Fulfillment of ESG Responsibilities and Firm Performance: A Zero-Sum Game or Mutually Beneficial

Abstract

Focusing on the 311 Chinese firms listed in the global markets from 2008 to 2019, based on the trade-off theory and the resource slack theory, using panel vector autoregressive model and panel threshold model, this paper explores the impact of fulfilling ESG responsibility on firm performance. The study reveals that in the short run, fulfilling ESG responsibility presents a “Substitution Effect,” whereas, in the long run, it presents a “Promotional Effect.” On the other hand, the improvement of firm performance has a significantly positive impact on ESG fulfillment investment, even though there is a strong hysteresis effect. Significant heterogeneity exists regarding the relationship between ESG fulfillment and firm performance. ESG fulfillment has a negative impact on firm performance in the short run, with the most affected firms being those small and mid-sized firms listed in the Mainland China markets. In the near term, the impact of firm performance on ESG fulfillment is positive, with those listed in the overseas markets and large firms being affected the most. The study reveals that firm size and the factors affiliated with ESG fulfillment tend to cause the differentiation effect in the inhibitory influence of ESG fulfillment on firm performance in the short run. This study could be used as a guideline for the social responsibilities of nonprofit organizations.

1. Introduction

With the gradual advancement of the supply-side structural reforms and the development of the real economy, it becomes urgent for corporations to fulfill their social responsibilities in order to promote sustainable growth. In the past decade, companies in China have made significant environment, society and corporate governance (ESG). Even though pursuing profit maximization is still considered the top priority to those enterprises, with increasingly constrained resources and the government’s pressure, those Chinese firms have shifted from passively complying with laws and disciplines to participate in providing services to the societies actively.

To encourage a firm to take its social responsibilities proactively, the most direct motivation is to let them learn about the tangible benefits of fulfilling social responsibilities. Further, when a company invests more in social responsibilities, will it help improve its Corporate Financial Performance (CFP)? When a firm’s financial performance gets better, shall it continue increasing investments in ESG to make more profits? If both ESG fulfillment and financial performance could be enhanced, no doubt, there will bring more benefits to the enterprise, the society as well as stakeholders.

Different from commercial enterprises, manufacturing firms have raw material processing and manufacturing links. Compared with green innovation, in addition to energy consumption and material consumption, there are also negative external effects such as pollutant emissions. The entire production process is subject to rigid constraints of environmental regulations. Therefore, manufacturing firms have to take more responsibility in ESG responsible investment.

Therefore, the key question that academia and business must answer is whether ESG responsible investment can be transformed into positive corporate financial performance (CFP). For many years, the relationship between ESG responsible investment and financial performance has been the focus of debate in academia. A series of research results found that ESG responsible investment can improve financial performance, and there is a significant positive correlation between the two [1,2,3], while some studies shows that ESG responsible investment will deteriorate financial performance, and there is a negative correlation between the two [4,5], ESG responsible investment will not have a positive impact on the company’s financial performance within five years [6]. Some scholars believe that the relationship between ESG responsible investment and financial performance is vague, contradictory, and uncertain [7,8,9], ESG varies greatly among different industry sectors and different financial variables [10]. In fact, there is no relationship between ESG responsible investment and financial performance [11,12,13]. Since ESG activities are often driven by a series of factors [14], many of which may not be observed, the overall ESG-CFP relationship may be zero or slightly positive [15]. In a nutshell, whether and how ESG responsible investment is related to company performance is still the focus of debate among academics and practitioners.

There are few literatures on the impact of manufacturing ESG single dimension indicators on financial performance. Some studies believe that environmental (E) disclosure is positively related to Tobin’s Q, and corporate governance (G) disclosure is positively related to ROA and Tobin’s Q [1]. Strengthening environmental management can positively affect corporate financial performance [16]; corporate governance (G) indicators have a greater impact on financial performance than the environment (E) and society (S) [17]. The opposite view is that the quality of corporate governance also has a negative impact on accounting performance and market valuation [17].

In summary, the literature has documented mixed results regarding the relationship between CSR and firm performance. The mixed results might be caused by the following. Firstly, the relationship between CSR and firm performance (ROA here after) is time-varying. It tends to change with the development of the economy. Secondly, different ways of measuring corporate social responsibility tend to have different effects on the relationship between CSR and ROA. Thirdly, the relationship between CSR and ROA may show varying influences under different circumstances, such as the listed countries, the industry, and variant firm size, etc.

In this study, we contribute to the literature with the following improvements. Firstly, we utilized more comprehensive ESG indicators to verify ESG and ROA’s relationship based on Chinese firms’ data from 2008 to 2019 listed in multiple markets, including Mainland China, Hong Kong, the USA, and Singapore. We also emphasize the bilateral effects between ROA and ESG rather than the unilateral role of ROA on ESG alone. Secondly, we focused on firm performance in the long run as well as in the short run and identified the changes in the relationship between ESG and ROA. Specifically, the relationship shows a win-lose effect in the short term compared with symbiosis and mutual beneficial effect in the long run. Lastly, we explore the dynamic impact of the overall fulfillment of ESG responsibilities on firm performance as well as each dimension of ESG, with E, S, and G representing the environment, society, and corporate governance, respectively. We find the threshold effect regarding the impact of ESG on firm performance and the strength changes in the short term.

The paper is organized as follows. In Section 2, we explained the relationship between ESG and ROA. In Section 3, we provided the data sources and methodology. In Section 4, we analyzed the empirical results. In Section 5, we showed the robustness test results. We conclude in Section 6.

2. The Dynamic Interaction between Fulfilling ESG Responsibility and Firm Performance

2.1. The Dynamic Interaction between Fulfilling ESG Responsibility and Firm Performance

In this study, based on the trade-off theory, the stakeholder theory, and the resource slack theory, we decompose ESG’s impact on CFP into both the short-term and the long-term effects to explore the dynamic interaction between ESG and ROA among Chinese firms.

2.1.1. The Connotation of ESG Responsibility Fulfillment

In international research, ESG (environmental, social and corporate governance) responsibility fulfillment is gradually regarded as a whole, and has become the three most important dimensions to measure the sustainable development of enterprises [18,19,20,21]. These three dimensions are used by financial services investment companies to help determine their future financial performance. Among them, the environmental (E) concerns the performance of a company as a natural environment manager; the social (S) examines how a company manages its relationship with its employees, suppliers, customers and communities; and the corporate governance (G) standard concerns the company’s leadership, executive compensation, audit and internal control, as well as shareholders’ rights. “ESG” is a universal, sustainable and responsible investment of all types [22]. In China, the concept of ESG started relatively late, and the mainstream market participants also lack a unified understanding of the concept, evaluation and implementation standards of ESG system. Before that, there was no authoritative organization of third-party evaluation in China. At present, there are three leading international financial and non-financial data service providers: Bloomberg, MSCI and Thomson Reuters.

2.1.2. The Impact of ESG Responsibility Fulfillment on Firm Performance

In general, the impacts of fulfilling ESG responsibility on ROA can be viewed differently in the short run and the long run. Based on the trade-off theory, fulfilling ESG responsibilities could negatively impact financial performance in the short run. Friedman (1970) pointed out that costs tend to increase with the investment in ESG. The costs could be direct and indirect, such as the costs associated with the treatment of waste, the expenses in planning, budgeting, managing, and evaluating ESG [23]. Some scholars argue that the indirect costs could be higher than documented since waste management, investments in occupational health and safety [24,25], and fair trade, expenses in employee welfare and community services, and donations, are all viewed as a firm’s social responsibilities. Hence, whenever a company gets more involved in ESG, the corresponding costs tend to rise, and profits tend to fall, thus generating a loss in terms of shareholder value [26,27]. Therefore, due to the increased costs, fulfilling ESG responsibility may have a negative impact on financial performance. This is called the substitution effect. From a long-term perspective, based on the stakeholder theory [28], fulfilling ESG can help promote the relationship between the management and various stakeholders, thus improve firm performance. Jo and Harjoto point out that managers can resolve conflicts with various stakeholders through ESG activities to maximize shareholder wealth [29]. Chen et al. state that the long-term positive impact of ESG on ROA can be manifested in the increased firm value in the existing businesses and the value created for future businesses [30]. Specifically, by satisfying the various stakeholders’ needs, a firm can establish a reputation, build corporate images, enhance product value, reduce firm risks, establish competitive advantages, and ultimately improve firm value [29,31]. For future business, fulfilling ESG can help the company to find new opportunities and open up new markets. However, the fulfillment of ESG may require a lot more investment beyond the firm’s capabilities in the current period.

Therefore, the promotion effect based on the stakeholder theory may need to be manifested in the long term.

2.1.3. The Impact of Firm Performance on the Fulfillment of ESG Responsibilities

As shown above, the bilateral relationship between ESG and ROA is multi-dimensional [26]. Generally, consistent with the resource slack theory, more profitable firms tend to invest more in social responsibilities than their peers. Further, the management has full control over the capitals only, not over other surplus resources, such as additional raw materials, excess labor, surplus productivity, etc. Therefore, firms with more financial resource slack tend to invest more in CSR [32]. Some studies find that the improvement of financial performance positively influences the fulfillment of social responsibilities [33,34,35]. Some point out that the extent of ESG fulfillment tends to be affected by resource slack. For example, the company’s profitability in previous years will greatly affect its ESG fulfillment in the following year [35]. Hence, the better the company’s financial future, the more would be invested in the fulfillment of ESG responsibilities. Of note, as agents of shareholders, management tends to be short-sighted and overlook the long-term benefits resulted from fulfilling ESG responsibilities.

2.2. Heterogeneity in Interaction between ESG and Firm Performance

The relationship between ESG and ROA is bilateral and dynamic. Factors, such as firm size and listing locations, could strengthen the heterogeneity in the interaction between ESG and ROA.

2.2.1. Listing Locations

It is crucial for those Chinese firms listed in foreign markets to fulfill ESG responsibilities, in that those firms treat ESG fulfillment as a reputation maintenance mechanism, as being used to deal with different appeals and pressures of stakeholders, including customers, investors, regulators, and NGOs [35]. When a firm increases investment in ESG, its reputation, competitiveness, and popularity tend to be enhanced. Even though costs could increase accordingly, the generated benefits could be high enough to compensate for any additional costs. Therefore, in the short term, ESG seems to have a minor negative impact on firm performance. To companies solely listed in Mainland China, ESG’s impact on firm performance might be significantly negative in the short run due to the lack of capital to support ESG fulfillment. On the other hand, Chinese firms listed in foreign markets face dual supervision by regulators in both countries. The stricter regulatory and disclosure requirements tend to force the companies to invest more resources in ESG to meet the global investors’ needs, the local markets’ expectations, and the firms’ best practice requirements [32]. Boubakri et al. points out that those Chinese firms cross-listed need to maintain a higher level of ESG fulfillment than their peers listed locally in order to keep in line with the local regulators in terms of corporate governance practices [36], reduce the litigation risks, and stay competitive as a foreign company.

It is noted that after listing in overseas capital markets, besides higher disclosure and corporate governance requirements, foreign companies listed overseas face litigation risks, especially in the United States, since its litigation environment is much more complicated than other countries [37,38]. There are also costs incurred only by foreign companies [39]. Therefore, Chinese firms listed outside China will pay more attention to ESG fulfillment when their financial performance has improved compared to those listed locally.

In summary, companies listed in different locations tend to exhibit different patterns regarding the relationship between ESG fulfillment and firm performance.

2.2.2. Firm Size

The ability to get access to resources depends on the firm’s size [4]. Big companies have plenty of resources that allow them to take more social responsibilities, build a stronger brand image, and intensify the government’s trust to earn more funding from them. All of the above could help the firm to promote itself for sustainable development. On the contrary, due to insufficient resources, small and medium sized firms (SMEs hereafter) are constrained in developing ESG. Meanwhile, SMEs are less exposed to pressures from society for ESG fulfillment. Hence, the negative impact of fulfilling ESG on a firm may be relatively bigger to SMEs, as compared with large companies. The exceptions include a study by Lin et al. who finds a positive impact of ESG fulfillment on firm performance based on China’s automotive industry [27]. Some scholars find a lag in ESG fulfillment’s impact on a firm [40,41].

In sum, companies of different sizes adopt different strategies in dealing with issues related to ESG. The gaps in this regard between small and large firms are even wider in China than in developed countries. Indeed, all firms in China need to strengthen awareness of ESG responsibility fulfilment.

Based on the above theoretical analyses, the theoretical model and the logical framework for the dynamic ESG-ROA relationship are shown in Figure 1.

3. Data Sources and Research Design

3.1. Sample Selection and Data Sources

This study focuses on Chinese firms listed in Mainland China, Hong Kong, the USA, and Singapore in the period of 2008 to 2019. The ESG data and financial data used in this study are from the databases of Bloomberg and Wind, and the data are screened according to the following steps: (1) the companies not given ESG score in the database are excluded; (2) the annual samples of ST Companies in the current year are excluded; (3) the annual samples of IPO companies in the current year are excluded; (4) the state-owned enterprises are distinguished according to whether the actual controller belongs to the government supervision Enterprises and non-state-owned enterprises; (5) manual review of the company’s annual report, if the enterprise belongs to the actual controller of the legal nature of the state-owned company, it belongs to the same state-owned group. Finally, 311 effective sample companies are obtained, and 12 years of unbalanced panel data are used for parameter estimation. Continuous variables were winsorized at a 1% level to eliminate the influence of outliers. The 311 manufacturing enterprises listed in the global capital market cover all the Chinese mainland manufacturing enterprises listed in the four capital markets of mainland China, Hongkong, the United States and Singapore. The sample includes various manufacturing enterprises of different sizes, different ownership, different regions and different factor intensity, which is typical.

3.2. Analyzed Variables and Their Definitions

3.2.1. Financial Performance

In theoretical research, there are many ways to measure financial performance, such as return on total assets (ROA), return on net assets (ROE) and Tobin’s Q. In this paper, combined with the characteristics of manufacturing enterprises, most of China’s manufacturing firms are asset oriented firms. In addition, this paper mainly studies the dynamic interaction between business performance and ESG responsible investment. Therefore, in the benchmark regression, we use ROA to measure financial performance, and in the robustness test, we use ROE and ROIC to measure financial performance.

3.2.2. ESG

As an important extension of social responsibility, the attention of ESG (environment, society and corporate governance) in international research has increased continuously in recent years. The ESG data used in this paper is selected from Bloomberg database. The three dimensions of environment (Env), society (Soc) and corporate governance (Gov) are composed of different secondary indicators. In the evaluation of secondary composition indicators of each dimension, there are 120 more detailed three-level indicators as the scoring basis [21].

3.2.3. Grouping Variables and Control Variables

There are significant differences regarding the interactive dynamic relationship between fulfilling ESG responsibility and firm performance among firms listed in variant locations. We thus separate the sample into two groups based on the listing locations: Those listed domestically and those listed overseas. Since the firm size is another important factor in determining a firm’s investment in ESG, we use total assets at the end of the year as a measure for firm size and take the natural log of it in the study [35]. We also separate the sample into two groups based on firm size. Firms ranked top 75% on firm size are classified as large firms, whereas the rest are classified as SME The sample has 83 large firms and 230 SMEs.

In addition, the factors affecting firm performance include competitive strategy [30,42,43], financial leverage, enterprise growth [44]. In addition, the company’s age [41] and the nature of control right [30] are also analyzed. In addition, it also controls the year and manufacturing sub industries.

The variables name and definition are shown in

Table 1. Classification of variables and their definitions.

Classification	Variable	Abbreviation	Explanation
Explained variable	Firm performance	ROA ROE ROIC	Net profit/total assets Net profit/shareholders’ equity Net profit after tax/invested capital
Core explanatory variables	ESG Combined	ESG	ESG Scores of Bloomberg database
	Environmental	Env	Environmental performance score of Bloomberg
	Social	Soc	Social performance score of Bloomberg
	Firm governance	Gov	Firm governance performance score of Bloomberg
Grouping variables	Listing locations	List	Take 1 for Chinese mainland listing, otherwise take 0
	Firm size	Size	Natural logarithm of total assets at terminal
Control variables	Low cost strategy	Cost	Cost effectiveness + capital intensity + capital expenditure rate
	Differentiation strategy	Diff	Sales expense rate + R&D intensity
	Financial leverage	Lev	Total liabilities/total assets
	Corporate growth	Gro	Sales growth of this year/sales of last year
	Nature of property rights	SOE	State owned enterprises take 1, others take 0
	Firm age	Age	Sample year—listing year + 1
	Sub industry	Ind	Take 1 for the i industry and 0 for the others
	Particular year	Year	Take 1 in the j-th year and 0 for others

.

3.3. Model Selection

We build a panel data vector autoregressive model to conduct empirical research on the dynamic impact of ESG fulfillment on firm performance. The models are as follows.

$$RO{A}_{i,t}={\alpha }_1+{\displaystyle {\sum }_{j=1}^m{\alpha }_{1j}}RO{A}_{i,t-j}+{\displaystyle {\sum }_{j=1}^m{\alpha }_{1j}}\ln ES{G}_{i,t-j}+{\displaystyle {\sum }_{j=1}^m{\alpha }_{1j}Controls+}{\mu }_i+{\gamma }_i+{\epsilon }_{i,t}$$

(1)

$$\ln ES{G}_{i,t}={\alpha }_2+{\displaystyle {\sum }_{j=1}^m{\alpha }_{2j}}\ln ES{G}_{i,t-j}+{\displaystyle {\sum }_{j=1}^m{\alpha }_{2j}}RO{A}_{i,t-j}+{\displaystyle {\sum }_{j=1}^m{\alpha }_{2j}Controls+}{\mu }_i+{\gamma }_i+{\epsilon }_{i,t}$$

(2)

where, i represents firms; t is for a year, m is the number of lags, α₁ and α₂ are coefficients, µ_i and γ_i are for individual fixed effect and time effect, respectively. ε_i,t is the error term.

4. Empirical Results and Hypothesis Testing

4.1. Descriptive Statistics of Main Variables

Table 2. Descriptive Statistics.

Panel A	Firms Listed in Mainland China					Panel B Firms Listed Overseas
	N = 238					N = 73
Variable	Obser.	Mean	Stad.	Min	Max	Obser.	Mean	Sta.	Min	Max
ROA	2860	4.598	5.029	−21.502	24.795	522	4.483	6.892	−18.318	24.931
ROE	2878	10.002	16.052	−191.662	156.382	522	7.305	35.699	−505.002	116.787
ROIC	2624	8.015	8.355	−79.288	69.191	507	5.823	45.447	−691.525	183.622
ESG	2319	18.937	6.437	7.438	50.826	433	20.395	10.283	0.826	48.347
Env	1692	9.996	5.600	1.502	47.287	379	17.122	10.822	1.550	42.636
Soc	2014	22.795	9.085	3.418	61.178	433	20.732	14.483	3.508	63.157
Gov	2319	44.726	5.201	28.571	52.501	433	48.367	6.846	3.571	62.500
Cost	2620	3.419	3.693	1.134	118.961	506	3.572	3.870	1.156	130.004
Diff	2620	0.128	0.331	0.000	12.235	506	0.139	0.356	0.000	12.867
Size	2955	8.783	1.471	3.811	14.437	581	8.423	3.541	1.821	13.78
Lev	2955	0.523	0.257	0.017	7.034	581	0.822	2.728	0.027	48.880
Grow	2142	18.86	41.31	−44.49	290.20	573	17.491	51.710	−65.423	356.105
SOE	2955	0.416	0.491	0	1	581	0.401	0.513	0	1
Age	2955	9.123	5.439	0.000	23.000	581	10.000	5.861	1.000	25.000

shows that the average ROA of firms in mainland China is 4.598, which is slightly higher than that of overseas listed companies. From ROE and ROIC, the average value of Listed Companies in mainland China is also slightly higher than that of overseas listed companies. However, the corresponding standard deviation is slightly larger than that of the listed enterprises in China, which indicates that the degree of the dispersion of profitability among overseas listed firms is greater than that of firms listed mainland. At the same time, the standard deviation of ROA, ROE and ROIC is greater than the average value, indicating that there are significant differences in profitability between different firms. Bloomberg ESG score is between 0 and 100, and the average score of ESG of listed manufacturing firms in mainland China is only 18.937, which indicates that the ESG responsibility investment is low. Meanwhile, the average score of ESG of overseas listed manufacturing firms is slightly higher than that of listed manufacturing enterprises in mainland China, which is 20.395. From the ESG dimension, whether it is listed in mainland or overseas, the score of Corporate Governance (G) is higher than that of Environment (E) and Society (S).

From the Pearson correlation coefficient of the main continuous variables, the correlation coefficients of ESG with ROA and ROIC are −0.075 and −0.044 respectively, and they are significant at the level of 1% (limited to space, the correlation coefficient table is not listed). On the one hand, it shows that the collinearity between the main variables is weak and the choice of variables is reasonable. On the other hand, it also shows that the current ESG responsibility investment has a significant inhibitory effect on the financial performance of the company.

4.2. Panel Data Unit Root Test and Number of Lags

In order to avoid the pseudo-regression results with the PVAR model, it is necessary to perform a unit root test on the variables involved to ensure the robustness of the regression results. Since the data in this study are unbalanced panel data, we use the Fisher-ADF and Fisher-PP tests for unit root tests to enhance regression results’ robustness. We also follow MAIC, MBIC and MQIC to determine the number of lags. The results show that one lag is sufficient. Due to the limitation of space, the test results are omitted.

4.3. Dynamic Panel with GMM Estimation for PVAR Model

We estimate the PVAR model using the Generalized Moment Estimation (GMM) method to test the mutual impact of financial performance and ESG. We fully consider the issue of heterogeneity due to listing locations and firm sizes and thus clustered the data into the following four groups: Mainland listed SMEs, Mainland listed large firms, overseas-listed SMEs, and overseas-listed large firms. We conducted a panel vector autoregressive analysis based on GMM and reported the results in

Table 3. GMM resulted for PVAR model.

Variable	Full Sample		Mainland + Small		Mainland + Large		Overseas + Small		Overseas + Large
	ROA	lnESG	ROA	lnESG	ROA	lnESG	ROA	lnESG	ROA	lnESG
L.ROA	0.457 ***	0.010 ***	0.380 ***	0.006 **	0.575 ***	0.010 *	0.363 ***	0.014 *	0.382 **	0.019 **
	(7.64)	(3.72)	(4.58)	(2.06)	(5.52)	(1.68)	(3.07)	(1.82)	(2.47)	(2.09)
L.lnESG	−3.464 ***	0.873 ***	−5.996 ***	0.794 ***	−2.075 **	0.778 ***	−1.338	1.051 ***	−0.066	1.028 ***
	(−4.95)	(25.43)	(−4.95)	(17.44)	(−2.25)	(11.49)	(−1.26)	(13.96)	(−0.07)	(14.53)

Note: The z value is reported in the brackets. ***, **, and * represent significant level at 1%, 5%, and 10%, respectively.

.

Table 3 shows that the current year’s financial performance measured by ROA is significantly affected by itself in the prior year. In all of the PVAR, the lagged ROA significantly affects the current year’s ROA and its coefficients are all greater than 0.363, among which, the impact of the lagged ROA has the greatest impact for Mainland listed large firms. This indicates of the momentum phenomenon in terms of firm performance. On the other hand, fulfilling ESG in the prior year has a negative impact on ROA in all of the five PVAR models. The corresponding coefficients are all significant except for that of the overseas-listed large firms, with the Mainland listed SMEs having the highest degree of impact. Furthermore, the coefficients of the lag of ESG are all positive and significant at the 1% level, indicating that the prior year’s ESG could promote the current year’s ESG fulfillment. The overseas-listed SMEs have the largest coefficient, reaching 1.051; Regarding the influence of ROA on ESG, the lagged ROA significantly promote the ESG fulfillment in the current period. Among them, the lagged ROA of overseas-listed large companies has the strongest impact on ESG fulfillment, indicating that those companies can involve more in ESG activities when they become more efficient.

4.4. Impulse Response and Variance Decomposition

4.4.1. Impulse Response

In the base period, ESG and ROA are set as a unit of impulse. Figure 2 and Figure 3 are the impulse response diagrams of the interaction between ESG and ROA in 10 periods after 300 Monte Carlo simulations. The horizontal axis represents the shock response period, and the vertical axis represents the response degree of the endogenous variable to the shock.

The impulse response diagrams shown in Figure 2 compare Mainland China listed SMEs versus large firms. It shows that ROAs of all firms are impacted negatively by the base period ESG fulfillment. The negative influence on SMEs tends to decline very rapidly initially and then reached the maximum in the second period, before gradually decreasing and converging to zero for a long time. Instead, ROA showed a U-shaped influence of first declining and then rising. The negative impact has a much smaller intensity for large enterprises compared with SMEs, indicating that increasing ESG investment could lower firm performance among SMEs. The reason might be that, unlike large firms, SMEs have too little resources to fulfill more ESG.

Further, the negative influences of ESG fulfillment on ROA are different between large firms and SMEs. In specific, among the SMEs, there shows a significant negative impact in both the current and the first periods, and it turns from negative to positive after the second period before reaching the peak in the third period; for large firms, ESG fulfillment first showed a negative impact on ROA, but after the first period, it turned from negative to positive, reached the peak in the third period and gradually weakened afterward. The response trend showed a clear pattern of upward, downward, and flattened. Overall, the influence of ESG fulfillment on ROA is significantly stronger for large firms than SMEs. The reason may be that, firstly, large companies pay more attention to maintaining their brand reputation and corporate image, etc. Secondly, shareholders and managers from large firms are more proactive than their peers from SMEs with regard to the awareness and consciousness of social responsibility. Therefore, when large enterprises’ financial performance improves, they will enhance their competitiveness and sustainable development capabilities by assuming more corporate social responsibilities.

The impulse response diagrams shown in Figure 3 compare SMEs listed overseas and those large firms also listed overseas. It shows that after ROA is impacted by ESG fulfillment during the base period, all of the overseas-listed firms’ ROAs are lowered, but insignificantly. However, large overseas-listed companies show the least negative impact. After the base period, overseas-listed companies tend to be impacted significantly and positively in the first phase. In addition, the impact on overseas-listed SMEs is relatively weak while the impact of overseas-listed large companies is strong. It reached a peak in the positive direction in the second period, and then slowly decreased, but insignificantly.

A detailed comparison between firms listed overseas and firms listed domestically shows the variant relationships between ESG fulfillment and ROA. Using one standard deviation of ESG fulfillment to test the impact of ESG on ROA, we find that regardless of its size, the negative response of ROA among the overseas-listed companies was significantly weaker than that of Mainland listed companies. Of note, the results are more significant among Mainland listed large firms. Overseas-listed companies did not show a significant negative impact. In addition, the impact on Mainland listed companies was negative in the current period and gradually became positive afterwards. After reaching the maximum in the third period, it began gradually weakening after that. One possible explanation is that the improvement in ROA in the current year among Mainland listed firms is due to decreases in ESG fulfillment in the prior year since, in the run, it is a trade-off between ESG fulfillment and better ROA.

On the contrary, the ESG fulfillment responds positively among overseas-listed companies since the first period and remains stable in the second period after reaching the peak. This indicates that improved financial performance tends to encourage firms listed overseas to invest more quickly in ESG than their peers listed in Mainland China. The necessity to maintain a high level of ESG fulfillment for a long time among overseas-listed firms could result from stricter regulatory requirements, higher litigation risks, and investors and other stakeholders’ requirements. The increased costs resulted from ESG investment in the short run may be quickly compensated by the benefits generated from fulfilling ESG.

In sum, there is significant heterogeneity regarding the relationship between ESG and ROA among firms with differ in sizes and listed locations. Firstly, the short-term impact of ESG fulfillment on financial performance is negative. Of note, the intensity of the impact could be ranked as follows from the strongest to the weakest: Mainland listed SMEs, Mainland listed large firms, overseas-listed SMEs, overseas-listed large firms. Secondly, the short-term impact of financial performance on ESG fulfillment is positive, ranked as follows in terms of impact intensity: Overseas-listed large firms, overseas-listed SMEs, Mainland listed large firms, Mainland listed SMEs.

4.4.2. Variance Decomposition

In order to further study the relationship between ESG fulfillment and financial performance, we use the variance decomposition approach to evaluate the contribution of each shock to the changes in all endogenous variables (see

Table 4. Variance Decomposition Result.

Variable	Lagged Term	Full Sample		Mainland + SMEs		Mainland + Large Firms		Overseas + SMEs		Overseas + Large Firms
		ROA	lnESG	ROA	lnESG	ROA	lnESG	ROA	lnESG	ROA	lnESG
ROA	1	1.000	0.000	1.000	0.000	1.000	0.000	1.000	0.000	1.000	0.000
	5	0.766	0.234	0.685	0.315	0.874	0.126	0.897	0.103	1.000	0.000
	10	0.697	0.303	0.649	0.351	0.835	0.165	0.744	0.256	0.999	0.001
lnESG	1	0.008	0.992	0.023	0.977	0.004	0.996	0.000	1.000	0.000	1.000
	5	0.021	0.979	0.012	0.988	0.022	0.978	0.031	0.969	0.062	0.938
	10	0.028	0.972	0.013	0.987	0.030	0.970	0.041	0.959	0.081	0.919

). Regarding the financial performance, regardless of whether it is viewed from the full sample or the sub-sample, the ROA changes are mainly affected by the ROA in the prior period, indicating the momentum effect for financial performance. Although the variance contribution of the ESG fulfillment to ROA is relatively small, it has a gradually increasing trend. Further, in the long run, ROA tends to be affected more by ESG fulfillment. In specific, in the 10th stage, with the full sample, the variance contribution of ESG fulfillment to ROA reached 30.3%; Among the Mainland listed companies, the variance contribution of ESG (35.1%) among SMEs was significantly greater than that of large companies (16.5%); for the overseas-listed companies, the ESG variance contribution of SMEs (25.6%) is also significantly greater than that of large enterprises (0.1%). In summation, the variance contribution of ESG fulfillment on ROA is relatively higher in SMEs than in large firms.

Regarding the ESG fulfillment, in both the full sample and sub-sample, its changes are mainly affected by ESG in the prior period. In the tenth stage, the contribution of ROA to the variance of ESG fulfillment in the full sample was only 2.8% while the lagged ESG contributed 97.2% of the explanatory power, indicating a strong inertial development trend. We thus conclude that the impact of ESG fulfillment on financial performance is greater than the impact of ROA on ESG fulfillment. Of note, there is a gradual increase in the contribution of ROA to the variance of ESG fulfillment. In the tenth stage, for Mainland listed companies, the contribution of the variance of ROA to the ESG fulfillment is 3% among large firms, which was significantly greater than that of the SMEs (1.3%). For overseas-listed companies, the contribution of the variance of ROA is 8.1% among large companies, also significantly larger than that of the SMEs (4.1%).

5. Other Tests

5.1. Robustness Tests

We did several robustness tests to find the impulse response and to decompose ESG fulfillment and ROA variance, including the Monte Carlo simulation approach and replacing ROA with Return on Equity (ROE) and Return Invested Capital (ROIC). The empirical results are consistent with the prior findings. The results further conclude that the prior findings are robust and reliable. Due to space limitations, we do not report the robustness test results.

5.2. Threshold Effect between Firm Size and Each Dimension of ESG

Considering that ESG score is a comprehensive index based on three dimensions of environment, society and corporate governance, the influence of one dimension may sometimes eliminate the opposite influence of the other dimension [45,46,47]. Therefore, it is necessary to consider the impact of environment (E), society (S) and corporate governance (G) on financial performance. This classification helps to evaluate the heterogeneity of the impact of different dimensions of ESG responsible investment on financial performance.

In order to further investigate whether there is size threshold effect in the impact of ESG responsible investment on financial performance of different enterprise sizes, this paper introduces the manufacturing enterprise size variable, constructs the benchmark model and panel threshold model of the impact of ESG responsible investment on ROA, and verifies whether the cross factor of enterprise size and ESG dimensions is the threshold variable of short-term “Substitution Effect”.

$$RO{A}_{i,t+1}={\beta }_0+{\beta }_{1}ES{G}_{i,t}+{\beta }_{2}Siz{e}_{i,t}+\theta X_{i,t}+{\epsilon }_{i,t}$$

(3)

$$RO{A}_{i,t+1}={\beta }_0+{\beta }_{11}ES{G}_{i,t}·I(S\_ESG\le {\xi }_1)+{\beta }_{12}ES{G}_{i,t}·I(S\_ESG>{\xi }_1)+\theta X_{i,t}+{\epsilon }_{i,t}$$

(4)

$$\begin{array}{l}RO{A}_{i,t+1}={\beta }_0+{\beta }_{11}ES{G}_{i,t}·I(S\_ESG\le {\xi }_1)+{\beta }_{12}ES{G}_{i,t}·I({\xi }_1<S\_ESG\le {\xi }_2)+ES{G}_{i,t}·I(S\_ESG>{\xi }_2)\\ +\theta X_{i,t}+{\epsilon }_{i,t}\end{array}$$

(5)

where $\theta =({\theta }_1,{\theta }_2,{\theta }_3,{\theta }_4,{\theta }_5,{\theta }_6),X_{i,t}=(X{1}_{i,t},X{2}_{i,t},X{3}_{i,t},X{4}_{i,t},X{5}_{i,t},X{6}_{i,t})$.

The above model excludes the lag of financial performance as an explanatory variable. Model (3) is the benchmark model, which assumes that financial performance does not have the threshold effect of firm size’s initial conditions. Equations (4) and (5) are the models with a single threshold and a double thresholds as the initial condition. Among them, β_i is the parameter to be estimated; ξ₁ and ξ₂ represent different threshold values, respectively; X is the control variable; I (·) is the indicator function to segment the sample according to the firm size threshold. Firm size is denoted as S, and the interaction variables between firm size and the three dimensions of ESG fulfillment, environment (E), society (S), and corporate governance (G), are denoted as S_E, S_S, and S_G, respectively, as threshold variables. A firm’s size is crucial to its capabilities in raising capital, hiring talents, developing technology, and increasing profits. In addition, a firm’s ESG fulfillment is related to its size. Therefore, we consider the interaction variable based on the three specific dimensions of ESG fulfillment and firm size as the threshold variable to identify the segmented financial performances. This is also a contribution to this study.

Next, we converted the unbalanced panel into a balanced panel and reported the threshold test results in

Table 5. Threshold Test Results.

Model	Threshold Variable	Threshold Value	F Value	p Value	BS Times	Critical Value
						1%	5%	10%
Single Threshold	S	7.530	21.99 **	0.020	300	27.713	20.212	18.211
	S_E	5.381	13.41	0.213	300	27.884	20.107	17.506
	S_S	5.704	20.74 **	0.033	300	25.641	19.015	17.113
	S_G	5.620	23.92 **	0.023	300	35.508	20.150	15.802
Double Threshold	S	[7.530, 9.247]	12.67	0.406	300	26.512	20.687	19.006
	S_E	[4.138, 5.381]	2.69	0.980	300	23.404	16.496	14.115
	S_S	[4.061, 5.704]	12.89	0.160	300	25.247	20.757	16.016
	S_G	[4.934, 5.620]	7.21	0.560	300	21.459	15.733	13.018

Note: The z value is reported in the brackets. ***, **, and * represent significant level at 1%, 5%, and 10%, respectively.

. The results show that when using ESG fulfillment to measure ESG, in terms of the size S and its interaction variable S_S with ESG sub-item S, the single threshold model is better, as shown in Figure 4a,c. As far as the interaction variable S_E of firm size S and ESG item E is concerned, the threshold effect is not significant, as shown in Figure 4b. The single threshold effect is better regarding the interaction variable S_G of firm size S and ESG item G, as shown in Figure 4d.

It should be pointed out that the presence of break or threshold in time-series data may be sharp or smooth. Since Gallant and Souza show that a Fourier approximation can capture unknown numbers of breaks of both gradual and sharp structural breaks [48], Yilanci et al. modify the Bootstrap ARDL with sharp breaks (using Dummy variables) to Bootstrap ARDL with smooth breaks (using a Fourier function) [49]. Because it is not the focus of this article, it will not be listed.

Table 6. The results of the threshold effect for firm size and the crossover factors.

S = Size		S_E = Size*Env		S_S = Size*Soc		S_G = Size*Gov
Single Threshold ξ1 = 7.350	(1)	No Threshold Effect	(2)	Single Threshold ξ1 = 5.704	(3)	Single Threshold ξ1 = 5.620	(4)
Cost	0.405 ***	Cost	−0.698 **	Cost	−1.094	Cost	−1.007 *
Diff	3.307 ***	Diff	−24.956 **	Diff	−2.724	Diff	−8.691 **
Size	−2.273 ***	Size	−1.664 ***	Size	−1.750 ***	Size	−1.745 ***
Lev	−7.294 ***	Lev	−7.218 ***	Lev	−7.015 ***	Lev	−7.241 ***
Grow	0.001 ***	Grow	0.002 ***	Grow	0.002 ***	Grow	0.002 ***
ESG S ≤ ξ1	−0.149 ***	ESG	−1.664 ***	ESG S ≤ ξ1	−0.078 ***	ESG S ≤ ξ1	−0.125 **
ESG S > ξ1	−0.037 **			ESG S > ξ1	−0.034 *	ESG S > ξ1	−0.037 **
Const	26.018 ***	_cons	24.455 ***	_cons	25.731 ***	_cons	23.309 ***
R2	0.172	R2	0.153	R2	0.163	R2	0.164

Note: The z value is reported in the brackets. ***, **, and * represent significant level at 1%, 5%, and 10%, respectively.

lists the threshold effect model of firm size and its interaction variables. The results show that if the role of firm size is taken into account, the impact of ESG fulfillment on financial performance in the short term shows obvious segmented characteristics; that is when the firm is small, ESG fulfillment has a significant inhibitory effect on financial performance. Specifically, when the company’s size is below the threshold of 7.350, the impact coefficient of ESG fulfillment on ROA is −0.149 at the 1% significance level. When the company’s size exceeds the threshold of 7.350, in the short term, the restraining effect of ESG fulfillment on financial performance weakened, and the coefficient of restraint effect of the former (−0.149) was 4.03 times that of the latter (−0.037).

We further examine the interaction variable’s threshold effect between the three specific dimensions in ESG fulfillment and firm size. The results are reported in Table 6.

The results show that the impact of ESG fulfillment on financial performance is closely related to firm size. In addition, there exist significant differences between firm size and the allocation of ESG fulfillment in various dimensions. As compared with social (S) indicators and corporate governance (G) indicators, firm size and the configuration of the environment (E), no matter how large or small, have a significant inhibitory effect on financial performance in the short term. Specifically, the cost is generally greater than the benefits during the process of fulfilling environmental responsibility. Hence, the impact of ESG fulfillment on financial performance in the short-term is manifested as a “Substitution Effect”.

Further, when the firm size and the social (S) configuration are matched well, the inhibitory impact of ESG on ROA in the short-term will turn from strong to weak. Similarly, after firm size and the configuration of corporate governance (G) crosses the threshold, the restraining influence of ESG on ROA will also turn from strong to weak in the short term. This indicates that as compared with SMEs, when large firms increase ESG investment, the negative impact and “Substitution Effect” of ESG fulfillment on financial performance will be relatively weaker in the short run.

5.3. The Long-Term Impact of ESG Fulfillment on ROA

The impulse response analysis shows that ESG fulfillment tends to impact ROA in the short term and gradually weakens after the second period. It also presents the “Replacement Effect” in the short term, but can the impact show a “Promotion Effect” in the long run? We explored this issue using the following model.

$$RO{A}_{i,t+j}={\beta }_0+{\beta }_{1}RO{A}_{i,t}+{\beta }_{2}ES{G}_{i,t}+\theta X_{i,t}+{\displaystyle \sum Year}+{\displaystyle \sum Ind}+{\epsilon }_{i,t}$$

(6)

where, j = 1, 2, 3, 4, 5;

$\theta =({\theta }_1,{\theta }_2,{\theta }_3,{\theta }_4,{\theta }_5,{\theta }_6),X_{i,t}=(X{1}_{i,t},X{2}_{i,t},X{3}_{i,t},X{4}_{i,t},X{5}_{i,t},X{6}_{i,t})$.

Of note, since the explanatory variables are lagged for 1 to 5 periods, considering ROA’s momentum effects, we select the SYS-GMM model to deal with the endogenous issue. The results are reported in

Table 7. The impact of ESG responsibility on ROA in the lagging Period.

Variable	ROAi,t+1	ROAi,t+2	ROAi,t+3	ROAi,t+4	ROAi,t+5
ROAi,t	0.474 ***	0.256	0.438 ***	0.216 *	0.080
	(5.90)	(1.29)	(3.05)	(1.88)	(0.57)
ESGi,t	−0.056 **	0.040	0.199 **	0.150 *	0.100
	(−2.09)	(0.16)	(2.07)	(1.87)	(1.47)
Controls	Yes	Yes	Yes	Yes	Yes
Year/Ind	Yes	Yes	Yes	Yes	Yes
AR(2)	0.312	0.164	0.488	0.740	0.848
Hansen	0.073	0.114	0.408	0.125	0.120
Observations	2287	2010	1729	1469	1232

Note: The z value is reported in the brackets. ***, **, and * represent significant level at 1%, 5%, and 10%, respectively.

.

As seen in Table 7, a firm’s financial performance is significantly and negatively impacted by the ESG fulfillment in the prior period due to the incurred costs and opportunity costs associated with relevant resources in the short term. However, the ESG fulfillment has a significantly positive impact on the financial performance in the three to four periods afterwards, indicating that the role of ESG fulfillment on financial performance is dynamic and long term, which cannot be achieved overnight or quickly. In summation, the impact of ESG on ROA shows a significant “Substitution Effect” in the short term, but a significant “Promotion Effect” in the long run. Therefore, when fulfilling ESG responsibilities, firms should take it as part of their corporate strategy and adhere to them for a long time, avoid short-sighted behaviors, and improve corporate financial performance in the long run.

6. Discussion and Conclusions

Based on the trade-off theory, stakeholder theory, and resource slack theory, this study explores the long term and short term dynamic interactions between ESG fulfillment and financial performance. We conclude the following.

Firstly, the ESG fulfillment has a short-term negative impact on financial performance called the “Substitution Effect.” This negative impact will gradually weaken. Moreover, the improvement in financial performance will encourage a firm to invest more in ESG, but there is a strong lag.

Secondly, there is significant heterogeneity in terms of the response direction and intensity regarding the dynamic interactions between ESG fulfillment and ROA among firms listed at different locations and with different sizes. In specific, the short-term impact of ESG fulfillment on financial performance is negative. Mainland listed SMEs has the highest impact intensity, followed by Mainland listed large firms, overseas-listed SMEs, and overseas-listed large firms. On the other hand, the short-term impact of financial performance on the fulfillment of ESG is positive, with overseas-listed large firms ranked the highest, followed by overseas-listed SMEs, Mainland listed large firms, and Mainland listed SMEs.

Thirdly, firm size is an important factor in determining the role of ESG fulfillment on ROA. In specific, when a firm keeps on growing and it’s social (S) and corporate governance (G) derived from the fulfillment of ESG responsibilities are improving as seen from the interaction variable crossing the threshold, the restraining influence of ESG fulfillment on ROA tend to change from strong to weak in the short term.

Fourthly, from a long-term perspective, ESG fulfillment has a significant positive impact on financial performance, leading to a “Promotional Effect,” and ultimately the two-way effect and a closed-loop effect of ESG-ROA that could benefit both. Of note, the loop starts from the ESG fulfillment.

The study suggests the following. Firstly, to achieve a firm’s long-term goal and to satisfy all stakeholders’ demands, a firm may establish an environmentally friendly business model, especially for those with historically high polluting records. Secondly, it is a complex continuing dynamic process in terms of improving a firm’s ESG fulfillment as well as financial performance. This requires the firm to increase investment in ESG and adhere to it for a long time. Thirdly, even though firms listed in Mainland China do not face strict regulatory supervision as their peers in the developed countries do, those firms still need to strive to improve ESG fulfillment in order to reduce the short-term negative impact of ESG fulfillment on financial performance for sustainable development in the future.