New research by Vesa Pursiainen, Hanwen Sun and Yue Xiang finds that competition hurts corporate incentives to fulfill environmental, social, and governance (ESG) goals. Firms facing more competitive pressure have worse ESG scores, in particular when the firms have short-term-oriented shareholders. However, firms located in areas that are more concerned about climate change appear more willing to sacrifice profits for better ESG performance.
In the face of competitive pressure, is there a trade-off between a company’s financial performance and its commitment to environmental, social, and governance (ESG) activities? Is ESG a source of competitive advantage, or do managers simply use investors’ money on sustainability to make themselves look good and burnish their companies’ reputations? In a new paper, we seek to answer these questions by looking at the impact of exposure to domestic competition (the domestic product-market) and increased competition from foreign competitors on companies’ ESG scores.
Numerous academic studies suggest that ESG engagement and the associated reputational benefits for corporate responsibility can be a source of competitive advantage. This could be because customers, employees, or investors value ESG and are thus more likely to apply to, invest in, and buy from companies that promote ESG goals. There is also evidence that good ESG performance can enhance a firm’s access to capital markets. But better ESG performance also entails costs and hence represents a trade-off with other potential uses of funds. For example, a firm’s promise to lower its carbon footprint may require investment in cleaner but more expensive processes and supply chains. Competitive pressures may exacerbate these constraints, compelling firms to cut costs and prioritize the core needs of their operations.
This prompts the question: Do businesses operating in an especially competitive environment invest more in ESG to set themselves apart from their peers? Or does competitive pressure force management to focus on profits and cut back on sustainability?
ESG scores and domestic competition
In our study, we use ESG scores from Refinitiv Eikon, a financial data provider, as the main measure of ESG performance. To measure United States firms’ exposure to domestic product market competition, we use a product fluidity index, based on descriptions of firms’ products, to measure the similarity between their products and rivals’ products. A higher fluidity implies that a firm’s products are closer to its competitors’ products, leading to more competitive pressure. Our main finding is that firms under greater domestic competitive pressure have lower ESG scores. This finding is robust even after controlling for a large number of firm characteristics. The economic magnitude of the effect is not trivial. A one-standard-deviation increase in product fluidity is associated with a nearly 4% reduction in ESG score.
To get a more sophisticated sense of how heightened competition impacts ESG investment, we take a closer look at how the firms in our sample promote the individual components of ESG scores. We find that lower ESG scores amid competition apply to each element of ESG: environmental, social, and governance. We also look at specific activities contributing to these scores. Firms with higher product fluidity (more domestic competition) are most likely to cut back on activities that could be expected to incur substantial costs for the firm. These activities include environmental investment, environmental products, human rights initiatives, quality management systems, supplier ESG training, and external sustainability audits. Conversely, activities less negatively affected by competitive pressure tend to be those that likely require less investment.
If heightened competition curtails ESG investment due to constraints on capital allocation, we might expect this effect to be more pronounced among financially constrained firms. Our study supports this hypothesis. The negative relationship between competition among domestic competitors and corporate ESG performance is more pronounced among financially constrained firms and in more capital-intensive industries. Collectively, these findings suggest that firms face a trade-off between ESG and other investment needs.
Changes in ESG scores in response to foreign competition
To see how changes in foreign competitive pressure affect ESG, we study the economic shock of the surge in Chinese imports into the United States since China’s accession to the World Trade Organization in 2001. Our sample period, commencing in 2002, coincides with this influx, primarily attributed to supply-side dynamics in China. In line with our domestic competition results, we find that an increase in export competition from China is associated with weaker development in American firms’ ESG scores over time relative to other American firms that face less competition. This shows that our findings are not driven by different industries having different levels of competition.
When we segment the sample based on product fluidity, we see that increasing import competition reduces ESG scores more for firms that are less exposed to domestic competition. This suggests that firms facing less domestic competition may have more latitude to curtail their ESG investments in response to increasing foreign import competition.
How local attitudes to climate change influence firms ESG investments
Finally, we explore the role of county-level attitudes toward climate change in moderating the effect of competitive pressure. In general, more exposure to competition tends to reduce profitability. We find that in areas where climate action is considered more important, competitive pressure reduces ESG scores less but has a larger negative effect on profitability. This suggests both that there is a trade-off between profitability and ESG investment, and that firms’ and their stakeholders’ views on climate change affect the decisions they make regarding this trade-off.
While our findings point towards a trade-off between profitability and ESG, this trade-off might depend on the time horizon. It is possible that ESG investments are negative for short-term profits but create value in the long run. Indeed, we find that ESG investment in firms with longer-term shareholders is less affected by competitive pressure. We also find that the ESG investments of well-governed firms are more sensitive to competitive pressure.
In conclusion, it seems that increasing competitive pressure does not lead to increased investment in ESG but instead appears to curb ESG activities. Hence, while competition undoubtedly fosters positive outcomes such as lower prices and enhanced quality, it may also bear potentially negative societal consequences by diminishing firms’ commitment to sustainability. This also suggests challenges for policymakers attempting to balance antitrust concerns with calls for more sustainable businesses.
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