MSc Finance Thesis

MSc Finance Thesis

Relationship between Corporate Social Responsibility

and Corporate Financial Performance

ABSTRACT

I analyze how Corporate Social Responsibility is related to Corporate Financial Performance in European companies from 2002 to 2014. Drawing from the Resource Based View perspective, I argue that firms that engage in CSR activities create firm specific resources and capabilities that can result in sustain competitive advantage. In turn, this sustain competitive advantage can improve the financial performance of the company. I analyze 571 European companies listed on the Stoxx Europe 600 index and reveal that CSR is positively related to CFP. The four components of CSR (economic performance, environmental performance, social performance and corporate governance performance) are also positively related to CFP.

Student nr.: s2792710

Name: Madelin Perdomo Pineda

Study Program: MSc Finance Supervisor: Dr. L. Dam

Field Key Words: Corporate Governance, Ethics & SRI

Corporate Social Responsibility and Financial Performance 2 Corporate Social Responsibility (CSR) has recently been the subject of increased academic attention. As the awareness about global social issues continues to grow, the relationship between CSR and CFP continues to be important. For example, the pension fund ABP in the Netherlands is implementing a new strategy, this strategy will increment investments in socially responsible companies and motivate companies to be more socially responsible. More concrete, the pension fund ABP wants that its whole investment portfolio reduces 25% carbon dioxide emissions within five years (ABP eist meer aandacht voor klimaat, 2015). CSR refers to a business practice that involves participating in activities that benefit society, environment and the governance. However, the activities nowadays seems to be more varied and active. Companies have taken on different CSR activities and in return they can receive several benefits in addition to shareholder wealth maximization: they can improve their reputation, their brand and their company image. Companies can also inspire customer loyalty, increase sales, earn the attention of the media and meet the stakeholder’s obligations. Furthermore, CSR activities have enabled companies to make contributions to groups that they belong to and are regarded as an important way of communication in order to maintain relationships with stakeholders. Therefore, CSR is considered an essential factor in management strategy. Because of the importance of the topic, numerous researches have attempted to study the relationship between CSR and CFP, however, there is still no consensus among the results. In this thesis, the relationship between CSR and CFP will be analyze through the lens of the resource based view theory (RBV). It also addresses differences in results between previous studies that examine the relationship between CSR and CFP with U.S. firms. Europe and the U.S. differ in their social responsible behavior because of their understanding and development of the concept, their culture and their social values differences. This study contributes to the literature by comparing the results of the relationship between CSR and CFP of European companies with the results of previous studies with U.S. companies. First, a theoretical framework is developed, outlining the relationship between CSR and CFP, second the theoretical predictions are tested by using a European companies listed on the Stoxx Europe 600 index.

Corporate Social Responsibility and Financial Performance 3 can create the resources and capabilities that can generate sustain competitive advantage, in turn, this contributes to the firm’s financial performance. The different view of CSR that Europe and the U.S. have, creates different resources and capabilities for both Europe and the U.S. that can have a different impact on the financial performance of the companies in each region. Scholars have considered different perspectives when investigating the relationship between CSR and CFP. The stakeholder theory proposes that companies must take into account all the stakeholders (employees, suppliers, costumers, other organizations) that can influence the value of the firm. Engaging in CSR can be driven by internal forces (the management incentives), as well as, external forces (competitors and other stakeholders) (Woddock & Graves, 1997). Taking this into account, the shareholders are not the only ones who will benefit from CSR. Instead, the benefits are shared among different stakeholders. Despite the positive relation between CSR and CFP, results of previous studies show the opposite, this contributes to the inconsistency in the results. In contradiction with the RBV theory and the stake holder theory, Friedman (1970) states that the only responsibility of a firm is to increase the returns to stockholders, this is in line with the agency theory. Theoretically, I argue that firm specific resources and capabilities that are rare, inimitable and for which there are no substitutes in the market, create sustained competitive advantage. This argument is in line with the resource based view.

Corporate Social Responsibility and Financial Performance 4 components of CSR, economic performance, environmental performance, social performance and corporate governance performance are also positively related to corporate financial performance. As a robustness check, the CSR variable is lagged one year, and the findings show that the previous year CSR is also positively related with corporate financial performance. These findings are consistent Woddock and Graves (1997) who found a positive significant relationship between the variables. However, these results differ slightly form the results of studies conducted with U.S companies.

This study contributes to the existing literature by analyzing the relationship between CSR and CFP in European firms for the year 2002 to 2014 and by explaining the possible differences in results for U.S. companies and European companies. This study looks at this relationship through the lens of the resource-based theory, to examine the relationship between corporate social responsibility and corporate financial performance and aims at finding an answer to the research question: What is the relationship between corporate social responsibility and corporate financial performance? So, resources and capabilities are developed based on a set of social responsibility principles. As these social responsibility principles differ per country, so will the resources and capabilities vary, in turn, these differences will have a different effect on corporate financial performance. Drawing from the RBV, I hypothesize that the relationship between CSR and CFP must be positive, to further analyze this relationship, the four components of the overall score of CSR are analyzed individually.

The rest of this study is organized as follows: section I presents the description of the variables CSR and CFP, reviews selected empirical studies on the link between CSR and economic performance and develop the hypotheses. Subsequently, section II presents the descriptive statistics of the relevant variables and the methodology that will be used in this research. Section III presents the results of the analysis and the last section, section IV discusses the finding of this research.

I.

Literature Review

Corporate Social Responsibility and Financial Performance 5 Performance. Second, the link between CSR and CFP is addressed, and third, the hypotheses are developed.

A. Definitions of Corporate Social Responsibility and Corporate Financial Performance The definition of CSR has changed during the years, in the past it was referred to more as Social Responsibility than as Corporate Social Responsibility. As Carroll (1991) discusses in his study, CSR has four components (economic, legal, ethical and philanthropic) and he also discusses that in general CSR most fulfill all the four responsibilities at the same time. As research is conducted the definition of CSR will be adapted or new definitions will arise (Carroll, 1999). For this reason, it is important that all the different concepts and practices that define the term CSR must recognize that firms have an obligation towards its society, environment and individuals. Another important fact is that engaging in CSR activities reduces the resources available and the costs incurred are observed immediately, but the benefits are observed in the long run.

For Corporate Financial Performance as well as for CSR, there is no real consensus on the appropriate measure, which can lead to different results across studies (Woddock & Graves, 1997). Two types of measures have been used for CFP: accounting- based and market-based (Orlitzky, Schimdt & Rynes, 2003). Accounting-based measures, measure how a company’s proceeds change in response to different managerial plans, the most used measures of accounting- based measures are return on equity (ROE), return on assets (ROA), earnings per share (EPS) (Cochran & Wood, 1984). Market- based measures, measure a firm’s market value, which is determined by stock-markets participant. The different operationalizations of both corporate social responsibility and corporate financial performance lead to different results. The findings of Orlitzky et al. (2003) show that accounting measures are more correlated with corporate social performance (CSP) than market-based measures. Orlitzky et al. (2003) also found that studies that used reputation indices as proxies for corporate social performance have a higher correlation with financial performance and that accounting measures are more correlated with these reputation indices than market based measures.

B. The link between CSR and CFP

Corporate Social Responsibility and Financial Performance 7 These differences in results can be attributed to the method, the measurement or the theory used. This thesis will analyze the relationship between CSR and CFP through the lens of the resource based view theory. The RBV theory suggests that a firm can gain competitive advantage by recognizing the importance of tangible and intangible concepts, such as physical resources, organization culture and reputation (Russo & Fouts, 1997). In addition, these resources and capabilities need to have the potential of sustained competitive advantage by being heterogeneous and immobile (Barney, 1991). As Branco and Rodrigues (2006) discuss in their paper, companies generate sustain competitive advantage by having resources and capabilities that are rare, valuable, that cannot be easily imitated by the competition and resources and capabilities for which there are no perfect substitutes in the market. To conclude, RBV theory recognizes the important of resources and capabilities and consider them to be the most important sources for companies’ success.

Corporate Social Responsibility and Financial Performance 8 resources theory predicts that financial perfomance has an impact on CSR and not the other way arround. Slack resources theory predicts reverse causality between CSR and CFP by arguing that a company with a good financial performance have the resources to invest in CSR. Thus, having a better financial performance can result in investing more in CSR, which results in improved CSR overall (Woddock & Graves, 1997).

C. Resource Based View, Europe and the U.S.

In summary, after many years of research in this area, the results of previous literature are not consistent, there is evidence of a positive, a negative, as well as a neutral link, between CSR and CFP. As it is mentioned before, these differences in results are associated with different theoretical views among others. RBV theory aims at understanding the relation between firm performance, firm resources and capabilities and sustained competitive advantage (McWilliams, Fleet and Cory, 2002). Based on previous research this theory predicts a positive relationship between CSR and CFP. Sustained competitive advantage contributes to positive returns to the company and exists when a company has the resources and capabilities and use them to pursue a value creating strategy that the competition cannot duplicate (Barney, 1991). These resources and capabilities have to be valuable, rare, inimitable and non-substitutable. Valuable resources and capabilities enable a company to pursue a strategy that can improve the effectiveness and efficiency of the firm. Rare resources and capabilities are uncommon resources (capabilities), inimitable resources and capabilities are resources (capabilities) that competitors cannot obtain. And non-substitutable resources and capabilities are resources (capabilities) that are not easily available in the market (Barney, 1991).

Corporate Social Responsibility and Financial Performance 9 value maximization (Forte, 2013). In the U.S., CSR includes voluntary corporate events outside of a firm’s main business. In 2001, the Green Paper “Promoting a European Framework for CSR” was presented by the European Commission, this Green Paper states that CSR is an idea whereby firms must voluntarily integrate environmental and social concerns, business operations and their communication with shareholders (Forte, 2013). Maignan and Ralston (2002) investigated the desirability and content of CSR communications in Europe and the U.S. and they found that firms established in different countries (the Netherlands, France, the U.K. and the U.S.) have different perspectives on this topic. In conclusion, the results show that businesses in different countries demonstrate different levels of dedication to being perceived as socially responsible. Maignan and Ralston (2002) explain the difference in perceptions by giving different factors: that the countries might have different perceptions of business, second the difference may be because of the nature and role of investors in the different countries. In Europe companies are mandated by the government to have a socially active role, whereas, companies in the U.S. have less pressure from the government to be social responsible. Another example is that CSR activities in the U.S. include health care insurance issues for the personnel, while in Europe the health care insurance is not problem because of the National Healthcare plans (Danko, Goldberg, Goldberg, & Grant, 2008). Each country have different motivating CSR values, the value-driven perspectives dominate in the U.S., while the performance-driven and the stakeholder-driven view dominate in Europe (Maignan & Ralston, 2002). Maignan and Ralston (2002) found that the selected countries in their study, have varying CSR practices to show a socially responsible image. For example the U.S. portray their socially responsible image by promoting their philanthropic projects and volunteerism. And Europe do this by focusing on environmental environment, by sponsorship, emphasizing promotion-oriented programs and by highlighting traditional production. Thus, Europe and the U.S. might be different in terms of definitional differences, role of government, workers’ right, environmental protection, collective bargaining, market organization, corporate governance, education, corporate irresponsibility, other cultural differences and sources of capital.

Corporate Social Responsibility and Financial Performance 10 different perspectives towards CSR that exists in Europe and the U.S.. In turn, these difference perspectives create different resources and capabilities in each region and this result in different financial performance.

As the RBV theory suggests, engaging in CSR activities can create resources and capabilities that are valuable, rare, inimitable and with non-substitutable. And when managing these resources and capabilities in an effective manner, a company can generate a unique and sustainable competitive advantage (Branco & Rodrigues, 2006). Following this line of reasoning, the following hypothesis is developed.

H1: Corporate Social Responsibility creates resources and capabilities that cannot be

acquired by competitors, which generate sustain competitive advantage and thus Corporate Social Responsibility improves the Corporate Financial Performance.

Corporate Social Responsibility and Financial Performance 11 all the stakeholders. Corporate governance controls that the resources are used in an efficient manner, which protects the interest of the stakeholders (Waddock, Bodwell, & Graves, 2002). Thus, the corporate governance performance is positively related to financial performance. As Europe and the U.S. engage in the different CSR activities, the resources and capabilities created are different in Europe and the U.S.. To conclude, European companies can have a different financial performance in comparison with the U.S. because of the different resources and capabilities created. This includes the four components of corporate social responsibility.

The following hypotheses follow:

H2a: There is a positive significant relationship between the Economic Performance and

CSR.

H2b: There is a positive significant relationship between the Environment Performance and

CSR.

H2c: There is a positive significant relationship between the Social Performance and CSR.

H2d: There is a positive significant relationship between the Corporate Governance

Performance and CSR.

This study will examine the relationship between corporate social responsibility and corporate financial performance in European companies. This research contributes to the literature by investigating this relationship in European companies, and discussing what are the possible factors that contributes to the difference in financial performance.

II. Methods

Data for the dependent variable, independent variables and control variables were obtained from DataStream for European companies listed in the Stoxx Europe 600 index for the period 2002-2014. This research will use regression analysis to study the relationship between CSR and CFP. The following sections will describe first, the data collection, second, the descriptive statistics and correlation for the dependent variables. Third, the independent variables and the control variables are presented and, at last the method of analysis is described.

Corporate Social Responsibility and Financial Performance 12 Greece, Ireland, Italy, Luxembourg, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland and the United Kingdom.

The first step after collecting the data was to restructure the data in a way that it could be analyzed by the statistical program Eviews; the second step was to convert all the currencies to the Euro and then calculate the needed variables. After this was done, the data was screened and cleaned for all errors and missing values, all observations with no ROA and ROE available was removed. This led to a total sample of 571 companies, which accumulates to a total of 5863observations for ROA and 567 companies with a 5781 observations for ROE.

Corporate Social Responsibility and Financial Performance 13 Table 1: Sample composition by Country and by Industry for European firms 2002-2014

Panel A in this table presents the sample composition by country and panel B presents the sample composition by industry, industry represented by the Industrial Classification Benchmark (ICB).

Panel A

Country Count Percent

Austria 72 1.23 Belgium 147 2.51 Czech Republic 14 0.24 Denmark 200 3.41 Finland 181 3.09 France 861 14.69 Germany 560 9.55 Greece 32 0.55 Ireland 69 1.18 Italy 315 5.37 Norway 130 2.22 Portugal 39 0.67 Spain 278 4.74 Sweden 403 6.87 Switzerland 468 7.98 The Netherlands 234 3.99 United Kingdom 1860 31.72 Total 5863 100.00 Panel B

Industry Count Percent

Basic Materials 524 8.94 Consumer Goods 464 7.91 Consumer Services 927 15.81 Financials 1344 22.92 Health Care 366 6.24 Industrials 1255 21.41

Oil & Gas 250 4.26

Technology 245 4.18

Telecommunication 215 3.67

Utilities 273 4.66

Total 5863 100.00

A. Dependent variable

Corporate Social Responsibility and Financial Performance 14 1. ROE: _{𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟}𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒_{′𝑠 𝐸𝑞𝑢𝑖𝑡𝑦}

2. ROA: _{𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠}𝐸𝑏𝑖𝑡𝑎

Table 2 shows the descriptive statistics of the ROA and the ROE per year from 2002 to 2014. As can be noted during the financial crises, the ROA and ROE percentages fell and rose in 2010. The table also shows the presence of an outlier for the variable ROE, mainly 7206.45.

Table 2: Descriptive Statistics for Return on Assets and Return on Equity for European firms 2002-2014 This table presents the descriptive statistics (mean, median, maximum, minimum, standard deviation and number of observation) for the return on assets and the return on equity. Statistic are presented per year for the return on assets. Panel A: Return on assets

Year Mean Max Min. Std. Dev. Obs.

2002 4.029 31.530 -44.900 7.460 264 2003 4.969 35.970 -54.820 6.898 269 2004 6.569 37.370 -15.630 6.351 371 2005 7.877 46.700 -14.300 6.879 451 2006 8.864 53.220 -32.030 7.794 461 2007 9.528 70.080 -13.260 9.743 490 2008 5.997 65.800 -55.890 10.021 501 2009 5.178 61.810 -36.860 8.461 510 2010 7.769 122.080 -13.660 8.687 522 2011 7.046 109.510 -29.510 8.776 542 2012 7.039 175.040 -29.830 11.031 548 2013 7.202 234.420 -21.720 12.471 536 2014 7.959 269.110 -12.670 15.076 398 2002-2014 7.087 269.110 -55.890 9.748 5863

Panel B: Return on equity

Year Mean Max Min. Std. Dev. Obs.

Corporate Social Responsibility and Financial Performance 15

B. Independent variables

Data for the independent variable Corporate Social Responsibility was obtained from the ASSET4 database, an important provider of environmental, social and corporate governance data. Asset4 collects extensive, objective, quantitative and qualitative data on 4000 firms worldwide since fiscal year 2002. Approximately 700 individual data points are rated and compared. Then these data points are combined into 250 key performance indicators, which are aggregated into a framework of 18 categories grouped into 4 pillars that are integrated into a single overall score. The four pillars are Economic performance, Environmental performance, Social Performance and Corporate Governance Performance (See figure 1). Table 3 shows the descriptive statistic of the independent variables and control variables. As can be seen in the table the overall score increase per year, the mean rose from 62.29 in 2002 to 75.84 in 2014. This shows that companies are more social responsible then in the past.

Figure 1: Composition of Corporate Social Responsibility

Corporate Social Responsibility and Financial Performance 16 Table 3 Descriptive Statistics for CSR, the components of CSR and the control variables of European firms

2002-2014.

Panel A in this table presents the descriptive statistics (mean, median, maximum, minimum, standard deviation and number of observation) for the overall score CSR, statistic are presented per year, from 2002 to 2014. Panel B presents the descriptive statistics (mean, median, maximum, minimum, standard deviation and number of observation) for the independent variable CSR, the four components of CSR (economic performance, environmental performance, social performance and corporate governance performance) and the control variables leverage and firm size.

Panel A

Year Mean Std. Dev. Obs.

2002 62.170 29.365 264 2003 61.574 28.500 269 2004 65.416 29.482 371 2005 65.482 28.523 451 2006 65.566 28.853 461 2007 67.056 28.189 490 2008 69.062 28.025 501 2009 73.350 26.146 510 2010 76.033 24.407 522 2011 74.665 25.353 542 2012 75.365 24.238 548 2013 75.766 23.557 536 2014 75.743 23.163 398 2002-2014 70.627 27.023 5863

Panel B: Descriptive Statistics for CSR, the components of CSR and the control variables

CSR Economic Environment Social Corp. Gov. Leverage Firm Size Mean 70.627 65.237 69.545 71.185 58.495 25.268 7.007 Median 82.870 73.550 81.640 82.070 64.430 24.390 6.893 Maximum 98.260 99.160 97.320 98.960 97.260 167.240 9.511 Minimum 2.630 1.220 8.270 3.580 1.7200 0.000 4.450 Std. Dev. 27.023 27.728 27.234 26.386 26.131 16.707 0.776 Observations 5863 5863 5863 5863 5863 5863 5863 C. Control variables

In this research three control variables were used, these variables has been suggested in previous research to be elements that affect a firm’s performance. The controls variables used are: Leverage, Industry (IND) and Firm size (SIZE).

Corporate Social Responsibility and Financial Performance 17 larger firms may have a better financial position to invest in social activities (Margolis et al., 2009). Firm size in this paper will be measured by the natural logarithm of total assets (or sales). An industry may influence firm performance differently (Woddock & Graves, 1997), and an industry can vary in its social responsible behavior, thus it is essential to control for industry (Margolis et al., 2009). For the variable industry, dummy variables were included in the regression, table 3 shows the descriptive statistics of the control variables.

D. Correlation

Table 4 shows the correlation matrix for the relevant variables, to see if there is presence of multicollinearity, the correlation must not be higher than 0.8. As can be seen the overall CSR performance has high correlation with the four components: Social, Economic, Environment and Corporate Governance, this was expected because the four components are part of the overall CSR performance. But these variables are not included in the same regression, so I suspect no problems regarding multicollinearity. None of the CSR measures have substantial correlation with the dependent variables ROA and ROE. Moreover, CSR is positively correlated with ROE, while negatively correlated with ROA.

Table 4: Correlation matrix for the variables that will be used in the regressions

This table presents the correlations between financial performance variables (return on assets and return on equity), the corporate social responsibility, the four components of CSR (economic performance, environmental performance, social performance and corporate governance performance) as well as the control variables (leverage and firm size).

ROA ROE CSR _{Economic Environment Social Corp. Gov. Leverage Firm Size} ROA 1 ROE 0.282 1 CSR -0.052 0.012 1 Economic 0.053 0.025 0.757 1 Environment -0.104 -0.011 0.852 0.521 1 Social -0.100 -0.005 0.884 0.584 0.763 1 Corp. Gov. 0.005 0.036 0.640 0.327 0.386 0.433 1 Leverage -0.192 0.020 0.010 -0.050 0.058 0.055 -0.044 1 Firm Size -0.370 -0.090 0.350 0.270 0.379 0.388 0.123 0.141 1 E. Method of analysis

Corporate Social Responsibility and Financial Performance 18 regression will be run to empirically test the hypotheses. Using a panel data has various benefits when compared with a normal OLS, these are: first, a panel data can address more issues and can be used for more difficult problems. Second, with a panel data it is also possible to study how variables or relationship between them vary change over time and the last one. Third, by using panel data the impact of omitted variables bias in the results can be removed (Brooks, 2008). Previous studies have also used panel data regression to examine the impact of exogenous factors on corporate financial performance. To mitigate the effect of outliers, the dependent variables ROA and ROE are winsorized at the 1st _{and the 99}th _{percentile. Winsorizing is a method that}

reduces the effect of outliers by transforming the data, it replaces the smallest values to the 1st percentile and replaces the largest values to the 99th percentile.

The following regression models were used:

(1) CFPit= α + β1CSRit + β2LEVit + β3INDit + β4SIZEit +

ε

it (2a) CFPit= α + β1ECOit + β2 LEVit+ β3INDit+ β4SIZEit+

ε

it (2b) CFPit= α + β1ENVit + β2 LEVit+ β3INDit+ β4SIZEit+

ε

it (2c) CFPit= α + β1SOCIALit + β2 LEVit+ β3INDit+ β4SIZEit+

ε

it (2d) CFPit= α + β1GOVit + β2 LEVit+ β3INDit+ β4SIZEit+

ε

it

To address the causality effect the independent variable will be lagged one year. The following model will be used to test this:

(3) CFP= α + β1CSRit-1 + β2LEVit+ β3INDit+ β4SIZEit+

ε

it

Corporate Social Responsibility and Financial Performance 19

III. Results

This section presents the results of the panel analysis: first a pooled OLS was used to estimate the regression, and then fixed effects were used. This method is relatively simple, however, the pooled OLS has several limitations, this method assumes that the values of the variables and the relationships between them are constant over time and across all the cross-sectional units in the sample (Brooks, 2008), it does not take into account the heterogeneity of the data.

Table 5 shows the results of the different OLS regression models, a total of 5863 observations remained in the sample after accounting for missing values for both ROA and CSR, the adjusted R2 is also presented. First, a pooled OLS regression is used, even though this method has several limitations. In general, there is significant positive relationship between CSR and CFP when the control variable Firm Size is included in the regression. As is discussed by Fama and French (1992), Firm Size has a negative relationship with financial performance. Thus, since firm size is positively related to CSR, it is important to control for firm size, otherwise, CSR will absorb the size effect. The results of the pooled OLS regressions show that there is significant positive relationship between CFP as measured by ROA and CSR, at a 1% significant level, the same was found in the regression with ROE. The control variables have a significant negative effect on ROA at a 1% level of significance. This negative effect for leverage and firm size is consistent with the results of Woddock and Graves (1997) and Nelling and Webb (2008), who found a significant negative relationship between these control variables and CFP as measured by ROA or by ROE. Looking at the economic significance, 2.7% of the change in ROA is explained by the overall score CSR. These results are consistent with the findings of Woddock and Graves (1997) who found a positive significant relationship between the variables, they found that corporate social performance explain 2.4% of the variation in ROA. The results of the meta-analysis of Margolis et al. (2009) show that the 0.152 average effect size indicates a 2.23% of the variation in CFP. The adjusted R2 shows that 26.64% of the total variability of the ROA is explained by the independent variables.

Corporate Social Responsibility and Financial Performance 20 score. Overall, the adjusted R2 shows that 8.81% of the total variability of the ROE is explained by the independent variables.

Thus, as the results of the regression analysis indicate, the null hypothesis of no relationship can be rejected, indicating that there is a positive relationship, specifically, CSR improve financial performance.

Omitted variables that are not included in the regression, but that do correlate with the dependent and independent variable, can bias the results if they are not included in the regression estimation. For this reason, it is important to take these omitted variables into account, a way to deal with this is by using fixed-effects models. To see whether this is necessary, a Redundancy test and Hausman1 test were performed. The results of the Redundancy test are significant, this indicates that the fixed-effects model is more appropriate and the results of the Hausman test are also significant indicating that the random effects are not appropriate and the fixed- effect model is sufficient.

The fixed effect is used to control for unobservable variables when estimating the effect of the independent variable on the dependent variable, the unobservable variables vary cross-sectional but are constant over time. The results of the fixed-effects model are presented in table 5 model (6), compared to the pooled OLS regression results, the fixed effects results do not reveal many differences. The relationship between CSR and ROA is still positive and significant, the coefficient increased from 2.7% to 3.6%. The adjusted R2 increased when using fixed effect, or, in other words it increased the goodness of fit of the model, as it went from 26.64% to 58.82%.

In summary, the results of the analysis may encourage companies to invest more in CSR as it increases the financial performance of the firm. Panel B shows the results of the relationship between CSR and ROE, the relationship is significantly positive, with a coefficient of 0.098. In this case, the adjusted R2 increased, it went form 8.81 % to 48.15%.

When comparing the results of this research with the results of studies for U.S. firms, it can be noted that a positive significant relationship is found for both European firms and U.S. firms. However, there is a slight difference in the coefficient found in this study and the study of Waddock and Graves (1997). I found that CSR explain 3.6% of the variability in ROA and 9.8% of the

1 _{To determine whether the fixed effects are needed or not, a redundant fixed effects test is run. The p-values in all}

Corporate Social Responsibility and Financial Performance 21 variability in ROE, the paper of Waddock and Graves (1997) reports that CSR explain 2.4% of the variability in ROA and 8.1% of the variation in ROE.

Table 5: The effect of Corporate Social Responsibility on Corporate Financial Performance for European companies from 2002 to 2014

This table presents the results for the regressions models estimating the relationship between CSR and CFP (ROA and ROE). Model 5 presents the results of the pooled OLS, model 6 presents the results with firm fixed effects, model 7 presents the result with year fixed effects and model 8 present the results with both firm and year fixed effects. The equation estimated is CFPit= α + β1CSRit + β2LEVit + β3INDit + β4SIZEit + εit. The regressions are estimated with 571 firms,

both CFP variables ROA and ROE were winsorized. Numbers in parenthesis are the standard errors and *, **, *** indicates significance at the 0.10, 0.05 and 0.01 levels, respectively.

Panel A Dependent variable: Return on assets

Model (1) (2) (3) (4) (5) (6)FE (7)TE (8) Both

Constant 7.957*** (0.261) 36.436*** (0.753) 9.842*** (0.292) 9.947*** (0.500) 35.336*** (0.883) 39.429*** (2.479) 36.733*** (0.737) 42.930*** (2.920) CSR -0.014*** (0.003) 0.032*** (0.003) -0.014*** (0.003) -0.023*** (0.003) 0.027*** (0.003) 0.036*** (0.004) 0.031*** (0.003) 0.038*** (0.005) Firm Size -4.523*** (0.114) -4.267*** (0.133) -4.677*** (0.367) -4.374*** (0.112) -5.224*** (0.420) Leverage -0.075*** (0.005) -0.058*** (0.005) -0.089*** (0.008) -0.050*** (0.005) -0.080*** (0.008) Industry F. effect No No No Yes Yes No Yes No No No Yes

Year No No No No No No Yes Yes

R²adj (%) 0.27 21.42 3.28 8.63 26.64 58.82 25.32 61.32

N 5863 5863 5863 5863 5863 5863 5863 5863

Panel B Dependent variable: Return on equity

Model (9) (10) (11) (12) (13) (14) FE (15) TE (16) Both Constant 17.760*** (0.818) 71.457*** (2.565) 18.900*** (0.933) 17.753*** (1.615) 68.437*** (3.044) 102.233*** (8.761) 70.617*** (2.530) 105.720** * (10.419) CSR -0.001 (0.011) 0.084*** (0.011) -0.001 (0.011) -0.016 (0.011) 0.089*** (0.012) 0.098*** (0.015) 0.089*** (0.011) 0.107*** (0.016) Firm Size -8.514*** (0.387) -8.866*** (0.461) -12.861*** (1.300) -8.504*** (0.386) -13.573*** (1.503) Leverage -0.047** (0.018) -0.006 (0.018) -0.051 (0.032) 0.0167 (0.018) -0.015 (0.032) Industry F. Effect

No No No Yes Yes Yes No Yes

Year No No No No No No Yes Yes

R²adj (%) -0.00 7.70 0.00 2.88 8.81 48.15 10.56 51.16

Corporate Social Responsibility and Financial Performance 22

A. The four components

To test the second hypothesis to see if the underlying components of CSR are positively related to CFP, a regression analysis is conducted using the fixed effects model. Table 6 shows the results of the analysis, as can be seen in the table, the economic performance, the corporate governance performance, the environmental performance and the social performance are positively related to ROA. The economic performance and the corporate governance performance the only two with a significant effect at the 1% level of significance, with coefficient 0.060 and 0.012 respectively. The control variables have a significantly negative relationship with the dependent variable, at the 1% significant level. Model 1, which includes the economic performance explain 61.06% of the variability in ROA. Model 2, which includes the environmental performance explain 58.27% of the variability in ROA. Model 3, which includes the social performance explain 58.27% of the variability in ROA and model 4, which includes the corporate governance performance explain 58.34% of the variability in ROA. The results are consistent with the results of Russo and Fouts (1997), who found that environmental performance has a positive significant relationship with ROA. According to the results of Wagner (2010), the environmental performance and the social performance has a positive effect on CFP, as measured by Tobin’s Q. These findings are consistent with the results of this thesis, as for both the social performance and the environmental performance a positive relationship with the CFP was found. The corporate governance performance has positive significant relationship with CFP, this result is not consistent with the results of Margolis et al. (2009), who found that their corporate policies variable does not reveal a significant relationship with CFP. As can be seen from the table, the pattern of coefficients on the variables from model 2, model 3 and model 4 change little. Thus, the hypotheses of positive relationships between each components and CFP cannot be rejected.

Corporate Social Responsibility and Financial Performance 23 These different results obtained when all the four components are included in the specification, might be due to multicollinearity problems. As it is explain the correlation section, because the four components are part of the overall CSR score, there is high correlation between the components.

Table 6: The effect of the four components of Corporate Social Responsibility on Corporate Financial Performance as measured by return on assets for European companies from the year 2002 to 2014 This table presents the results for the fixed effects regression models estimating the relationship between the four components of CSR and CFP as measured by return on assets. Model 1 presents the results including the economic performance, model 2 presents the results including the environmental performance, model 3 presents the result including the social performance and model 4 present the results including the corporate governance performance. The equation estimated is CFPit= α + β1ECOit + β2 LEVit+ β3INDit+ β4SIZEit+ εit, the term ECOit is replaced by the

other components: ENVit, SOCIALit and GOVit. The regressions are estimated with 571 firms, 5863 observations in

total the CFP variables ROA was winsorized. Numbers in parenthesis are the standard errors and *, **, *** indicates significance at the 0.10, 0.05 and 0.01 levels, respectively.

Model (1) (2) (3) 4 Constant 41.018*** (2.368) 34.742*** (2.461) 34.841*** (2.447) 36.434*** (2.505) Economic 0.060*** (0.003) Environment 0.002 (0.004) Social 0.004 (0.005) Corp. Gov. 0.012*** (0.004) Firm Size -5.157*** (0.343) -3.637*** (0.361) -3.674*** (0.357) -3.967*** (0.368) Leverage -0.072*** (0.008) -0.096*** (0.008) -0.096*** (0.008) -0.094*** (0.008) R2 adj (%) 61.06 58.27 58.27 58.34 N 5863 5863 5863 5863 B. Causality effect

Corporate Social Responsibility and Financial Performance 24 and Graves (1997) and Nelling and Webb (2008), they found a positive significant between the one-year lagged CSR and CFP, which implies that the previous year level of CSR does contribute a better financial performance. However the results of Nelling and Webb (2008), when using the fixed effects regression model, show that the relationship is in this case negative and not significant. However. Wagner (2020) found that the previous year’s CSR does not result in a better financial performance.

Table 7: The effect of the lagged Corporate Social Responsibility on Corporate Financial Performance as measured by Return on Assets for European companies,2002 to 2014.

This table presents the results for the regressions models estimating the relationship between the one-year lagged CSR and CFP as measured by return on assets. Model 1 presents the results of the pooled OLS, model 2 presents the results with firm fixed effects, model 3 presents the result with year fixed effects and model 4 present the results with both firm and year fixed effects. The equation estimated is CFP= α + β1CSRit-1 + β2LEVit+ β3INDit+ β4SIZEit+ εit. The

regressions are estimated with 568 firms, 5292 observations in total, the CFP variables ROA was winsorized. Numbers in parenthesis are the standard errors and *, **, *** indicates significance at the 0.10, 0.05 and 0.01 levels, respectively.

Model (1) (2) FE (3)TE (4) Both

Constant 36.054*** (0.937) 43.789*** (2.865) 37.646*** (0.782) 44.35*** (3.312) CSR-1 0.016*** (0.004) 0.007 (0.004) 0.022*** (0.003) 0.007 (0.005) Firm Size -4.191*** (0.141) -4.942*** (0.420) -4.380*** (0.118) -5.065*** (0.474) Leverage -0.061*** 0.005 -0.097*** (0.009) -0.053*** (0.005) -0.087*** (0.009) Industry Ind. Effect Yes No No Yes No No No Yes

Year No No Yes Yes

R2

adj (%) 25.36 60.43 25.29 62.58

N 5292 5292 5292 5292

IV. Discussion and Conclusion

Corporate Social Responsibility and Financial Performance 25 capabilities must be rare, valuable, inimitable and non-substitutable to generate sustain competitive advantage. Following this way of reasoning, the first hypothesis is that engaging in CSR creates the resources and capabilities that contribute to a better financial performance. The dependent variables return on assets and return on equity were used as proxies for financial performance, and for the independent variable CSR, the overall CSR score was obtained from the ASSET4 database. The variables leverage, firm size and industry were used as control variables. Companies listed on the Stoxx Europe 600 index, were selected and used in the analysis, this index consist of 600 companies across 18 European countries (Austria, Belgium, Czech Republic, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland and the United Kingdom). Using a sample of 571 European companies with a total of 5863 observations from 2002 to 2014, the results of this study support the theory set out in the literature review section. First, I analyze the relationship using the pooled OLS regression analysis, the coefficient obtained is 0.027. When estimating the model with fixed effects, the results suggest a stronger relationship, the coefficient of the fixed effect model is 0.036. When using the return on equity as dependent variable, the relationship is in this case also significant and positive. The results are consistent with other studies, that CSR has a significant positive relationship with corporate financial performance (Woddock & Graves, 1997). Overall, the results reveal that in European firms for the years 2002 to 2014 there is indeed a positive relationship between the variables CSR and CFP. Although the results of this study show a positive relationship between CSR and CFP, as well as, the results of studies with U.S. firms, there is a slight difference between the coefficients reported by studies conducted with U.S. companies and this study. An explanation is that Europe differ from the U.S. in that it has a different understanding of the concept, Europe has a different culture and different social values. These differences have caused that Europe has different social responsible principles in comparison with the U.S.. Consequently, because Europe will engage in different CSR activities, it will create other resources and capabilities in comparison with the U.S.. These resources and capabilities, when exploit effectively can generate sustain competitive advantage which in turn contributes to a better financial performance.

Corporate Social Responsibility and Financial Performance 26 economic and corporate governance performance are positively significant at 1% level of significance. Lastly, to mitigate the endogeneity problems, the previous year CSR was included in the specification. The results show that the previous year CSR has a positive impact on the financial performance. The slight differences in results for European firms can be explain because of the different social responsible principles each region has. For example the culture differences play an important role in CSR: the role of religion in the society and individualism. In Europe religion is not involved in political economic matters, contrary to the U.S., where religion is not separated from the political economic matters. Another difference between Europe and the U.S. is that U.S. companies view CSR explicitly whereas Europe companies view CSR implicitly. In Europe, the government mandates companies to be socially active and in the U.S., the government has less pressure on the companies (Danko et al., 2008). Thus European companies don’t need to publicly proclaim to be socially responsible. Companies having an implicit commitment to CSR would no act voluntary but as an obligation towards its stakeholders and corporate environment (Danko et al., 2008).

In general, a social responsible firm can create a good brand image and a positive reputation among customers which leads to a higher turnover, social responsible firm can also attract better business partner and qualified personnel that can efficiently and effectively improve business performance, which can result in increased profits. Depending on the industry a firm can avoid paying heavy fines for too much polluting, in turn this help reducing unexpected costs. Another explanation for a positive link between CSR and CFP is that a company can be in competitive disadvantage, when it attempts to reduce its implicit cost by behaving socially irresponsible because this lead to higher explicit costs (Woddock & Graves, 1997). Another source of competitive advantage is that engaging in CSR results in low costs and that the benefits are great. An example for this is that companies being reported in best firms to work for, may attract qualified personnel that can improve a business performance at a low cost or improving the employee’s relations policy can increase productivity and be in competitive advantage in comparison to other firms at a low cost. By increasing sales to socially conscious consumers, and by increasing the volume of sales by charging a higher price per unit can also improve the financial performance.

Corporate Social Responsibility and Financial Performance 27 reward them for being social responsible (Woddock & Graves, 1997). Managers can also engage in CSR as part of a strategy to improve their financial performance (Orlitzky et al., 2003). In summary, CSR and CFP are positively related; however, because of the ‘virtuous circle’ the relationship can be in either way, companies with a good financial performance can invest more in CSR, or investing in CSR leads to a better financial performance.

Limitations and Future research

The shortcoming of this research I only used accounting-based measures, but with other measures, other results may be obtained. For example Orlitzky et al. (2003) found that market-based measures are less correlated with corporate social performance. In addition by adding market-based measures, this can increase the validity of the study. This research does not include the variable company’s rate of investment in R&D. As it is stated in the study of McWilliams and Siegel (2000), R&D have a strong positive impact on firm performance. Thus, excluding this variable from the model can result in biased result. Another limitation is that I could not completely solve the endogeneity problem with the availible data, however I tried to mitigate the endogeneity problem by including an one year lagged CSR value in the spesification.

Corporate Social Responsibility and Financial Performance 28

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Corporate Social Responsibility and Financial Performance 31

Appendix A

Variable Definition Source

Return on Assets (ROA)

(Net Income – Bottom Line + ((Interest Expense on Debt-Interest Capitalized) * (1-Tax Rate))) / Average of Last Year's and Current Year’s Total Assets * 100

DataStream

Return on Equity (ROE)

(Net Income – Bottom Line - Preferred Dividend Requirement) / Average of Last Year's and Current Year’s Common Equity * 100

Total Assets _{TOTAL ASSETS represent the sum of total current assets, long} term receivables, investment in unconsolidated subsidiaries, other investments, net property plant and equipment and other assets.

DataStream

Leverage (Short Term Debt & Current Portion of Long Term Debt + Long Term Debt) / Total Assets * 100

Corporate social responsibility

The Equal Weighted Rating reflects a balanced view of a company's performance in all four areas, economic, environmental, social and corporate governance

Corporate Governance The corporate governance pillar measures a company's systems and processes, which ensure that its board members and executives act in the best interests of its long term shareholders. It reflects a company's capacity, through its use of best management practices, to direct and control its rights and responsibilities through the creation of incentives, as well as checks and balances in order to generate long term shareholder value.

Corporate Social Responsibility and Financial Performance 32 efficient use of all its resources. It is reflection of a company's

overall financial health and its ability to generate long term shareholder value through its use of best management practices. Environmental The environmental pillar measures a company's impact on living and non-living natural systems, including the air, land and water, as well as complete ecosystems. It reflects how well a company uses best management practices to avoid environmental risks and capitalize on environmental opportunities in order to generate long term shareholder value. Social The social pillar measures a company's capacity to generate trust and loyalty with its workforce, customers and society, through its use of best management practices. It is a reflection of the company's reputation and the health of its license to operate, which are key factors in determining its ability to generate long term shareholder value.

Industry Classification Benchmark

Corporate Social Responsibility and Financial Performance 33

Appendix B

List of abbreviations

CSR Corporate Social Responsibility CFP Corporate Financial Performance RBV Resource Based View

Corporate Social Responsibility and Financial Performance 34

Appendix C

Table 8: The effect of the four components of Corporate Social Responsibility on Corporate Financial Performance as measured by return on assets for European companies from the year 2002 to 2014 This table presents the results for the fixed effects regression models estimating the relationship between the four components of CSR and CFP as measured by return on assets. Model 1 presents the results of the pooled OLS, model 2 presents the results with firm fixed effects, model 3 presents the result with year fixed effects and model 4 present the results with both firm and year fixed effects. The equation estimated is CFPit= α + β1ECOit + β2ENVit+ β3SOCIALit

+ β4GOVit + β5LEVit+ β6INDit+ β7SIZEit+ εit. The regressions are estimated with 571 firms, 5863 observations in total

the CFP variables ROA was winsorized. Numbers in parenthesis are the standard errors and *, **, *** indicates significance at the 0.10, 0.05 and 0.01 levels, respectively.

Model (1) (2) FE (3)TE 4 Both Constant 34.102*** (0.906) 39.533*** (2.424) 36.172*** (0.742) 41.931*** (2.819) Economic 0.058*** (0.004) 0.069*** (0.003) 0.061*** (0.004) 0.071*** (0.003) Environment -0.010** (0.005) -0.013*** (0.005) -0.007 (0.005) -0.007 (0.005) Social -0.012** (0.005) -0.026*** (0.005) -0.006 (0.005) -0.027*** (0.005) Corp. Gov. 0.004 (0.003) 0.003 (0.004) -0.003 (0.004) -0.005 (0.005) Firm Size -4.212*** (0.140) -4.665*** (0.3615) -4.414*** (0.113) -5.053*** (0.404) Leverage -0.051*** (0.005) -0.070*** (0.008) -0.044*** (0.005) -0.060*** (0.008) Industry Ind. Effect Yes No No Yes No Yes No Yes

Year No No Yes Yes

R²adj (%) 27.26 61.42 28.26 64.04