Corporate social responsibility and/or excess returns? Determining the optimal trade-off between ESG and financial performance

Abstract

This paper aims to investigate how the non-linear relationship between environmental, social and governance (ESG) scores relate to operational (ROA) and overall (market capitalisation) firm health and how those scores influence the systemic risk of assets. The study covers 3,284 firms from 2018 until 2022 in Western and Northern Europe, Canada and North America across a multitude of industries. First-differenced panel regression analysis and factor models were used to evaluate the hypotheses of the study. The results show strong evidence in favour of a U-shaped relationship between ESG scores and firm performance and value. ESG initially negatively affects a firm’s performance measures. However, the marginal long-run effect of ESG scores is positively associated with firm efficiency. Further, environmental scores have an immediate positive effect on the ROA in industries that are more competitive than average. Lastly, I conclude that high ESG score portfolios are less systemically risky and tend to produce higher excess returns compared to low ESG score portfolios. This study sheds light on the complex relation between ESG scores and firm performance by examining the non-linear relationship between the two.