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Corporate Environmental Responsibility and Firm Risk

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Abstract

In this study, we examine the relation between corporate environmental responsibility (CER) and risk in U.S. public firms. We develop and test the risk-reduction, resource-constraint, and cross-industry variation hypotheses. Using an extensive U.S. sample during the 1991–2012 period, we find that for U.S. industries as a whole, CER engagement inversely affects firm risk after controlling for various firm characteristics. The result remains robust when we use firm fixed effect or an alternative measure of CER using principal component analysis or downside risk measures. To address the concern of endogeneity bias, we use a system equations approach and dynamic system generalized methods of moment regressions, and continue to find that environmentally responsible firms experience lower risk. These findings support the risk-reduction hypothesis, but not the resource-constraint hypothesis, along with the notion that the top management in U.S. firms is generally risk averse and that their CER engagement facilitates their risk management efforts. Our cross-industry analysis further reveals that the inverse CER-risk association mainly comes from the manufacturing sector, whereas in the service sector, CER tends to increase firm risk.

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Notes

  1. For example, in a recent survey of 766 CEOs conducted by Accenture and United Nations Global Compact (UNGC), 93 % of the CEOs surveyed believe that sustainability will be critical to the future success of their businesses and 91 % report that their companies will use new technologies (e.g., renewable energy or clean technology) to address sustainability issues over the next five years (Accenture and UNGC 2010).

  2. To examine the relation between the manifestation of CSR and shareholder wealth, Godfrey (2005) argues that good deeds earn chits. Specifically, he establishes the following core assertions: (1) corporate philanthropy can generate positive moral capital among communities and stakeholders, (2) moral capital can provide shareholders with “insurance-like” protection for many of a firm’s idiosyncratic intangible assets, and (3) the insurance-like protection contributes to shareholder wealth.

  3. The effect of CSR engagement on firm risk is documented by several studies including McGuire et al. (1988), Feldman et al. (1997), Orlitzky and Benjamin (2001), Husted (2005), Godfrey et al. (2009), Salama et al. (2011), and Oikonomou et al. (2012). In general, they find an inverse association between CSR and firm risk.

  4. Brammer et al. (2006) assert that environmentally responsible companies underperform if their environmental responsibilities are considered. Karnani (2012) argues that in circumstances in which financial performance and social welfare are in direct opposition, an appeal to CSR and/or CER is almost always ineffective because senior managers are unlikely to act voluntarily against shareholder interests.

  5. See the overview studies of the empirical relation between CSR engagement and financial performance (Orlitzky et al.2003; Margolis and Walsh 2003; Allouche and Laroche 2006; Beurden and Gössling 2008; Baron et al. 2011).

  6. We refer to firms’ environmental concerns as CER. In their literature review article, Molina-Azorin et al. (2009) report that 21 studies obtain a positive CER-firm performance relation, whereas 11 document either an insignificant or a negative association.

  7. Our study differs from Oikonomou et al. (2012) in several aspects. The first difference is that we take an extensive sample of all U.S. public firms, whereas their study focuses on S&P500 index components. We include all KLD firms to insure a wider spectrum of environmental strengths and concerns. The second difference is in model selection. Their variable of interest is CSR, whereas our variable of interest is CER. They choose a multivariate model to simultaneously embrace five different CSR dimensions, whereas we sharply focus exclusively on the environmental responsibility. Due to these major differences and other findings, our results of the CER-firm risk relationship provide additional evidence and contributions beyond Oikonomou et al. (2012).

  8. To illustrate, we borrow from Montiel and Delgado-Ceballos (2014) to summarize the different items used to measure the social versus environmental dimensions in the literature and secondary resources. The summary is included in Appendix 2.

  9. Despite his terse dismissal of CSR as “hypocritical window-dressing,” Friedman (1970) does nonetheless acknowledge that a firm’s investment in CSR could “make it easier to attract desirable employees … may reduce the wage bill or lessen losses from pilferage and sabotage or have other worthwhile effects.” In noting that CSR can generate valuable goodwill for firms, he thus provides a basis for the counter-argument of stakeholder theorists that CSR and CFP are positively related.

  10. Alternatively, to comply with the increasingly rigorous environmental laws and regulations, firms should expand CER investments to improve environmental management and performance, shrinking firm profitability. For instance, firms should use costly environmental technologies and/or equipment to prevent and control pollution. This additional and costly CER investment may not bring returns in the short term, or even in the long term, and therefore may increase firm risk. Unfortunately, the KLD Stats database does not provide the absolute dollar amount of CER investment. Thus, it is difficult to directly examine the validity of the CER-cost argument.

  11. The KLD also has exclusionary screens, such as alcohol, gambling, military, nuclear power, and tobacco, which differ from the inclusive screens in that only concern ratings, no strength ratings, are assigned. We only make use of the inclusive screens in our tests. In some CER studies (Cai and He 2014), “nuclear power” is also included because radioactive waste is harmful to the environment.

  12. The KLD conducts its annual evaluation based on various sources, such as surveys, financial reports, mainstream media, government documents, etc.

  13. The KLD compiles information on CSR beginning in 1991. The initial sample size of the KLD is 38,058 firm-year observations during the 1991–2012 period. After matching the KLD data with the Compustat database, we obtain a combined sample of 31,033 firm-year observations. The first six characters of CUSIP (including leading zeroes) identify the issuer and the last two identify the issue itself. The CUSIP identifier may change for a security if its name or capital structure changes. We use the 6-digit issuer number to merge COMPUSTAT and CRSP. After matching across all three databases, the size of the combined sample is approximately 25,800 firm-year observations from 1991 to 2012. When we take the lagged variables, our final sample is reduced to 23,000 firm-year observations.

  14. CAPM beta measures a firm’s systematic risk relative to the risk of the stock market in general, i.e., the market portfolio.

  15. CAPM uses only one variable to describe the returns of a portfolio or stock with the returns of the market as a whole. In contrast, the Fama–French model uses three variables. Fama and French start with the observation that two classes of stocks tend to do better than the market as a whole, (i) small caps and (ii) stocks with a high book-to-market ratio (customarily called value stocks, contrasted with growth stocks). They then add two factors to CAPM to reflect a portfolio’s exposure to these two classes.

  16. In addition, we use the second-order lower partial moment and downside betas for our robustness check in the additional tests section.

  17. Our main results remain intact when we control for corporate governance by the independent board proportion or by the G-Index established by Gompers et al. (2003) from the RiskMetrics database.

  18. The book value and market value are not necessarily consistent, so we use both as a proxy for firm size when testing robustness.

  19. Using Fama and French’s (1997) information on 48 industries to construct the industry dummy gives similar, if not stronger, results.

  20. In Table 6, the main independent variable is the net environmental scores, ENV_NET. The results of the aggregate environmental index, ENV_IDX, are consistent and qualitatively similar, and we choose not to report them to save space.

  21. Using an environmental variable lagged by two years as the instrument allows us to address the concern of reverse causality. We also use a three-stage least square method with firm risk and CER measures as two dependent variables. In the results (not shown), we obtain a negative and significant association between CER variables and firm risk variables even after controlling for the reverse causality side of CER variables being dependent variables.

  22. For space concerns, we use the Fama–French market factor beta as the single risk measure in Table 10. The results using the CAPM beta or volatility are rather consistent; they are available upon request.

  23. In Table 11, the main independent variable is the net environmental score, ENV_NET. The results of the aggregate environmental index, ENV_IDX, are consistent and qualitatively similar, thus we choose not to report them to save space.

  24. Recently, Albuquerque et al. (2013) find that CSR decreases systematic risk and that a negative CSR-risk association is more pronounced in differentiated product industries, including furniture and fixtures, printing and publishing, rubber and plastic products, stone, glass, and clay products, fabricated metal products, machinery, electrical equipment, transportation equipment, instruments, and miscellaneous products (Giannetti et al. 2011). Albuquerque et al. (2013) claim that profit maximization (and therefore, possible risk reduction) may come from product differentiation strategies. Their main focus is on CSR, not on CER, and our results shed some light on whether differentiated goods industries demonstrate stronger CER-risk associations. Panel B of Table 12 indicates that only Industrial Machinery and Equipment (SIC 35) decreases firm risk, but not the other differentiated product industries.

  25. The nature of statistical testing is to uncover the characteristics of population using samples. A larger sample more reliably reflects the population and thus offers more reliable statistical inference. When sample size is small relative to the population, the potential bias is large.

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Acknowledgments

The authors appreciate the excellent guidance of section editor Gary Monroe and thank two anonymous referees for their many valuable comments and suggestions.

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Authors and Affiliations

  1. Stuart School of Business, Illinois Institute of Technology, 10 West 35th St, 18th Floor, Chicago, IL, 60616, USA

    Li Cai

  2. School of Business, Korea University, Seoul, Korea

    Jinhua Cui

  3. Leavey School of Business, Santa Clara University, 500 El Camino Real, Santa Clara, CA, 95053-0388, USA

    Hoje Jo

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  1. Li Cai
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Correspondence to Hoje Jo.

Appendix

Appendix

Appendix 1

See Fig. 1.

Fig. 1
figure 1

Number of Articles Published in CER and CSR (1995-2013). This appendix is a reproduction of Fig. 2 in Montiel and Delgado-Ceballos (2014). It counts the number of articles published in Academic Management Journals, Practitioners Management Journals, and Specialized Management Journals in two subject areas, environmental management, and corporate social responsibility (1995–2013)

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Appendix 2

See Table 14.

Table 14 Measurements of CSR and CER
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Appendix 3

See Table 15.

Table 15 List of environmental strength and environmental concern dimensions in KLD
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Appendix 4

See Table 16.

Table 16 2-Digit SIC (standard industrial classification) codes
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Appendix 5

See Table 17.

Table 17 MSCI IVA scores
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Cai, L., Cui, J. & Jo, H. Corporate Environmental Responsibility and Firm Risk. J Bus Ethics 139, 563–594 (2016). https://doi.org/10.1007/s10551-015-2630-4

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