**1. Introduction**

Corporate social responsibility (CSR) has become an important topic that has attracted significant attention not only from academic scholars but also from business practitioners and governments. For example, Europe enacted the Non-Financial Reporting Directive (NFRD) in 2014, which requires public companies with more than 500 employees to disclose the methods through which they manage social and environmental challenges [1]. The Indian government passed a new law that requires specific firms (according to firms' profitability, net worth, and size) to spend at least 2% of their net income on CSR each year [2]. In China, in 2008, the Shanghai Stock Exchange (SSE) and Shenzhen Stock Exchange (SZSE) published regulations that mandate some public firms to disclose their social and environmental governance information in their annual reports. Previous studies have examined the effects of mandatory social and environmental regulations (hereafter, MSER) on business operations such as firm performance, shareholder value, and CSR expenditure [2–5].

However, we have little knowledge about how the MSER have impacted firms' other important activity—innovation. Innovation is a dominant corporate strategy that boosts long-term growth and enhances sustainable competitiveness [6,7]. In 2018, PwC surveyed 1000 public firms around the world and found that these firms spent a total of USD 782 billion on innovation activities [8]. Moreover, a report suggests that innovation-related activities account for around 50% of a country's total GDP growth, with their effects varying depending on the level of economic development and the phase of the economic cycle of each country [9]. Accordingly, it is necessary and paramount to investigate whether firm innovation activities are affected by the local government's sudden implementation of MSER.

**Citation:** Cao, Z.; Mu, Y. Social and Environmental Regulations and Corporate Innovation. *Sustainability* **2022**, *14*, 16275. https://doi.org/ 10.3390/su142316275

Academic Editors: Akrum Helfaya and Ahmed Aboud

Received: 28 October 2022 Accepted: 2 December 2022 Published: 6 December 2022

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**Copyright:** © 2022 by the authors. Licensee MDPI, Basel, Switzerland. This article is an open access article distributed under the terms and conditions of the Creative Commons Attribution (CC BY) license (https:// creativecommons.org/licenses/by/ 4.0/).

The relationship between MSER and firm innovation is not immediately clear. On the one hand, such mandatory regulations may lead to a reduction in investment in innovation activities, especially for small- and medium-sized enterprises (SMEs). This is because the affected firms may allocate parts of their available funding, which could be used on innovation projects, to investment in social and environmental governance, thereby causing a decline in the innovation activities. For SMEs whose financial resources are limited [10], their R&D expenditures would rapidly shrink once they are forced by the government to conduct environmental and social activities. On the other hand, MSER may also increase innovation. First, the improvement in CSR performance driven by the regulations may enhance employees' satisfaction, teamwork, and innovative productivity (i.e., CSRimproving effect), which consequently sparks innovation output [11,12]. Second, disclosing non-financial information allows a firm to increase its transparency and reduce uncertainty and information costs (i.e., information-disclosing effect), thereby possibly prompting firm innovation [13–15]. Third, MSER may encourage innovation by reducing the pressures on managers to pursue short-term benefits [16–19], as myopic investors treat these regulations as a negative sign and escape from these firms (i.e., market-reaction effect) [2,3]. Therefore, we attempt to answer the following questions in this study:


A Chinese policy provides an ideal setting to identify the causal effect between MSER and firm innovation. At the end of 2008, the SSE and SZSE announced regulations that require certain firms to disclose social and environmental governance information. Since the regulations were unexpected for Chinese firms and only covered some public firms, this provides a quasi-experimental context that can help us accurately estimate the impact of MSER. We leverage this exogenous variation and adopt difference-in-differences with propensity-score matching (DID-PSM) to identify the impact of MSER on firm innovation. We found that MSER led to a significant increase in the firm innovation output measured by the number of patents in the post-regulation period. Specifically, the treatment firms experienced a higher innovation output than the control firms by 19.7% three years after the regulations. The results also revealed that the number of invention patents that were more innovative and original from the treatment firms significantly increased following the regulations, relative to the control firms. Thus, the increase suggests a positive impact on innovation quality. The findings hold up to a variety of robustness checks.

To understand the underlying mechanisms of this association further, we explored the three possible channels proposed above. First, we examined whether CSR performance of the treatment firms was enhanced after the regulations. Prior studies have suggested that the improvement in CSR performance would facilitate firm innovation by increasing the work atmosphere and employee satisfaction [11,12,20]. Our regression results revealed that the CSR performance of the treatment firms increased significantly compared to the control firms. Thus, this supports the mechanism of the CSR-improving effect. Second, we examined whether the information asymmetry of the treatment firms declined after the regulations. MSER may reduce firms' environmental uncertainty and information asymmetry by disclosing more information to stakeholders, thereby eliminating the transaction costs to prompt innovation [15,21]. Ref. [13] also documented that high transparency (i.e., low uncertainty and information asymmetry) facilitates innovation by reducing information costs. If a firm becomes more transparent, an analyst's forecast will be more accurate [22]. Therefore, we adopted the analysts' forecast errors to capture the information asymmetry. The results showed that these errors did not drop significantly for the treatment firms after the regulations, thus suggesting that the positive effect of the regulations on innovation was not driven by the information-disclosing effect. Last, we examined whether the pressures on managers to reap short-term benefits were reduced after the regulations. The extant literature documents that the pressures on short-term benefits from institutional investors stifled firm innovation [16–19]. Accordingly, we explored how institutional ownership

changed when firms were affected by MSER. Our regression results indicated that institutional ownership declined significantly for the treatment firms after the regulations. Thus, this supports the market-reaction effect. In sum, these results revealed that the effects of MSER on firm innovation were primarily driven by the CSR-improving effect and market-reaction effect.

This study is mostly related to Hong et al. [23] and Mbanyele et al. [24] who investigated the impact of mandatory CSR disclosure on firms' green innovation. Although their research provided us with initial insight into the relationship between MSER and green innovation, we do not know how much MSER have impacted firms' whole innovation activities (e.g., non-green innovation). Moreover, previous research did not address why these types of regulations would impact firm innovation activities and output. Accordingly, this study contributes to the literature by examining the impact of MSER on firms' whole innovation output and also provides deeper insights into the underlying mechanisms that explain why the regulations would impact innovation activities.
