Adopting the institutional perspective as its theoretical underpinning, this study seeks to unearth the antecedents of the mixed results in the extant literature on the association between environmentally responsible investment (ERI) and firm profitability. The study sample comprises an unbalanced sample of 2290 firm-year observations of China’s A-share listed firms for the period 2010–2019. The findings indicate that ERI enhances firms’ profitability, and the positive association is reinforced by the promulgation of environmental protection law. Regional development also augments ERI’s positive effect on firms’ profitability. Nevertheless, no significant association is observed between firms’ profitability and ERI within firms operating in environmentally sensitive sectors. Our findings imply that in addition to regulatory forces, normative and cognitive pressures are also important factors that governments may employ to motivate firms to become environmentally friendly and embrace sustainable practices. Theoretically, we content that these factors serve as a link between institutional growth and corporate environmental management practices.
Research Article
Does Environmentally Responsible Investment Enhance Firm Profitability? An Institutional Perspective
https://doi.org/10.21203/rs.3.rs-1499301/v1
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Since the signing of the Kyoto Protocol in 2005, governments worldwide have recognized the value of enterprises aimed at reducing carbon emissions and improving environmental performance (Shen et al., 2020). It is now evident that businesses are responsible for a considerable proportion of the pollution in the environment. In China, businesses’ manufacturing and operational activities are responsible for around 80% of the total environmental pollution (Shen et al., 2012). From the perspective of institutional development, the Chinese government has issued several regulations with the aim of enhancing ecological environment (Wang et al., 2020). China’s Environmental Protection Law holds that firms should assume responsibility for preventing and controlling environmental pollution because they are the primary users of resources and major contributors to environmental pollution. In practice, it urges businesses to participate in environmental protection efforts and to invest in projects that serve as a micro-foundation for long-term sustainable growth (Xu & Yan, 2020). However, firms that engage in environmental protection initiatives may face greater operating costs and lower profitability. Thus, the goal is for corporations to develop environmental strategies that minimize environmental pollution while allowing economic performance to improve (Lee et al., 2015).
A growing body of research concerning the economic benefits of corporate environmental investment has emerged. However, the extant literature does not provide a clear direction or type (negative, positive, etc.) of association between environmental protection investment and firm performance. For example, some studies observed a positive correlation between environmentally responsible investment (ERI) and financial performance (Nakamura, 2011; Singal, 2014), while others claimed a negative or non-significant relationship (de Souza Cunha & Samanez, 2013; Lee et al., 2015; Su, 2019; Zhang & Shuang, 2021). Several studies have demonstrated a non-linear association between them (Pekovic et al., 2018). These contradictory results can be explained by these studies’ lack of any theoretical underpinning to explain the relationship, methodological issues, and contextual factors (e.g., regulatory environment under which firms operate) (Wong et al., 2018). In terms of contextual factors, governmental actions have the potential to enhance or impede overall sustainable economic growth. The regulations that governments introduce have a major impact on firms’ behavior with respect to environmental responsibility, particularly when it comes to investing in environmental initiatives (Huang & Lei, 2021). In this scenario, it remains unclear how firms deal with the institutional pressures they experience and how they maintain environmental legitimacy while sustaining profitability.
To fill the above research gap, the current study is designed to understand the impact of the institutional environment on the association between ERI and firm profitability. For empirical analysis, we have used updated environmental investment data pertaining to Chinese listed companies for the period 2010 – 2019 (Fig. 1). The findings of the study reveal that ERI enhances firms’ profits. In addition, after the promulgation of the environmental protection law, the above relationship becomes stronger. Likewise, regional development also augments ERI’s positive effect on firm profitability. However, firms that belong to environmentally sensitive sectors exhibit no positive association between firms’ profitability and ERI.
This study contributes to the extant literature in several ways. First, we add to the debate concerning the economic benefits of investing in corporate environmental management practices (Stevanović et al., 2019; Wong et al., 2018)—specifically investment in environmental protection initiatives (Lundgren & Zhou, 2017; Nakamura, 2011; Shabbir & Wisdom, 2020; Su, 2019). Our research provides evidence for ERI’s positive influence on Chinese firms’ profitability. Second, our study identifies environmental policy, regional development, and environmental industry affiliation as institutional factors that impact the relationship between ERI and firm profitability. It functions as a link between institutional growth and corporate environmental management. Third, the present study employs the novel longitudinal environmental investment dataset (for the period 2010–2019) pertaining to Chinese companies obtained from China’s largest database. In comparison to earlier investigations conducted in similar contexts (Yufeng Chen & Ma, 2021; Yutao Chen & Feng, 2019; Su, 2019), the availability of updated longitudinal data allows us to capture the cross-sectional industry effects in our analysis. Finally, this study contributes to institutional theory by arguing that in addition to regulatory forces, normative and cognitive pressures are also key factors that governments may employ to motivate firms to become environmentally friendly and embrace sustainable practices.
The rest of the paper is structured as follows. The section that follows explains the research’s theoretical foundations, reviews relevant literature, and generates hypotheses. Section 3 describes the research methodology; Section 4 analyzes the empirical findings; and Section 5 concludes the study with a discussion of the significant results and presents the findings’ implications and future research prospects.
2.1 Theoretical Perspective
Dimaggio and Powell's (2013) influential study on the convergence of firms’ behavior due to different institutional pressures in various organizational fields is widely cited in the extant literature on firm behavior and business strategy. Institutional theory concerns stakeholders’ attitudes and expectations toward a firm’s environmental performance under different internal and external contingency factors (Yang et al., 2018). Therefore, we adopted an institutional perspective to evaluate the relationship between ERIs and firms’ financial performance. Although institutional theory first emerged under the auspices of political science and sociology (Scott, 2001), it also has viable implications for management sciences. This theory suggests that the coercive, normative, and mimetic pressures from different formal and informal institutions shape and constrain the strategies and decisions that firms adopt out of concerns for legitimacy (Grewal & Dharwadkar, 2002; Matten & Moon, 2008).
Suchman (1995) opined that a firm’s legitimate actions are those that are deemed suitable within the beliefs, norms, and values of a socially constructed system. In tandem with this, Chiu and Sharfman (2011) suggest that a firm’s environmentally and socially responsible behavior stems from its legitimacy-seeking drive under various external pressures elicited by stakeholders and society. Through these actions, firms disseminate signals that they are proactively engaged in environmentally responsible activities in an attempt to garner legitimacy (Frondel et al., 2008).
Under institutional theory, coercive pressures are enticed by regulatory forces, such as policies, laws, and rules formulated by the authorized entities. In a recent study, Naveed et al. (2021) reported these pressures as the key drivers of environmental management practices in the extant literature. These tools use enabling incentives or impeding sanctions to channel firms’ actions toward the desired behavior. Therefore, firms are inherently motivated to comply with the laws and policies devised by the authorities (Qian et al., 2010), not only as a means of garnering legitimacy but also to avoid penalties and to establish a relationship with them (Huang & Sternquist, 2007).
The normative pressures under institutional theory are enticed by cognitive forces, such as communal values and social norms. These forces also reportedly entice environmentally responsible behavior from the perspective of a legitimacy urge on the firm’s part. The external environment reportedly entices differential legitimacy drives in different regions based on the mix of cognitive forces and enabling/impeding conditions (Marquis et al., 2007). As gross domestic product (GDP) is an indicator of business conditions, it can predict the extent to which the environment is conducive to a firm’s functioning. Its difference entices different levels of normative pressures elicited from the cognitive forces of the general business environment, while potentially guiding the firm’s behavior in terms of environmental responsibility (Campbell, 2007; Kolk & Levy, 2001; Matten & Moon, 2008).
Mimetic pressures under institutional theory are enticed by the professional norms and internalized normal of appropriate action in an organizational field (Fini & Toschi, 2016). Industry setting is one such organizational field that can be attributed to the differentiated adoption of environmentally responsible behavior (Jackson & Apostolakou, 2010). This convergence is reported to be more pronounced in uncertain business environments, in which an inherent drive to imitate leading firms for the purpose of legitimacy-seeking is at play (Cormier et al., 2005). Clarkson et al. (2008) proposed preferential adoption of environmentally responsible behavior by different entities on the basis of legitimacy urge from stakeholders shaped by the environmental impact of the firm. In view of the above discussion, institutional theory, complemented by the legitimacy view, constitutes this study’s theoretical underpinning.
2.2 Environmentally Responsible Investment and Firm Profitability
Despite four decades of research on the financial performance of environmentally responsible corporate practices, no single theoretical perspective can explain inconsistent results (for a review, see Stevanović et al., 2019). Studies that propose a negative relationship between environmental and financial performance (Hatakeda et al., 2012; Wagner, 2010) are backed by the traditional perspective. That is, to respond to environmental issues, businesses must incur additional expenses and financial constraints, thus reducing productivity and firm value (Lundgren & Zhou, 2017). However, supporters of the positive financial outcomes of corporate environmental activities (Clarkson et al., 2011; Li et al., 2017; Wong et al., 2018) believe that firms may increase their profitability by being first to implement environmental policies that may enhance corporate competitiveness (Porter & Van Der Linde, 1995). Some even claim a non-linear relationship between corporate environmental performance and financial outcomes (Boakye et al., 2021; Zhang et al., 2020).
These contradictory findings can be explained by the differences in study contexts (Molina-Azorín et al., 2009), the sizes of the firms under observation (Boakye et al., 2021), the empirical methodologies used for analysis (Horváthová, 2010), the extent of environmental performance (Trumpp & Guenther, 2017), and the direction of association and time horizons (Hang et al., 2019). Lee et al. (2015) assert that an in-depth conceptual characterization of corporate environmental performance is required. Environmental performance is not a unidimensional construct but includes various aspects that are expected to behave differently in different contexts, with diverse financial implications. Thus, it prompts the study of different aspects of corporate environmental performance in both theoretical and quantitative research (Hang et al., 2019).
Given that a growing body of literature has investigated the impacts of corporate environmental investments, a key research question addressed was whether it pays to invest in environmental initiatives. First, a strand of studies found that ERI has a positive influence on firm profitability (Shabbir & Wisdom, 2020; Singal, 2014; Su, 2019; Zhang & Shuang, 2021). Nakamura (2011) used a longitudinal dataset of small and medium-sized Japanese corporations to investigate the impact of environment-related investments on firm performance. The findings determine positive financial performance for environmental protection efforts in the long run. The results suggest that a time lag exists between environmental investment and financial outcomes. However, several researchers have claimed that investment in environmental initiatives does not pay off (de Souza Cunha & Samanez, 2013; Lee et al., 2015; Sueyoshi & Goto, 2009). In contrast to both of the above strands, Pekovic et al. (2018) observed a non-linear relationship between ERI and corporate economic performance, arguing that profit generation from investment in green projects tends to fall as the point of optimization, which surpasses expectation, is reached quickly. The firm must then identify the type of environmental investment with regard to various stakeholders, as generating profits has become complex due to increased environmental costs. At this point, the right magnitude of environmental investment will determine the decline or improvement of corporate profits. The presence of inconsistent findings suggests that no universal route exists that allows firms to sustain profitability while investing in environmental protection projects. Thus, firms should identify and develop environmental strategies in alignment with the stakeholders’ demands.
Many global corporations are embracing various environmental strategies in response to global calls to mitigate the impact of climate change on society (Reid & Toffel, 2009; Todaro et al., 2021). Multiple factors determine the adoption of environmental strategies, such as volume of business, industry affiliation, and the firm’s environmental proactivity (Lee, 2012; Radu et al., 2020; Weinhofer & Hoffmann, 2010). However, the financial implications of sustainable environmental strategies remain the subject of debate (see, for example, Damert et al., 2017; Lee, 2012). Proactive companies have invested in different sustainable environmental initiatives. In particular, Orsato (2006) contends that environmental investment is a strategic decision: managers must proactively identify and invest in projects that benefit society while optimizing company financial returns in the long run. Orsato (2006) further theorizes that companies should make sustainable investments based on their strategic skillsets. For example, for some businesses, effective resource usage may pay off as an environmental investment, but for others, the acquisition of environmental certifications and the development of eco-friendly products may be a source of increasing competitive advantage. Based on the above arguments and discussion, we hypothesize the following:
H1
Environmentally responsible investment is positively associated with firm profitability.
2.3 Role of Institutional Factors
Institutional factors have a significant impact on the operations of corporations in China, which is characteristic of emerging and transition economies. Therefore, we investigated the moderating role of environmental policy, regional development, and industry membership in the relationship between environmental investment and firm profitability.
2.3.1 Environmental Policy
To address climate change, the Chinese government has implemented several environmental regulations. In 1998, Green Watch developed a program for environmental disclosure and performance evaluation in partnership with China’s State Environmental Protection Administration (SEPA) (Situ & Tilt, 2018). Subsequently, in 2003, SEPA created a strategic plan aimed at encouraging voluntary disclosure of social and environmental reports and issued various guidelines to this effect at the end of 2006. In addition, Measures for Disclosure of Environmental Information (MDEI) were introduced to unleash the importance of voluntary disclosure as a modern tool for environmental governance. Regarding the role of stock exchanges as institutional influencers, the Shanghai Stock Exchange (SSE) published standards on the reporting of environmental information for listed firms in 2008. These standards require that companies in polluting sectors (as defined by the MDEI) disclose nine disclosure elements under the SSE. In a similar vein, the SSE produced a draft of environmental disclosure, requiring firms to disclose environmental reports in 2010 (Li et al., 2018). The watershed moment occurred in 2014 when China passed its Environmental Protection Law (enacted in 2015). The implementation of this law requires companies to fulfill their environmental responsibilities. Since this law was enacted, companies’ environmental performances are no longer private information. This new legislation is regarded as the strictest environmental administrative regulation. It bolstered corporate accountability for pollution control and enhanced the severity of legal penalties for environmental breaches (L. Huang & Lei, 2021).
The theoretical literature on the effect of environmental policy has been a forum of debate since the introduction of the Porter hypothesis. The Porter hypothesis states that appropriately strict environmental legislation may bring about dynamic innovation, improve efficiency, and eventually increase productivity (Porter & Van Der Linde, 1995). However, empirical studies on the relationship between environmental regulations and green investment were conducted at the provincial (Hu & Wang, 2020; Ren et al., 2020) and industrial levels (Jingyan & Lisha, 2010; Leiter et al., 2011). Few studies have investigated the micro-firm-level effect of corporate environmental regulations on green investment. You et al. (2019) used a sample of Chinese manufacturing companies and found that environmental regulations positively influenced the extent of corporate eco-investment. Their findings indicate that domestic administration, one of the key stakeholders, has exerted significant pressure and restrictions on company economic performance and encouraged businesses to undertake environmentally friendly investments in a bid to meet regulatory compliance. Jin-Fang et al. (2020) found that environmental policy positively moderates the relationship between corporate innovation and environmental investment. However, Huang and Lei (2021) observe an inverted U-shaped relationship between environmental regulations and green investment in China. Their research provides support for the Chinese government’s encouragement for green improvements and the role of environmental policies.
However, a trade-off exists between the cost of environmental investment and the cost of non-compliance in the context of mandatory regulations. This trade-off includes fewer intensive regulations, enabling firms to easily meet the cost of compliance and induce high investment in green technologies. However, when the intensity of regulations is high, the cost of compliance also increases, and firms can only respond passively because it is difficult for them to satisfy the requirements. Consequently, to reap their economic benefits, firms prefer to pay the cost of non-compliance penalties (L. Huang & Lei, 2021).
Although the enforcement of mandatory environmental regulations requires firms to comply with policies concerning emissions reduction and other environmental indicators (L. Huang & Lei, 2021), a firm can develop its environmental capabilities to deal with such regulatory changes. These capabilities are dependent on the institutional environment in which the firm operates (Madsen, 2009). The firm’s capabilities do not remain the same, as it often introduces new and eco-friendly production processes while investing more in green technologies. It not only allows firms to align their operations with mandatory regulations but also improves their corporate reputations, which in return enhances profitability (Gangi et al., 2020). Based on the above discussion, we hypothesize the following:
H2a
The enactment of the Environmental Protection Law of China (2015) significantly impacts the positive association between environmentally responsible investment and firm profitability.
2.3.2 Regional Development
The regional context is determined by the socio-economic structure of the country in question, such as whether the government is centralized or decentralized government, as well as by the civil ethos and the progress of well-being institutes (Albareda et al., 2007). Local institutions often promote an environment that enhances regional competitiveness. Regions can foster competitiveness through several measures, one of which is the creation of policies pertaining to corporate social and environmental responsibility. The creation of regional policies for social and environmental activities will assist companies in carrying out their social responsibility plans and improving their competitiveness, which will ultimately contribute to the region’s competitiveness (Apospori, 2018). Moreover, the appropriateness and efficiency of the local authorities’ social and environmental policies will differ according to regional context.
Based on the institutional theoretical framework (Dimaggio, 1983), Marquis et al. (2007) emphasized the relevance of legitimacy in various regions as a source of institutional pressure, which substantiates the profitability gaps in corporate environmental protection initiatives. In China’s case, the importance of social and environmental issues varies among various regions, leading to different institutional contexts in which the environmental policies must be implemented. Wong et al. (2018) noted that corporate environmental protection practices would differ across different Chinese provincial regions. They argued that firms generate more financial returns from environmental protection practices in regions where their policies are aligned with the domestic institutional environment. It is not only helpful for firms to establish a good relationship with local institutions but also to allow them to acquire resources or other benefits that will generate positive financial returns. Similarly, Gao et al. (2019) also indicated that companies are likelier to have lower earnings if they do not link their social responsibility initiatives with the degree of regional development. They contend that stakeholders in industrialized regions have higher expectations of corporate social responsibility. Consequently, companies in developed regions must devise distinct strategies to meet stakeholders’ demands.
Nevertheless, governments design environmental regulations to incentivize and assist businesses in executing eco-friendly projects, as the execution of such policies is deemed crucial. As in east China, ecologically friendly policies are strictly monitored by the regional government under a penalty and reward system (Wong et al., 2018). For instance, governments may give preferred tax policies and priority treatment, or they may use local infrastructure as an incentive to encourage firms to participate in environmental protection projects (H. Wang et al., 2008). The institutional theory holds that an conducive atmosphere for compliance promotes a method of oversight that aids businesses in adhering to environmental standards (Campbell, 2007). Under such a regulatory environment, firms are encouraged to become eco-innovative for competitive advantage (Porter & Van Der Linde, 1995). This entitles companies not only to maintain rapport with public authorities for legitimacy-seeking but also to invest in eco-friendly products and processes to gain profits, which ultimately improve environmental quality. By contrast, in a regulatory environment in which corporate pro-environmental efforts are not encouraged and in which the rewards system is lax or non-existent, firms acquire legitimacy by merely fulfilling their environmental responsibilities.
Given China’s regional sustainability, a substantial regional environmental performance disparity exists (Yu & Choi, 2015). Based on the discussion above, we conclude that regional development in China effectively shapes the institutional settings of different regions whereby businesses are often subject to different regulatory environments, and environmental preservation measures cannot always reap financial advantages. We also anticipate that firms from developed regions will generate greater profits from ERI than firms from underdeveloped regions. Therefore, we hypothesize the following:
H2b
Regional development significantly impacts the positive association between environmentally responsible investment and firm profitability.
2.3.3 Environmental Industry
Industry setting is an important organizational field that influences the extent to which firms will engage in environmentally responsible behavior. This is because stakeholders and the public have varying expectations regarding environmental investments from firms associated with different industries. In this regard, Bansal and Roth (2000) reported a strong positive relationship between the characteristics of industry setting and variant expectations of stakeholders relating to environmentally responsible behavior. Studies focused on this dimension operationalize the phenomenon through the bifurcation of industries among more and less polluting or environment-impacting industries. As firms with greater polluting potential and environmental impact have higher environmental sensitivity, they are overtly expected to have greater social and environmental responsibility (Reverte, 2009). The logic behind the stated proposition is derived from legitimacy theory, whereby environmentally sensitive industries are deemed liable for endangering environmental health, leaving them vulnerable to the extra pressure to obtain social and environmental accreditation to operate. The existing literature reports that firms from industries with greater environmental impact, such as oil and gas, mining, and chemical sectors are more liable for socially and environmentally responsible behavior (Jenkins & Yakovleva, 2006; Ness & Mirza, 1991). Given the above discussion, we hypothesize the following:
H2c
Environmental industry affiliation significantly impacts the positive association between environmentally responsible investment and firm profitability.
3.1 Data
The study sample comprises China’s A-share listed firms for the period 2010–2019. The data pertaining to all variables of the study have been sourced from the China Stock Market and Accounting Research (CSMAR) database. The longitudinal data on environmental investment were recently updated in CSMAR. This database includes various sets of data relating to financial and non-financial variables. Other researchers have also used CSMAR as a primary source of data for their investigations (Li et al., 2020; Su, 2019). To obtain the final sample for the research, we merged data pertaining to different variables and excluded missing values. Finally, we obtained an unbalanced sample of 2290 firm-year observations for our empirical analysis.
3.2 Variables
3.2.1 Firm Profitability
The dependent variable of the study was determined to capture the firm’s internal financial performance on the balance sheet. It is measured as the ratio of a firm’s annual return to its total assets (K.-H. Lee et al., 2015).
3.2.2 Environmentally Responsible Investment
Following Zeng et al. (2020), we measured this variable as the ratio of a firm’s environmental investment to its total assets at the end of each year. It conceptualizes a firm’s tendency to invest in environmental protection initiatives. However, in operational terms, the scale of environmental investment represents firms’ level of commitment to reducing the impact of environmental degradation.
3.2.3 Environmental Policy
China introduced its Environmental Protection Law at the end of 2014 and it came into effect in 2015. It is among the most stringent environmental policies that were regulated to reduce the negative impact of business and industrial operations on the external environment. This law requires listed firms to publicly disclose their environmental protection activities, including their green performance. In short, it has strengthened corporate responsibility for controlling pollution and has improved the severity of legal consequences for environmental violations. Hence, to understand the impact of stringent environmental policy on firms’ environmental investment and profitability, we measured environmental policy as a dummy variable. It is represented as the value ‘1’ if the year of observation is equal to or greater than 2015 and ‘0’ otherwise (L. Huang & Lei, 2021).
3.2.4 Regional Development
Following earlier studies (Gao et al., 2019; Wei et al., 2017), we used provincial GDP per capita to assess the level of development in each region of China. To operationalize the variable, we created a dummy for regional development by using the median value among the averages. It is denoted as ‘1’ if the GDP amount of the region is greater than the median GDP and ‘0’ otherwise. Thus, we divided regions into the two categories of ‘high’ and ‘low’ levels of development. This bifurcation supports our investigation of the differential impact of high- and low-development regions in the association between firm ERI and financial profitability.
3.2.5 Environmental Industry
To identify distinct industrial classifications in China, we used a two-digit CSRC (China Securities and Regulatory Commission, 2012) industry code. We construct a dummy variable equal to ‘1’ based on the purpose of the examination—that is, whether a company falls within the category of environmentally sensitive industries (metallic, nonmetallic, energy, other manufacturing, etc.)—and ‘0’ otherwise.
3.2.6 Control Variables
We employed firm characteristics and corporate governance factors as control variables in the study, following previous studies (K.-H. Lee et al., 2015; Nakamura, 2011; Pekovic et al., 2018; Sueyoshi & Goto, 2009; J. Zhang & Shuang, 2021). First, to control for the influence of business environmental action on profitability—return on assets (ROA)—we controlled for environmental performance (ENVP). In terms of other firm variables, we controlled for firm size (SIZE), age (AGE), leverage (LEVG), and fixed asset (FAR). SIZE and LEVG enable businesses to acquire more resources and put them to use to generate more profits. Furthermore, AGE enables firms to run their operations with a defined strategy and plan, allowing them to improve their financial performance. FAR, on the other hand, calculates company growth based on the effective utilization of noncurrent assets. In general, the greater the FAR, the larger the firm’s sales and hence the higher the profits.
In terms of the corporate governance framework, research suggests that board size (BSIZE) and institutional ownership (INSHR) have a positive impact on ROA, but board independence (BIND) and company performance have a mixed relationship (Merendino & Melville, 2019; Rashid, 2018; Rashid, 2020). Thus, we used BSIZE, BIND, and INSHR as controls for the effect of corporate governance on ROA. Finally, we included industry and year dummies to account for cross-sectional variations across various industrial sectors over time.
3.3 Research Model
We used the least squares dummy variable panel regression technique to empirically evaluate the impact of ERI on firm profitability (ROA) while adjusting for industry- and year-fixed effects. To control the effect of extreme values, we winsorized all continuous variables at 1%. The base model is as follows:
In the above research model, profitability is the dependent variable and ERI is the main independent variable, while all others are control variables (see Table 1 for variable definitions). Further, to examine the effect of environmental policy (POLICY), regional development (RGDP_D), and environmental industry affiliation (INDENV) on the association between ERI and ROA, we ran regression models similar to that of model (1). Three different sets of sub-samples were created to estimate the cross-sectional variations in terms of POLICY, RGDP_D, and INDENV.
|
Variable |
Symbol |
Operational Definitions |
|---|---|---|
|
Firm Profitability |
ROA |
It is measured as the rate of retunr on total assets. |
|
Environmentally Responsible Investment |
ERI |
It is calculated as the ratio of value of firm environmental investment to total assets at the end of each year. |
|
Environmental Policy |
POLICY |
It is a dummy variable representing value '1' if year is equal to or greater than 2015 (year when environmental policy was implemented) and '0' otherwise. |
|
Regional Development |
RGDP |
It is measured as the natural logarithm of the provincial GDP per capita. |
|
Environmental Industry |
INDENV |
A dummy variable denoted as '1' if firm belongs to environmentally sensitive industrial sector and '0' otherwise. |
|
Environmental Performance |
ENVP |
It is measured using HEXUN-environmental ratings for Chinese companies ranges from '0' to '100' . |
|
Firm Size |
SIZE |
It is measured as the natural logarithm of total assets of the firm at year end. |
|
Firm Age |
AGE |
It is calculated as the difference between the current year and firm's IPO (Initial Public Offerings) date. |
|
Firm Leverage |
LEVG |
It is measured as the ratio of total liabilities to total shareholders equity. |
|
Fixed Asset |
FAR |
It is the calculated by dividing firm's total sales to net fixed assets. |
|
Board Size |
BSIZE |
It is the logarithmic value of number of directors presented on board. |
|
Board Independence |
BIND |
It is measured as the ratio of number of independent directors to total directors presented on corporate board. |
|
Institutional Ownership |
INSHR |
It is measured as the number of institutional investors shares to total shares of the firm. |
4.1 Descriptive Results
Table 2 presents the descriptive statistics of the explanatory and dependent variables of the study. For our sample firms, the profitability (ROA) ratio is 4.3% on average, with a maximum of 19.5%. It is because the composition of the sample is based on larger, medium, and small-sized firms (SIZE). The mean environmental investment ratio (ERI) shows that each firm invests 0.5%, with significant variations in the rate of investment. Similarly, there exists a sizable gap between firms with respect to their ENVP. These differences prevail in emerging market firms, whereby each firm must deal with external pressures based on its available resources. Moreover, the sample includes a mixture of young and old firms (AGE) with reasonable financial leverage (LEVG).
| Variable | N | Mean | Std. Dev. | Min | Max |
|---|---|---|---|---|---|
| ROA | 2,290 | 0.043 | 0.052 | 0.147 | 0.195 |
| ROE | 2,202 | 0.080 | 0.106 | 0.317 | 0.447 |
| ERI | 2,290 | 0.005 | 0.006 | 0.000 | 0.017 |
| ENVP | 2,290 | 24.720 | 29.096 | 0.000 | 90.000 |
| POLICY | 2,290 | 0.493 | 0.500 | 0.000 | 1.000 |
| RGDP | 2,290 | 11.052 | 0.472 | 9.482 | 12.009 |
| INDENV | 2,290 | 0.409 | 0.492 | 0.000 | 1.000 |
| SIZE | 2,290 | 23.237 | 1.428 | 20.451 | 26.048 |
| AGE | 2,290 | 12.229 | 6.639 | 0.000 | 25.000 |
| LEVG | 2,290 | 1.292 | 1.129 | 0.084 | 5.912 |
| FAR | 2,290 | 0.286 | 0.172 | 0.012 | 0.706 |
| BSIZE | 2,290 | 2.202 | 0.204 | 1.609 | 2.708 |
| BIND | 2,290 | 0.376 | 0.059 | 0.333 | 0.571 |
| INSHR | 2,290 | 56.743 | 22.432 | 1.780 | 91.685 |
| Note: For variables definitions see Table 1. | |||||
| Variables | (1) | (2) | (3) | (4) | (5) | (6) | (7) | (8) | (9) | (10) | (11) | (12) | (13) | (14) |
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| (1) ROA | 1 | |||||||||||||
| (2) ROE | 0.760* | 1 | ||||||||||||
| (3) ERI | 0.061* | 0.016 | 1 | |||||||||||
| (4) POLICY | 0.028 | -0.014 | 0.085* | 1 | ||||||||||
| (5) RGDP | 0.031 | 0.044 | -0.024 | 0.351* | 1 | |||||||||
| (6) INDENV | -0.031 | -0.03 | 0.05 | -0.028 | -0.094* | 1 | ||||||||
| (7) ENVP | 0.041 | 0.080* | -0.098* | -0.442* | -0.295* | 0.064* | 1 | |||||||
| (8) SIZE | 0.069* | 0.062* | -0.113* | -0.049 | 0.086* | 0.139* | 0.019 | 1 | ||||||
| (9) AGE | -0.165* | -0.088* | -0.03 | 0.119* | -0.002 | 0.153* | -0.125* | 0.243* | 1 | |||||
| (10) LEVG | -0.437* | -0.263* | -0.088* | -0.141* | -0.079* | 0.005 | 0.052 | 0.473* | 0.160* | 1 | ||||
| (11) FAR | 0.152* | -0.173* | 0.239* | -0.056* | -0.144* | 0.128* | 0.038 | 0.087* | 0.059* | 0.049 | 1 | |||
| (12) BSIZE | 0.011 | 0.034 | 0.01 | -0.161* | -0.154* | 0.101* | 0.109* | 0.210* | 0.087* | 0.100* | 0.128* | 1 | ||
| (13) BIND | -0.011 | 0.034 | -0.065* | 0.005 | 0.081* | -0.088* | -0.023 | 0.131* | -0.034 | 0.061* | -0.099* | -0.417* | 1 | |
| (14) INSHR | 0.068* | 0.100* | -0.090* | -0.198* | -0.02 | 0.074* | 0.086* | 0.494* | 0.121* | 0.184* | 0.095* | 0.165* | 0.070* | 1 |
| *** p < 0.01, ** p < 0.05, * p < 0.1 | ||||||||||||||
Table 3 reports the results of pairwise correlation between the independent and dependent variables. As anticipated, ERI and ENVP showed a positive correlation with ROA. However, we found no significant correlation between explanatory variables.
4.2 Main Results
Table 4 presents the results of the baseline model (1) and other models. Models (2) to (7) show the regression results of the effect of the environmental policy, regional development, and environmentally sensitive industry. The baseline results in model (1) report that ERI is positively associated with ROA in China \((\beta =0.4936, p<0.01)\). This indicates that investment in environmental protection initiatives generates positive financial returns for Chinese companies. These results are consistent with earlier studies (Nakamura, 2011; Singal, 2014; Su, 2019) but contradict the findings of Shabbir and Wisdom (2020) and Lee et al. (2015).
To investigate the impact of China’s Environmental Protection Law (2015) on the association between ERI and ROA, we ran the baseline regression in models (2) and (3) based on sub-samples that identified the period before and after the law was implemented. The results demonstrate that the Environmental Protection Law (2015) has had a significant positive influence on baseline results \((\beta =0.8819, p<0.01)\). This suggests that environmental laws in China are not sufficiently strict to impede corporate profits while safeguarding the external environment. To examine the differential impact of the level of regional development in China, we ran a similar regression in models (4) and (5). The results suggest that regional development has a significant positive impact on the ERI–ROA relationship \((\beta =0.8791, p<0.01)\), in line with the findings of Wong et al. (2018) and Gao et al. (2019). Regarding the effect of a firm’s affiliation with environmentally sensitive sectors, we do not find any significant impact. These findings suggest that environmentally sensitive industries are under tremendous regulatory pressure, and businesses must fulfil their environmental responsibilities to achieve credibility for the sake of legitimacy.
Table 4 also presents the results of the control variables. ENVP shows a positive relationship with ROA, representing corporate environmental efforts that generate profits for Chinese corporations. Among the firm characteristics, FAR shows a positive relationship with ROA, while SIZE, AGE, and LEVG are negatively associated with firm profitability. In addition, corporate governance variables are not positively related to corporate financial performance, except INSHR.
| Variables | ROA | ROA | ROA | ROA |
|---|---|---|---|---|
| (1) | (2) | (3) | (4) | |
| ERI | 0.4902*** | 0.0902 | 8.6789** | 0.8884*** |
| (0.1699) | (0.2266) | (3.3977) | (0.2062) | |
| POLICY | 0.0239*** | |||
| (0.0058) | ||||
| ERI*POLICY | 1.1222*** | |||
| (0.3122) | ||||
| RGDP | 0.0062** | |||
| (0.0027) | ||||
| ERI*RGDP | 0.8294*** | |||
| (0.3065) | ||||
| INDENV | -0.0012 | |||
| (0.0025) | ||||
| ERI*INDENV | -0.4996 | |||
| (0.3193) | ||||
| ENVP | 0.0001*** | 0.0001*** | 0.0001*** | 0.0001** |
| 0.0000 | 0.0000 | 0.0000 | 0.0000 | |
| SIZE | 0.0095*** | 0.0096*** | 0.0095*** | 0.0068*** |
| (0.0010) | (0.0010) | (0.0010) | (0.0009) | |
| AGE | -0.0009*** | -0.0009*** | -0.0009*** | -0.0008*** |
| (0.0002) | (0.0002) | (0.0002) | (0.0001) | |
| LEVG | -0.0232*** | -0.0232*** | -0.0231*** | -0.0233*** |
| -0.0012 | -0.0012 | -0.0012 | -0.0011 | |
| FAR | 0.0563*** | 0.0569*** | 0.0552*** | 0.0513*** |
| (0.0070) | (0.0070) | (0.0070) | (0.0059) | |
| BSIZE | 0.0074 | 0.0077 | 0.0068 | 0.0030 |
| (0.0052) | (0.0052) | (0.0052) | (0.0053) | |
| BIND | -0.0427** | -0.0437*** | -0.0411** | -0.0272 |
| (0.0168) | (0.0167) | (0.0167) | (0.0169) | |
| INSHR | 0.0002*** | 0.0002*** | 0.0002*** | 0.0002*** |
| 0.0000 | 0.0000 | 0.0000 | 0.0000 | |
| Constant | -0.0737** | -0.0761** | -0.0300 | -0.0266 |
| (0.0370) | (0.0369) | (0.0400) | (0.0324) | |
| Industry FE | Yes | Yes | Yes | No |
| Year FE | Yes | Yes | Yes | Yes |
| Observations | 2,290 | 2,290 | 2,290 | 2,290 |
| R-squared | 0.3347 | 0.3386 | 0.3366 | 0.2919 |
| Robust standard errors in parentheses *** p < 0.01, ** p < 0.05, * p < 0.1 | ||||
4.3 Robustness
To ensure the sensitivity of our findings, we used a second proxy of firm profitability (which is measured as return on equity (ROE)). We also reran all regressions on the baseline model and models of sub-samples.
| Variables | ROE | ROE | ROE | ROE |
|---|---|---|---|---|
| (1) | (2) | (3) | (4) | |
| ERI | 1.0487*** | 0.1196 | 15.8724** | 1.7846*** |
| (0.3667) | (0.5012) | (7.4498) | (0.4822) | |
| POLICY | 0.0499*** | |||
| (0.0139) | ||||
| ERI*POLICY | 2.3722*** | |||
| (0.6648) | ||||
| RGDP | 0.0045 | |||
| (0.0059) | ||||
| ERI*RGDP | 1.5330** | |||
| (0.6714) | ||||
| INDENV | -0.0035 | |||
| (0.0053) | ||||
| ERI*INDENV | -1.2347* | |||
| (0.6785) | ||||
| ENVP | 0.0003*** | 0.0003*** | 0.0003*** | 0.0003*** |
| (0.0001) | (0.0001) | (0.0001) | (0.0001) | |
| SIZE | 0.0215*** | 0.0217*** | 0.0214*** | 0.0177*** |
| (0.0023) | (0.0023) | (0.0023) | (0.0024) | |
| AGE | -0.0011*** | -0.0011*** | -0.0011*** | -0.0008** |
| (0.0003) | (0.0003) | (0.0003) | (0.0003) | |
| LEVG | -0.0353*** | -0.0352*** | -0.0351*** | -0.0334*** |
| (0.0035) | (0.0035) | (0.0035) | (0.0032) | |
| FAR | 0.1114*** | 0.1130*** | 0.1095*** | 0.1184*** |
| (0.0154) | (0.0153) | (0.0154) | (0.0139) | |
| BSIZE | 0.0058 | 0.0054 | 0.0069 | 0.0119 |
| (0.0114) | (0.0115) | (0.0114) | (0.0114) | |
| BIND | -0.0199 | -0.0225 | -0.0172 | -0.0094 |
| (0.0363) | (0.0364) | (0.0363) | (0.0366) | |
| INSHR | 0.0002** | 0.0003** | 0.0002** | 0.0002** |
| (0.0001) | (0.0001) | (0.0001) | (0.0001) | |
| Constant | -0.3249*** | -0.3303*** | -0.2443*** | -0.3027*** |
| (0.0796) | (0.0793) | (0.0870) | (0.0717) | |
| Industry FE | Yes | Yes | Yes | No |
| Year FE | Yes | Yes | Yes | Yes |
| Observations | 2202 | 2202 | 2202 | 2202 |
| R-squared | 0.2345 | 0.2387 | 0.2361 | 0.2015 |
| Robust standard errors in parentheses*** p < 0.01, ** p < 0.05, * p < 0.1 | ||||
Table 5 demonstrates that the main model’s findings are similar to earlier findings, representing a significant positive relationship between firm profitability and environmental investment. As anticipated, the results relating to the pre-post environmental policy of China demonstrate that environmental regulation positively enhances the association between environmental investment and firm profitability. Similarly, results concerning the effect of regional development suggest that firms operating in developed areas of China are generating positive financial returns from their environmental protection efforts. Finally, our results demonstrate that firms in environmentally sensitive industries do not find it profitable to invest in environmental protection initiatives. In general, all the study’s results hold in Table 6. However, higher coefficients of ERI were found in all models, which suggests that ERI is more strongly associated with ROE than ROA. The results pertaining to the control variables remain the same across all models. Hence, we can claim that our results remain robust to the use of another proxy for financial profitability in our analysis.
4.4 Endogeneity
Endogeneity can be induced by reverse causality, simultaneity, omitted variables, and company-specific heterogeneities (Semykina & Wooldridge, 2010). In our main findings (Table 4), the reverse causality and omitted variable bias may be the cause of endogeneity. As we propose that environmental investments produce positive corporate returns, it is also possible to theorize that profitable firms are more inclined toward environmental efforts because they possess larger financial resources. Thus, endogeneity may affect the generalizability of this study’s findings. We employed two-stage least squares (2sls) with an instrumental variable approach (Baum et al., 2007) to resolve the problem of endogeneity in our study, which may be the result of reverse causation and omitted variables. Previous studies have identified ENVP as the endogenous variable and the ‘industry mean of ENVP’ as the instrumental variable (Al-Hadi et al., 2019; Shahab et al., 2018). It has been argued that the level of company social and environmental performance differs across different industries because of variances within the product nature, monitoring, and social standards (Mammilla & Siegel, 2001).
| Variables | ROA | ROA | ROA | ROA |
|---|---|---|---|---|
| (1) | (2) | (3) | (4) | |
| ERI | 0.6686*** | 0.0886 | 10.6304** | 1.0024*** |
| (0.2382) | (0.2730) | (4.7494) | (0.3001) | |
| ENVP | 0.0001 | 0.0001 | 0.0001 | 0.0001 |
| (0.0003) | (0.0003) | (0.0003) | (0.0002) | |
| POLICY | 0.0162 | |||
| (0.0148) | ||||
| ERI*POLICY | 1.2080*** | |||
| (0.4122) | ||||
| RGDP | 0.0070* | |||
| (0.0039) | ||||
| ERI*RGDP | 1.0195** | |||
| (0.4279) | ||||
| INDENV | -0.0005 | |||
| (0.0036) | ||||
| ERI*INDENV | -0.4694 | |||
| (0.4270) | ||||
| SIZE | 0.0112*** | 0.0114*** | 0.0112*** | 0.0076*** |
| (0.0013) | (0.0013) | (0.0013) | (0.0013) | |
| AGE | -0.0009*** | -0.0008*** | -0.0009*** | -0.0006*** |
| (0.0002) | (0.0002) | (0.0002) | (0.0002) | |
| LEVG | -0.0237*** | -0.0236*** | -0.0236*** | -0.0228*** |
| (0.0015) | (0.0015) | (0.0015) | (0.0015) | |
| FAR | 0.0563*** | 0.0569*** | 0.0541*** | 0.0507*** |
| (0.0107) | (0.0107) | (0.0107) | (0.0083) | |
| BSIZE | 0.0150** | 0.0152** | 0.0142** | 0.0051 |
| (0.0066) | (0.0066) | (0.0066) | (0.0069) | |
| BIND | -0.0212 | -0.0229 | -0.0203 | -0.0066 |
| (0.0221) | (0.0219) | (0.0220) | (0.0225) | |
| INSHR | 0.0002** | 0.0002** | 0.0002** | 0.0002** |
| (0.0001) | (0.0001) | (0.0001) | (0.0001) | |
| Constant | -0.1269** | -0.1341** | -0.0754 | -0.0737 |
| (0.0587) | (0.0586) | (0.0611) | (0.0477) | |
| Industry FE | Yes | Yes | Yes | No |
| Year FE | Yes | Yes | Yes | Yes |
| Observations | 1185 | 1185 | 1185 | 1185 |
| R-squared | 0.3459 | 0.3505 | 0.3485 | 0.2851 |
| Kleibergen-Paap rk LM statistic | 44.068 | 44.100 | 44.183 | 50.832 |
| Cragg-Donald Wald F statistic | 90.604 | 90.431 | 90.266 | 103.751 |
| Kleibergen-Paap rk Wald F statistic | 52.963 | 52.787 | 52.920 | 63.300 |
| Stock-Yogo weak ID test critical values (10% maximal IV size) | 16.38 | 16.39 | 16.40 | 16.41 |
| Note: Robust standard errors in parentheses*** p < 0.01, ** p < 0.05, * p < 0.1 | ||||
Table 6 presents the results of the analysis using 2sls as a technique to control for endogeneity. We found no results that were dissimilar to the study’s main findings. The empirical results indicate that environmental investment yields positive returns for Chinese listed companies. Moreover, this relationship was reinforced by the implementation of China’s Environmental Protection Law, while firms from developed Chinese provinces and less polluted industrial sectors do generate profits from their environmental protection efforts.
Table 6 also presents the results of the tests depicting the attributes of the instrument variable used in the analysis. To demonstrate a powerful instrument, the ‘Kleibergen-Paap rk LM statistic’ should be significant, and the value of the ‘Cragg-Donald Wald F statistic’ should be larger than 10. Under the ‘Stock-Yogo weak ID test critical values,' the ‘Kleibergen-Paap rk Wald F statistic' should be greater than the 10% maximum IV size for weak identification tests. All endogeneity tests applied fulfilled the criteria and confirmed that the instrument used was strong enough to control for reverse causality and omitted variable bias. Overall, these findings indicate that the problem of endogeneity was effectively addressed during the present study’s analysis.
ERI has emerged as a significant challenge to the economy and efforts to achieve sustainable development. The impact of ERI on firm profitability remains unclear owing to the positive externalities of investment in environmental protection initiatives and the public goods features of environmental governance (Chen & Ma, 2021). To open up the black box of companies’ ERI, the study employed a novel panel dataset pertaining to Chinese listed companies for the period 2010–2019 to investigate the effect of ERI on firm profitability. Our findings demonstrate that ERI promotes firms’ profitability. The results of the cross-sectional variations present the significance of environmental policy for improving the ERI–profitability relationship. In addition, regional development also contributes to corporate environmental investment behavior and facilitates profitability. However, the ERI–profitability association does not prevail for firms that operate within environmentally sensitive industrial sectors.
5.1 Policy Implications
The policy implications of the empirical findings are as follows. First, the study approves that the implementation of China’s Environmental Protection Law has not hampered corporate economic returns, except for environmentally sensitive firms. The government should carefully manage and increase charges and penalties for all enterprises in general and environmentally sensitive firms in particular. These should be designed in a way that keeps a positive track of the effect of environmental regulations on corporate profitability. Second, the cross-regional differences in economic development in China lead to inconsistent institutional growth. It is inevitable for ‘greener and cleaner’ China that the central government should ensure balanced regional GDP growth. Focusing on the underdeveloped regions, the government should provide resources and ensure the implementation of environmental regulations in such localities. As underdeveloped regions are already combating other economic challenges, these regions usually sacrifice their resources and environment in favor of economic development. Such regions are unable to create a corporate-friendly environment in which firms can effectively execute their social and environmental strategies to obtain a competitive advantage. Therefore, institutional incentives should be employed to encourage local governments in China to promote active environmental governance in an endogenous manner (Wong et al., 2018).
5.2 Managerial Implications
To address environmental challenges, firms must invest their financial and non-financial resources. Firms that are proactive in addressing environmental concerns frequently encounter budget restrictions; nevertheless, this presents opportunities that—if managed effectively—can contribute to greater financial performance. As this study has demonstrated, investment in environmental protection enhances firm profitability. The actual advantages of investing in environmental efforts may not be evident since managers lack the tools to assess outcomes and frequently overlook valuable business possibilities owing to a lack of information. The availability of a pragmatic instrument to assess the costs and advantages of environmental-financial performance will assist managerial executives in developing strategies and making long-term sustainable financial decisions (Lee et al., 2015). On the other hand, managers from environmentally sensitive firms should redesign their environmental strategy: using Porter’s framework, firms should transform their reactive strategies into proactive environmental decision making. The successful transformation of environmental strategies will enable companies to obtain a competitive advantage.
The regions across China differ in terms of institutional contexts, business norms, regulatory frameworks, and stakeholders. Managers should be cognizant of variations in local institutional contexts because obtaining resources and assistance from local authorities is a strategic task, particularly in developing regions. To ensure an effective environmental strategy, managers must fully examine the local institutional context as well as the local government’s intentions with respect to environmental governance.
5.3 Limitations and Future Research
In addition to contributing to the extant literature, the present study has some limitations and suggestions for future research. First, we employed ERI as an element of corporate environmental management performance. Future studies should consider multiple environmental management dimensions and compare their effects on firm profitability. Second, the study was conducted in an emerging market context; other researchers may conduct similar investigations in the developed world, which has different institutional and business environments. Third, future investigations may identify other contingency factors affecting the ERI–profitability relationship. It would be useful to perform an industry-by-industry study to determine how different sectors’ demands and resources may be combined to derive financial benefits from environmental management.
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No competing interests reported.