**1. Introduction**

Through economic, societal, and scientific and technological development, humans have accomplished great things [1,2]. The public's demand for environmental, social, and ethical responsibility of business has increased due to severe climate changes, depleting natural resources, harsh work conditions, and the proliferation of corporate scandals. More investors and consumers are focusing on corporate social responsibility and sustainability. Moreover, they expect companies to align their operating philosophies with social values [3]. In response to the emergence of these issues, the United Nations Commission on Environment and Development issued the "Brundtland Report" [4], and the concept of sustainable development was proposed. The ESG value concept is founded on sustainable development, and enterprises, as the fundamental units and organization of human economic and social operation, play a central role in sustainable development [5,6]. Therefore, for businesses to achieve sustainable economic and social development, the ESG value concept must be implemented.

ESG values can be traced back to the concept of socially responsible investment in the 1960s. It was not until 2004, when the United Nations Global Compact released its report [7], that ESG was introduced to the public as a holistic concept. ESG is an acronym for environmental, social, and governance. It provides a comprehensive framework for enterprises

**Citation:** Zhu, J.; Huang, F. Transformational Leadership, Organizational Innovation, and ESG Performance: Evidence from SMEs in China. *Sustainability* **2023**, *15*, 5756. https://doi.org/10.3390/su15075756

Academic Editors: Akrum Helfaya and Ahmed Aboud

Received: 22 February 2023 Revised: 21 March 2023 Accepted: 23 March 2023 Published: 25 March 2023

**Copyright:** © 2023 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/).

and investors to integrate environmental, social, and corporate governance concerns [8]. It conveys the development concept of pursuing integrated economic and social benefits, a sustainable development concept that has recently emerged in corporate management and financial investment. Environmental concerns include pollution control, renewable energy use, greenhouse gas emissions, and other factors, as well as the resulting environmental impact [9]. The social dimension refers to a company's responsibility to its employees, consumers, communities, suppliers, and other stakeholders while maximizing profits within the confines of the law [10]. Governance refers to business ethics, anti-competitive behavior, and protecting shareholders' rights. It is the internal mechanism established by the company to achieve self-management, effective decision-making, compliance with laws and regulations, and the satisfaction of external stakeholders' needs [11]. The core concept of ESG is that enterprises should pursue economic benefits in economic and social activities and pay attention to environmental resource protection, corporate social responsibility, and corporate governance effectiveness to achieve balanced development across multiple dimensions [12]. As a new value concept, ESG can promote corporate transformation from "profit maximization" to "sustainable development". It has a significant effect on how companies manage their strategies and integrate their resources [13]. It is also an important tool for promoting high-quality economic growth and sustainable development [14]. Amid economic globalization, enterprises can only stand out in the increasingly fierce market competition if they can comprehensively address environmental, social, and corporate governance issues [15].

At the same time, investors at the international or regional level in developed countries take ESG investments seriously. According to KPMG, the global ESG disclosure rate for N100 companies was 76% in 2022, while 96% of G250 companies published ESG reports, indicating that ESG reporting has become an important management and investment concept for companies and financial institutions. In addition, the importance of ESG disclosure is being recognized by increasing numbers of regulators, stock exchanges, and investors. Moreover, many stock exchanges worldwide have begun to provide ESG disclosure requirements or guidelines for listed companies in countries such as the USA, the UK, Brazil, Canada, India, Malaysia, Norway, South Africa, France, Germany, the Philippines, Italy, and Singapore [16]. In the past few years, ESG has become one of the focal points of China's economic development activities. Although ESG development in China is still in its infancy, ESG investment in China is improving as ESG becomes more common in the international market and corporate managers, consumers, investors, and regulators are becoming increasingly aware of the importance of ESG concepts [17]. Furthermore, the Chinese market has seen rapid developments in the areas of environmental, social, and governance reporting [18]. To encourage Chinese companies in the active practice of ESG responsibilities as well as to help balance economic growth and environmental sustainability, the CDFA released the 2018 Report on the ESG Rating System for Chinese Listed Companies and the Green Investment Guidelines (Trial), which require listed companies to become carbon-neutral by 2060. In addition, the "double carbon" target manifests China's green development philosophy; to achieve this goal, China has to accelerate the construction of an ESG system to enhance its voice in the global sustainable development agenda [19]. On a global scale, after the COVID-19 pandemic shocked the global economy in 2020, systemic risks such as pandemics and climate change showed the need for sustainable development and green economies again, leading many countries to incorporate sustainability goals into their post-pandemic recovery plans [20].

With the emphasis on the ESG value concept in corporate strategic management, numerous theoretical and empirical studies on ESG have been conducted at home and abroad. Most studies examine the relationship between ESG evaluation systems or ESG investment and corporate performance; however, the research results are highly contentious and present two contradictory views. On the one hand, neoclassical economic theory suggests that a firm's mission is to maximize profits, ESG has strong negative externalities, and managers may use it as a self-interest tool, so firms' investment in ESG will lead to

a waste of corporate resources and higher costs, resulting in a decline in corporate performance [21–24]. On the other hand, based on resource stakeholder theory and stakeholder theory, ESG disclosure helps increase a company's transparency. In addition, investing in ESG can help companies develop internal resources to increase intrinsic earnings by enhancing corporate reputation [25–27]. The realization of corporate value is not limited to shareholders; environmental, social, and corporate governance factors should also be considered [20,28]. Financial factors significantly impact a company's ESG rating [6]. Companies whose environmental, social, and corporate governance work is sound and whose relationships with stakeholders are strengthened can achieve good performance [16,29]. During the COVID-19 pandemic, portfolios with high ESG scores showed a higher risk tolerance. Furthermore, share prices of companies with good ESG performance were less volatile, thus demonstrating their investors' confidence [14]. In other words, better ESG performance guarantees the anti-risk ability and long-term competitiveness of an enterprise. Apparently, the ESG investment concept can help align capital allocations with the goals of sustainable economic development [15]. Therefore, it is necessary to study the factors that influence corporate ESG in the context of the ESG investment concepts being promoted.

Although ESG theories have proliferated in recent years, however, most studies focus on developed markets [30], and very few studies investigate emerging markets [31,32]. China is on a high-quality development path but is still in the early stages of ESG development. Investors and companies still do not have a clear understanding of what ESG performance means in terms of corporate sustainability, or of the mechanisms underlying the role of leadership in corporate ESG performance. This paper uses higher-order behavior theory, social network theory, resource-based theory, and stakeholder theory as a foundation to investigate the effect of transformational leadership through organizational innovation on ESG performance of SMEs in China by distributing questionnaires to leaders and employees as a sample, as well as the moderating role of external social capital in transformational leadership and organizational innovation. The result indicates that transformational leadership has a positive impact on the ESG performance of SMEs. Organizational innovation partially mediates the relationship between transformational leadership and corporate ESG performance. Furthermore, the role of transformational leadership in organizational innovation is stronger when firms have higher levels of external social capital.

This study will offer three original contributions. First, it will enrich the research on the ESG performance of SMEs in developed countries. Most studies on ESG performance are based on secondary data from capital markets or listed companies in developed countries; there are no empirical studies based on primary data. To bridge this gap in the literature, this paper will distribute questionnaires to Chinese SMEs, which is an unexplored approach to ESG performance research. Second, it will enrich knowledge of the antecedents of ESG performance in SMEs. Most studies focus on the impact of ESG indicators or ESG investment on corporate financial performance but do not focus on ESG performance as a dependent variable, which means this study's approach is a useful supplement to previous studies. Third, this study helps policymakers, stakeholders, regulators, and scholars improve their understanding of corporate sustainability. It also provides key theoretical and practical values for promoting corporate sustainability. This paper is organized as follows: first, a literature review based on pertinent theories and the establishment of research hypotheses; second, measurement of relevant variables and empirical analysis based on data and elaboration of research results; and third, a discussion of research findings, management insights, research limitations, and suggestions for future research.

#### **2. Theoretical Background and Research Hypothesis**

#### *2.1. Transformational Leadership and ESG Performance*

Higher-order theory is derived from Hambrick and Mason [33]. The theory is that executives are the subjects of strategic decision-making within an organization. They make limited rational decisions based on their psychological characteristics and highly individualized interpretations and decisions regarding the organizational situations they encounter. Senior managers participate in strategy formulation and play important roles such as control, coordination, and leadership in the process of strategy implementation. The top leaders who hold the decision-making power in the company have the strongest influence on the formation and adjustment of corporate behavior [34]. Therefore, strong leadership is required to formulate forward-looking corporate strategies and implement necessary organizational changes [35].

Transformational leadership theory was developed by Bass [36]. Transformational leaders possess four dimensions: idealized influence or charisma, inspirational motivation, intellectual stimulation, and individualized consideration [37]. In addition, transformational leaders have a solid sense of intrinsic value and a conceptual system. They provide a clear vision for their subordinates, stimulate their high-level needs by making them aware of the importance of the tasks they undertake, build a climate of mutual trust, motivate them to sacrifice their self-interest for the good of the organization, and ultimately achieve performance beyond expectations [38,39].

Researchers have looked into transformational leadership from various perspectives, including psychological factors such as personality, mindset, and cognition of business leaders, as well as environments that affect transformational leadership behaviors [40–42]. For example, transformational leaders influence their followers by the following means: (a) setting examples of appropriate behaviors; (b) projecting a view of the future that shows employees what to strive for and where to go; (c) taking an active interest in the lives and work of their employees; and (d) fostering independence and active participation in tasks to increase their employees' job satisfaction, organizational commitment, organizational identity, etc., and thus enhance job performance [43–46].

Transformational leaders communicate a clear and consistent vision regarding environmental responsibility by disseminating environmental information to demonstrate environmental commitment and values for action and discussing sustainability's significance [47,48]. Moreover, transformational leaders can inspire a shared organizational vision, demonstrate the value and significance of environmental stewardship, and provide cohesive and information-sharing rallying points, thereby integrating environmental performance into corporate strategic planning [49,50]. According to social identity theory, individuals' attitudes and behaviors can influence their group membership in CSR [51]. The humanistic perspective of transformational leaders, which is based on altruism, justice, and the greater good, effectively creates a collective identity based on appealing values, which may include catering to the more significant needs of stakeholder groups and the social good and are in line with corporate social responsibility [52,53]. Thus, followers will associate their organization's identity with the greater social good and be motivated to engage in CSR [54,55].

In 1963, the Stanford Research Institute introduced stakeholder theory, which emphasizes the mutual influence between a firm and its stakeholders. Stakeholders are individuals or groups, such as investors and employees, who are dependent on the firm to achieve their goals and who the firm depends on for its development [56]. Based on previous research, Freeman and Mcvea [57] defines stakeholders as "individuals or groups of individuals who can influence or are influenced by the achievement of a firm's organizational goals". This definition considers the individuals and groups that influence the goals of the company as stakeholders, also considers the individuals and groups that are affected by the achievement of the company's goals as stakeholders, and formally includes entities such as communities, governments, and environmental protection organizations in the study of stakeholders, all of which greatly expand the connotation of "stakeholders [58]". At the level of corporate governance, transformational leaders begin with the organization's shared vision and consider not only the interests of shareholders but also those of other stakeholders, such as small- and medium-sized shareholders, external investors, creditors, employees, and the government [59]. They also improve the transparency of corporate

information and develop a sound corporate governance system [60,61]. Based on the initial assertion, we propose the following hypothesis:

#### **Hypothesis 1 (H1).** *Transformational leadership has a positive impact on ESG performance.*

#### *2.2. Transformational Leadership and Organizational Innovation*

Organizational innovation can be a new product or service, a new production process technology, a new structure or management system, or a new program or project involving organizational members [62]. OCED [63] distinguishes four types of innovation: product innovation, process innovation, marketing innovation, and management innovation. Innovation within an organization generates the most valuable, organizational, and difficultto-replicate strategic assets that lead to enhanced business performance [64]. According to resource-based theory, a resource is anything in an organization that demonstrates the organization's core competencies, both in the form of tangible assets and intangible assets [65]. A company's competitive advantage and performance depend on how it uses its strategic resources, which are valuable, rare, and difficult for market rivals to imitate [66]. Therefore, organizational innovation is a direct source of competitive advantage and one of the essential sources of sustained competitiveness for modern businesses [67].

The impact of leadership style on organizational innovation has been the subject of extensive research. Most studies conclude that different leadership styles affect organizational innovation [68,69]. For example, transformational leadership, ethical leadership, servant leadership, and responsible leadership have a positive impact on organizational innovation [70,71], but authoritarian leadership has a negative impact on organizational innovation [72]. In addition, absorptive capacity, knowledge integration, organizational culture, and knowledge sharing at the organizational level also have a positive impact on organizational innovation [73–76]. Transformational leadership articulates the significant vision and mission of the organization. It enhances the significance of employees' interest in the organization by stimulating their high-level needs for self-actualization, enabling employees to identify with and be motivated by intrinsic motivation to achieve their goals and assisting them in achieving organizational goals [77]. Transformational leadership also fosters dedication to long-term goals, mission, and vision by demonstrating high expectations and confidence in employees' abilities and providing intellectual stimulation that encourages employees to think creatively and adopt innovative work practices [78]. The resulting increase in employee motivation and self-esteem will boost organizational innovation [79]. Based on the initial assertion, we propose the following hypothesis:

**Hypothesis 2 (H2).** *Transformational leadership has a positive impact on organizational innovation.*

#### *2.3. Organizational Innovation and ESG Performance*

Hellström [80] formulated the theory of responsible innovation. In 2011, the European Commission published the report [81], in which the concept of "responsible innovation" was included for the first time as a vital element of the EU's development strategy. Meanwhile, the report "Addressing Ethical and Regulatory Challenges in Research Policy at the Global Level" outlined the fundamental elements of responsible innovation as social interest, moral and ethical acceptability, and risk management. According to the theory, responsible innovation requires innovative understanding and practice characterized by methodological features such as respect and preservation of human rights, the promotion of social well-being, and the full and active assumption of responsibilities [82]. To manage innovation practices in a way that seeks to improve innovations for society, it is also characterized by more elements being included in the responsibility system, greater consideration of human rights, and the pursuit of green and inclusive innovation outcomes [83]. Introducing this concept provides an operational path for businesses to realize sustainable development, which is a result of the deepening development of the global concept of "sustainable development" at present [84]. Therefore, businesses should consider the

interests of both direct and indirect stakeholders in the innovation process and the ethical, ecological, and social dimensions in addition to the economic dimension [85,86].

The impact of organizational innovation on the economic performance and innovation performance of businesses has been the subject of numerous studies. Most academics believe that the influence of organizational innovation on enterprises includes reducing management or transaction costs to improve the performance of enterprises; increasing labor productivity by improving workplace satisfaction; acquiring assets that cannot be traded directly, such as non-coding knowledge or reduced supply costs; and flattening the inter-organizational or intra-organizational structure, which means employees and stakeholders are promoted to carry out potential innovation activities [87,88]. However, research on organizational innovation and ESG performance is scant. Legitimacy theory views legitimacy as an overarching concept or presumption in which organizations seek to establish coherence between the social values associated with or implied by their activities and the norms of acceptable behavior in the more extensive social system to which they belong [89]. Companies should consciously comply with social norms and contracts, actively fulfill their environmental responsibilities, and act to promote environmental protection to protect their interests [90]. Therefore, to achieve sustainable long-term business development as an ultimate business goal, innovation with only economic benefits can no longer meet the needs of enterprise development, which now requires strength in both economic and environmental performance [91]. By incorporating green concepts into organizational innovation, businesses can increase the environmental consciousness of their employees, which can lead to environmentally responsible actions [92]. On the other hand, innovation based on production process improvement can help reduce pollution emissions, reduce production costs, and improve the performance of the company's products, thereby satisfying the environmental ethics requirements of stakeholders and enhancing competitive advantage [93].

Porter [94] formally introduced the theory of competitive advantage. The theory states that a firm's competitive advantage refers to its ability to outperform other competitors in the process of providing consumers with products or services of a specific value in an effective "contestable market" and to create market dominance or profitability that is higher than the average of the industry in which it is located for a certain period [95]. A firm has a competitive advantage when it implements a value-creation strategy that is not implemented by any current or potential competitor. Innovation, according to Zeng et al. [96], is an efficient method for organizations to acquire and transform resources and shape resource differentiation, which can result in scarce, unique, and irreplaceable core competencies. Innovation influences CSR in a great variety of ways, such as by increasing the productivity of businesses to improve their ability to fulfill economic responsibility, by increasing the size of businesses to improve their ability to fulfill product responsibility, and by increasing the size of businesses to improve their ability to fulfill philanthropic responsibility [97]. Product innovation can result in product quality enhancement and product structure optimization, which better fulfill product responsibility; the development of enterprises enables them to engage in social charity and enhance their capacity to feed society [98]. The innovation drive also encourages businesses to fulfill their social responsibilities more effectively, enhancing their reputation and fostering a favorable external environment for future development [99].

The traditional principal–agent theory argued that the separation of ownership and control of modern companies is a significant source of governance issues and that in the principal–agent relationship, the principal and the agent pursue different goals. Agents seek to improve their social standing, income, and other concerns. With the separation of the two powers, corporate managers have more power and are likely to sacrifice the interests of corporate owners for their interests, resulting in moral hazard in the principal–agent relationship [100]. However, theory-based stakeholder co-governance was proposed as people began to question the unidirectional governance model of shareholders [101]. This model holds that businesses operate in an open market environment and that all stakeholders, including employees, suppliers, creditors, and investors, participate in corporate governance. Through a network of mutual interaction and influence, stakeholders create value and share risk [102].

Studies have examined the impact of corporate governance on technological innovation, considering factors such as equity concentration, board size, the number of independent directors, and executive incentives [103–106]. However, organizational innovation also impacts corporate governance effectiveness to some extent. For businesses to maintain their competitive advantage and achieve significant market expansion, continuous innovation is required [94]. New management techniques can reduce transaction costs and protect shareholders' and other stakeholders' interests [107]. In addition, organizational innovation can better motivate employees, make them realize they are the company's owners, and increase their participation in the business's day-to-day operations [108]. Therefore, organizational innovation influences corporate governance positively. Based on the initial assertion, we propose the following hypothesis:

#### **Hypothesis 3 (H3).** *Organizational innovation has a positive impact on ESG performance.*

Based on the above theoretical development, this study argues that the impact of transformational leadership on ESG performance may vary depending on the role of organizational innovation mechanisms as mediators. Transformational leadership increases employees' intrinsic motivation and work motivation through their organizational commitment, thereby fostering organizational innovation and enhancing ESG performance. Based on the statement above, the mediating-role hypothesis is proposed.

**Hypothesis 4 (H4).** *Transformational leaders have a positive impact on ESG performance through organizational innovation.*
