The effects of the Environment, Social and Governance performances on Corporate Financial Performance are non-linear, viz. it implies that the relationship could be convex (U curve) or concave (inverse U curve).