*5.3. Market-Reaction Effect*

Last, we explored the mechanism of the market-reaction effect. MSER might be a negative sign for investors who argue that treatment firms invest more in social and environmental governance at the expense of shareholders' benefits. Ref. [41] examined the market reaction to events associated with the passage of a directive in Europe mandating increased non-financial disclosure that was related to firms' ESG performance. They found a negative market reaction to events that increased the likelihood of the passage of these regulations. Similarly, ref. [2] investigated the mandatory CSR policy in India using the event study method, as well as a regression discontinuity design, and found that this policy caused a 4.1% drop on average in the stock prices of the affected firms. In China, ref. [3] also revealed that the MSER led to negative effects on firms' ROA and ROE. Consequently, the MSER were interpreted as a negative sign for outside investors.

Institutional investors who pursue short-term benefits may argue that these types of regulations will drive affected firms to pay increased attention to social and environmental issues at the expense of shareholders' benefits [6,47,48]. Therefore, they reduce the stock ownership of firms subject to the MSER. However, a reduction in institutional ownership may encourage firm innovation by eliminating the short-term earning pressures on managers [16–19,49]. Accordingly, the increase in innovation for the treatment firms after the MSER were implemented may have been caused by the reduction in institutional ownership. Institutional ownership is the percentage of outstanding shares held by institutional investors, data on which were collected from the Chinese Research Data Services (CNRDS) database. If the innovation increase for the treatment firms was caused by this, we expected to observe a significant decline in institutional ownership for the treatment firms. As shown in column 3 in Table 8, the coefficients of the interaction term, *Treated* × *Post*, were negative and significant, thus supporting the *market-reaction effect*.

Furthermore, institutional investors are usually classified into two types: transient institutional investors and dedicated institutional investors [17,47–49]. Dedicated institutional investors, such as pension funds, insurance companies, and banks, are institutions that have long-term holdings, are less constrained by liquidity needs, and are more willing to use longer periods to evaluate managers' performance [49]. In contrast, transient institutional investors are institutions that chase short-term price appreciation. Thus, they take small equity positions in many firms and tend to trade frequently [49]. Therefore, we suspect that the reduction in institutional ownership (column 3 in Table 8) stemmed mainly from the transient institutional investors. To test this expectation, we investigated the effects of the MSER on the changes in specific institutional investors. Table A4 reports the results. We found that the ownership of dedicated institutional investors (e.g., insurance companies in column 3 and social security funds in column 4) did not experience a striking decline after the regulations. In contrast, the ownership of normal funds that were smaller and more likely to chase short-term profits had a significant decrease after the regulations (see column 1). Additionally, the ownership of securities companies sightly declined (see column 2). The results in column 5 also reveal that qualified foreign institutional investors (QFII) did not change their investment strategies for the treatment firms, thus suggesting foreign investors in China were more likely to chase long-term profits.

In summary, we considered three potential mechanisms and demonstrated that the positive impact of the MSER in China on firm innovation was mainly due to the CSRimproving effect and market-reaction effect.

#### **6. Discussion**

An increasing number of countries and regions are paying attention to social and environmental issues and have enacted related laws and policies to cope with them. Previous studies have examined the equity market reaction to these mandatory social and environmental policies [2,41] and the impact of these policies on firm financial performance [3–5], whereas there is little knowledge of how these policies have affected firm innovation activities. On the one hand, some argue that MSER could reduce firm innovation because they could stifle investment in corporate innovation activities. On the other hand, some argue that MSER could facilitate firm innovation due to the benefits from the improvement in CSR performance or report disclosure.

Using the implementation of MSER that occurred in China, we empirically found that the treatment firms' innovation outputs significantly increased after the announcement of the MSER. We further analyzed the possible mechanisms and found that the CSR-improving effect and market-reaction effect played an important role in driving this relationship.

These findings contribute to the literature on the determinants of innovation [50], especially research that investigates the impact of various types of legislation on innovation [11,25,27,28,33–35,37]. In this study, we complemented this line of research by examining the effect of MSER on firm innovation. Our study documented the influencing mechanisms of social and environmental policies on innovation (i.e., the improvement in CSR performance and reduction in institutional ownership). It is helpful to understand the impact of mandatory social and environmental regulations. Additionally, our study contributes to the literature that investigates the impact of CSR and innovation. The endogenous issues related to this relationship have prevented prior researchers from making efficient causal inferences [20,51]. In this study, we addressed this challenge by leveraging an exogenous shock on firms' CSR practices and utilizing a difference-in-differences approach to estimate the relationship between CSR and innovation.

Our findings also have potentially important implications for managers and policymakers. Our findings demonstrate that the net effect of MSER on innovation was positive. In other words, CSR performance and innovation performance were not completely paradoxical. Accordingly, with the increasing CSR pressure nowadays, companies that are eager to innovate may find it worthwhile to improve social and environmental governance. For policymakers, our findings provide an unexpected result, that is, MSER have led to an increase in innovation. Understanding the impact of MSER on firms' other operating activities (e.g., innovation) and their underlying mechanisms allows legislators to comprehensively master the effectiveness of their enacted policies, which is able to assist with the formulation of future policy. This study finds that the CSR-improving effect plays a major role in influencing firm innovation. Thus, the government, for example, can publish policies that require companies to improve employee welfare or can set a higher environmental standard to prompt companies to improve their production technologies.

#### **7. Conclusions**

In this study, we answered two research questions: (1) How do mandatory social and environmental regulations influence corporate innovation? and (2) What are the underlying mechanisms that drive this relationship? We exploited an exogenous shock in China in 2008 to examine the impact of MSER on innovation. Using a difference-in-differences with propensity-score matching methodology, we found that MSER in China led to a significant increase in firm innovation. In particular, we found that firms that were mandated to disclose social and environmental information generated more patents, including invention patents that were more innovative and original, than the control firms, which were not required to adhere to these rules after three years of the regulations. Lastly, we verified that the positive effects of the MSER on firm innovation were mainly caused by the CSR-improving effect and market-reaction effect, manifesting in an improvement in CSR performance and a reduction in institutional ownership, respectively.

**Author Contributions:** Conceptualization, Z.C. and Y.M.; Methodology, Z.C.; Formal analysis, Z.C.; Data curation, Z.C.; Writing–original draft, Z.C.; Writing–review & editing, Z.C. and Y.M.; Supervision, Y.M. All authors have read and agreed to the published version of the manuscript.

**Funding:** This research received no external funding.

**Institutional Review Board Statement:** Not applicable.

**Informed Consent Statement:** Not applicable.

**Data Availability Statement:** Data used in this study are reported in Section 3.2.

**Conflicts of Interest:** The authors declare no conflict of interest.

#### **Abbreviations**

The following abbreviations are used in this manuscript:



#### **Appendix A**

**Table A1.** Industry Distribution of Matched Sample.


**Table A2.** Propensity-Score Matching (PSM) Results.


Note. All covariates in the above table are averages over the pre-regulation period (2006–2008), except for *patent growth*. Patent growth is measured by the growth ratio of the number of a firm's patents over the pre-regulation period, that is, (a firm's patents in 2008–the firm's patents in 2006)/the firm's patents in 2006. Significance at \* *p* < 0.1; \*\* *p* < 0.05; \*\*\* *p* < 0.01.

**Table A3.** Definitions of All Variables Used in This Study.



**Table A3.** *Cont*.

**Table A4.** The Types of Institutional Investors.


Note. This table reports the estimated coefficients and heteroskedasticity-adjusted robust standard errors clustered at the firm level (in parentheses). Significance at \* *p* < 0.1; \*\* *p* < 0.05; \*\*\* *p* < 0.01.

#### **References**

