Corporate Sustainability & Financial Performance

FACULTY OF ECONOMICS & BUSINESS

DEPARTMENT OF INTERNATIONAL ECONOMICS & BUSINESS

Corporate Sustainability

&

Financial Performance

Master’s Thesis

Student: Kinyoni John Mutebutsi

ID: 1586653

E-mail:

k.j.mutebutsi@student.rug.nl

Corporate Sustainability & Financial Performance 2010

TABLE OF CONTENTS

II. Literature Review ... 9

II.1. Corporate Sustainability Performance (CSP) ... 9

II.1.1. Defining relevant concepts ... 9

II.1.2. Principles of Sustainability ... 11

II.1.3. Sustainability Performance Measurement ... 12

II.2. Corporate Financial Performance (CFP) ... 14

II.2.1. The ‘social responsibility’ of corporate managers ... 14

II.2.2. Measuring Corporate Financial Performance ... 15

II.3. The link between CSP and CFP ... 15

II.4. Previous empirical research on CSP-CFP relationship ... 17

III. Methods and Data ... 20

III.1. Theoretical Model ... 20

III.2. Data Description ... 21

III.3. Variables ... 22

III.3.1. Independent Variables ... 22

III.3.2. Dependent variables ... 23

III.3.3 Control variables ... 24

III.4. Empirical model ... 24

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AKNOWLEDGEMENTS

No man is an island. Many people have contributed, directly or indirectly, into God‟s plan to make me who and what I have become today. I feel a deep sense of gratitude:

To my uncles Ezechiel Bizimana, Etienne Rusamira and Patrick Lutunga: Your love, patience through all we‟ve been through, your wise advices and inspiration have simply made me a different person. Without you I wouldn‟t be who I am today. I am forever grateful to you. To my Mum, brothers, nephews and nieces for your love and care.

To my late brother Tokos, Grandma, and aunt Sifa who have been taken away from us. I hope you are happy where you are now.

To family Mutambo. I can‟t say thanks enough for what you have done for me.

To my sponsor organization, the University Assistance Fund (UAF), I still wonder what could have been my future without your support. To every donor who contributed to make my education dreams a reality, I owe you so much.

To all my brothers and friends who lost their lives in the tragic war in the Democratic Republic of Congo. The world isn‟t the same anymore without you.

To all my friends who made life in Groningen a great fun (please allow me not mention names because the space is too limited to contain you all). You are always in my heart.

To the greatest love of my life and best friend, Darlene Ngabire. You give me all the reasons to keep on.

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ABSTRACT

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I. Introduction

In 1987 the World Commission on Environment and Development‟s report was published under the name Our Common Future1. Since then, corporate interest in the area of Sustainable Development has been rapidly increasing. A great number of companies have started to produce annual sustainability reports to communicate their progress.

The Brundtland Report highlighted three fundamental components of sustainable development, namely environmental protection, economic growth, and social equity2. Based on these three components, sustainability has thus been defined as “the development that

meets the needs of the present without compromising the ability of future generations to meet their own needs.” (Our Common Future, 1987)3. This definition contains two key concepts. First, the concept of needs which particularly refers to the needs of the world‟s poor which, as the report points out, should be given overriding priority. Second is the fact that the state of technology and social organization impose limitations on the environment‟s ability to meet present and future needs.

The concept of sustainability can be better understood in the context of corporate social responsibility (Epstein, 2008). Indeed, as White (2000) points out, although the original definition of “meeting the needs of the present without compromising the ability of future generations to meet their own needs” expressed well the concept, it “proved difficult to operationalise, and has failed to communicate effectively with the public at large.” He argues further that, “Recent sustainability discussions on trade, investments and governance demonstrate the need to integrate economic growth and social equity together with environmental protection to approach sustainable development.” (p.17). What White is suggesting here is that, although these two components (social equity and economic growth) are stated in the Brundtland Report, many still tend to think of sustainability as dealing with environmental issues alone.

1 _{This report is also known as Brundtland Commission Report or simply Brundtland Report.} 2

Also known as Triple Bottom Line or the 3 P’s of our Bottom Line: People, Planet, and Profit.

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As stated above, sustainability can be well understood when it is integrated into corporate operations. In order to achieve that purpose, Epstein (2008) breaks the concept of sustainability into nine principles, namely: Ethics, Governance, Transparency, Business relationships, Financial return, Community involvement/economic development, Value of products and services, Employment practices, and Protection of the environment.

The challenge to businesses today is how to integrate these principles into their day-to-day operations without losing money. It has been long argued that investments to enhance corporate social responsibility (CSR) and protect the natural environment were lost money since they provided few, if any, financial benefits to firms. However, in recent decades, a growing number of scholars tend to reverse that belief and contend, instead, that there are cases where going beyond just compliance with social and environmental regulations is a win-win situation for both the society and the firm. For instance, Koellner et al. (2005) show that the supply of mutual funds in the “green” investment sector has increased considerably. In the same study they point out that there are currently about 300 mutual funds in Europe alone that are managed according to sustainability and social responsibility criteria. In the same line of argument, Reinhardt (1999) argues that there are cases where, by internalizing costs (in situations of environmental externalities), firms may increase their shareholders‟ expected value by providing environmental public goods. He finds that a considerable number of firms in Europe and North-America assert to go “beyond-compliance” with environmental policies. Wood & Jones (1995) maintain that firm do well (financially) by doing good (socially).

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have reported a positive relationship. Seven years previous to that, Pava & Krausz (1996) examined 21 empirical papers and found that 12 of them reported a positive CSP-CFP relationship. They further assert that, “Nearly all empirical studies to date have concluded that firms which are perceived as having met social-responsibility criteria have outperformed or performed as well as other firms which are not (necessarily) socially-responsible.”(p.322) The reason of such differences in findings has mainly been attributed to the lack of well established and proper financial and social performance measures (Wood & Jones, 1995). What appears to be a major problem, however, is the fact that almost all the previous empirical studies assumed a linear relationship between a firm‟s financial and social performance and, consequently, linear regression models were used.

This research is, therefore, an attempt to provide what we think is a better analysis of the relationship between corporate financial and sustainability performance by using a nonlinear model in our empirical analysis. To that end, the questions addressed by this research are:

First, can a firm improve its financial performance by improving its sustainability (social and environmental) performance? Second, to what extent can a firm benefit (or be negatively affected) from engaging in corporate sustainability activities?

The added value of this research is twofold. First, we expect our findings to contribute to the validation of the CSP-CFP relationship found in previous studies. Second, they provide support to managers and stakeholders in their efforts to efficiently invest in practices that meet a sustainable development.

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II. Literature Review

II.1. Corporate Sustainability Performance (CSP)

II.1.1. Defining relevant concepts

Over the recent years of research in this field, the concepts of corporate social responsibility (CSR) and corporate sustainability have become closely intertwined (Sijtsma, 2006). After years of research on CSR, finding a consensus on its precise definition has not been an easy task. Some economists have argued that as long as corporations abide by the law they are by definition socially-responsible (Pava & Krausz, 1996). Others have gone further to suggest that CSR actually begins where the law ends; that is, socially-responsible firms take a step further to accept social obligations beyond what is required by the law (Davis, 1973). One early definition which many have seemed to adopt is that proposed by Donna Wood (1991). According to Wood, corporate social performance (CSP)4, as she calls it, is “a business

organization’s configuration of principles of social responsibility, processes of social responsiveness, and policies, programs, and observable outcomes as they relate to the firm’s societal relationships.” (p.693). Even though this definition is not fully complete itself, it has

nevertheless become an important stepping stone for understanding CSP (Ruf et al. (2001). As previously stated, since the 1990s CSP and sustainability have been increasingly linked, and this can be best shown by previously mentioned Triple P‟s or Triple Bottom Line5

. In other words the link between the two concepts is based on people, planet and profit (Elkington, 1997; WBCSD, 2000 [also quoted in Sijtsma, 2006]). The combination of corporate social performance and corporate sustainability will thereafter be called corporate sustainability performance (CSP)6.

4

CSR and CSP mean the same thing in this context and can be used interchangeably.

5 _{See note 2 in the introduction.} 6

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However, although linking both terms is tolerated in many cases, including in this study, probably due to the ambiguity still surrounding their definitions, sustainability does not necessarily mean social responsibility. McElroy (2008) suggests the following difference: “To be responsible is to embrace a particular strategy, or means, for achieving sustainability

as an end. We embrace responsibility not only because we believe it is the right thing to do,

but also because we believe that not doing it is self-defeating. To be irresponsible is to undermine our own well-being, and that, in the plainest sense of term, is unsustainable.” (p.11, italics added).

Another confusion which is often made is that of using sustainability and sustainable development as meaning the same thing. As it has just been pointed out, sustainability is an end while sustainable development is a process towards that end. McElroy (2008) suggests further that, “There is agreement that sustainability implies that certain indicators of welfare or development are non-declining over the very long term; that is, development is sustained. Sustainable development is a process of change in an economy that does not violate such a sustainability criterion.” (p.12, [quoting Pezzey, 1989]). From the above discussion, the three concepts should then be understood as follows: Sustainable development is a process, while social responsibility is a strategy to make that process work towards sustainability. Perhaps the following definitions will help make the above discussion clearer.

“For the business enterprise, sustainable development means adopting business strategies and activities that meet the needs of the enterprise and its stakeholders today while protecting, sustaining and enhancing the human and natural resources that will be needed in the future.” (International Institute for Sustainable Development [IISD] et al., 1992, p.1).

“Sustainability is an economic state where the demands placed upon the environment by people and commerce can be met without reducing the capacity of the environment to provide for future generations.” (Hawken, 1993, p.139).

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environmental project, with the very positive objective of optimizing human well-being.” (Porrit, 2005, pp.21-22).7

Following this, it is then argued that the Brundtland definition of “the development that meets the needs of the present without compromising the ability of future generations to meet their own needs” is a definition of sustainable development and not of sustainability (McElroy, 2008, p.14).

II.1.2. Principles of Sustainability

In order to have a better understanding of sustainability, Mark J. Epstein (2008) breaks the concept down into nine principles. This section discusses each of them briefly.

i) Ethics: This principle refers to the fact that firms “establish, promote, and maintain fair and

honest standards and practices in dealing with all of the company stakeholders and encourage the same from all other stakeholders, including business partners, distributors, and suppliers.” In order to do so, particular emphasis should be placed on human rights and diversity in such a way that ensures that all employees are treated fairly.

ii) Governance: This principle relates to how a firm‟s management is committed to manage

all resources “conscientiously and effectively”. In this way corporate boards and managers recognize their duty which is to focus on the interests of all firm stakeholders. In following practices of fair process and seeking to enhance both financial and human capital, the firm ensures that interests of all stakeholders are well balanced.

iii) Transparency: While governance relates to internal management issues, the transparency

principle refers to the fact that a firm should disclose information to its stakeholders. Recognizing the need of being accountable to both internal and external stakeholders, a transparent company provides full information to its existing and potential investors and lenders about its past, present and future financial performance.

iv) Business relationships: Good business relationships mean that companies should engage

in fair-trading practices with suppliers, distributors, and partners. In doing so, firms build

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long-term and stable relationships with their partners “in return for quality, performance, and competitiveness.”

v) Financial return: This principle relates to the fact that the firm “compensates providers of

capital with competitive return on investment and the protection of firm assets.”

vi) Community involvement/economic development: Recognizing that it is in best long-term

interest of both the firm and the community, the firm engages in practices that improve the community where it operates. In doing so, the firm plays a proactive and cooperative role in “making the community a better place to live and conduct a business.”

vii) Value of product and services: This principle requires the company to respect the needs,

desires, and rights of its customers and, thus, to ensure that it provides the highest levels of products and service values. Meeting this principle signals a firm‟s strong commitment to integrity, customer satisfaction, and safety.

viii) Employee practices: This principle refers to the fact a company engages in

human-resource management practices that ensure that personal and professional employee development, diversity, and empowerment are promoted.

ix) Protection of environment: This principle requires that companies strive to ensure that

environment is protected and restored, and that sustainable development with products, processes, services, and other activities, is promoted. 8

II.1.3. Sustainability Performance Measurement

One of the greatest challenges of corporations is how to measure sustainability performance. However, as Epstein (2008) argues, to know if sustainability strategies are successful, measuring them is critical to corporations. In their paper on environmental management, Berry and Rondinelli (1998) urge corporations to “live by the rule that what gets measured gets done.” (p.47).

Different CSP measurement methods exist. While some studies use a one-dimensional CSP measures such as charitable contributions to different causes (e.g. Levy & Shatto, 1980); compliance with air pollution regulation (e.g. Marcus & Goodman, 1986); voluntary product

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recall announcements (e.g. Davidson & Worrel, 1992), other studies use an aggregate measure or index of different CSP indicators. The two mostly used are the aggregate measures from the use of Fortune ratings data or indices from KLD provided social attributes (Callan & Thomas, 2009).

Other techniques exist, including the multicriteria analysis (MCA). Because of its growing importance, this method is briefly discussed here, although it is not used in our empirical study. Multicriteria analysis (MCA) is defined as “a range of evaluation techniques that tries to help decision-makers in situations when judgement depends on more than one criterion. MCA can be seen as the judgement-oriented alternative to cost-benefit analysis (CBA).” (Sijtsma, 2006, p.91 [quoted Howarth et al.2001; Merkhofer, 1987]). Seven stages of MCA have been identified (Edwards & Newman, 1982). In stage one, objects and functions of the evaluation are identified. Stage two deals with identification of stakeholders (groups that have an interest or stake in the project). In stage three, value dimensions/attributes are elicited. Stage four addresses the relative importance of value dimensions/attributes, while stage five estimates scores of alternatives on low level dimensions. In stage six, scores with relative weights are aggregated, whereas in the final stage (stage seven), sensitivity analyses are performed.9

As already pointed out, CSP measures proposed by Kinder, Lyndenberg, and Domini (known as KLD) Research Analytics, Inc. are among the mostly used measures in recent studies. These fall into two main categories. First, there are seven so-called Qualitative Issue Areas: Community, Corporate Governance, Diversity, Employee Relations, Environment, Human Rights, and Product. Second, there are six negative screens or so-called Controversial Business Issues: Alcohol, Gambling, Tobacco, Firearms, Military, and Nuclear Power. For example, in the case of Community, qualitative screens include actions such as generous giving, innovative giving, support for housing, support for education, etc. while negative or concern issues involve actions such as investment controversies, negative economic impact, indigenous people‟s relations, and other similar concerns. In the case of Employee Relations, qualitative screens comprise strong union relations, employee involvement, strong retirement benefits, cash profit sharing, and so on, while negative screens or concern issues include poor

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union relations, safety controversies, pension/benefit concerns. Another example in this category is the Product. In this case the qualitative or positive screens include product quality, R&D/innovation, and benefits to economically disadvantaged people; the concern issues include product safety, contracting controversies, antitrust and other related concerns. In the case Controversial Business Issues, an example is Firearms. The main issue concern in this situation is when a company is involved in the production of arms such pistols, rifles, shotguns, or sub-machine guns. (For a detailed description of these CSP measures, see KLD Research & Analytics, Inc., 2006).

Depending on data availability (or constraints), studies in the field of CSP use at least one of above (or related) discussed measures. We use the KLD measures in the present research. This is done for two reasons. First, because of data constraints we could not use other measures in this study. Second, and more important, because KLD measures are closely related to the principles of sustainability mentioned above.

II.2. Corporate Financial Performance (CFP)

II.2.1. The ‘social responsibility’ of corporate managers

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Despite these extreme views of business corporations, a considerable amount of studies suggest that there is a positive link between CSP and CFP. This is discussed in details in section II.2.3. Before that we briefly discuss how CFP is measured.

II.2.2. Measuring Corporate Financial Performance

There are various measures of corporate financial performance. These include, among others, economic value added (EVA), return on investment (ROI), and return on capital employed (ROCE).10However, some of the most extensively used measures are the accounting measures including return on assets (ROA), return on sales (ROS), and return on equity (ROE). Although these measures are extensively used in empirical studies, researchers mostly prefer to use only a subset of them (Callan & Thomas, 2009). For instance, Graves & Waddock (1997), Marcus & Goodman (1986) use only ROE and ROA; Hart & Ahujah (1996), Graves & Waddock (2000), Griffin & Mahon (1997) use all three measures, whereas other studies use only one of them ((e.g. Turban & Greening (1997) and Kedia & Kuntz (1981) use ROA whereas Bowman & Haire (1975) and Spicer (1978) use ROE.

II.3. The link between CSP and CFP

Does it really pay for firms to “go green”? Can firms possibly serve business interests of their shareholders while at the same time they are compelled to spend more and more resources to meet the increasing societal interests of their stakeholders? It requires considerable management efforts and financial resources for firms to jointly serve these two objectives. Various arguments are made regarding this the CSP-CFP relationship. One view is that firms face a trade-off between social responsibility and financial performance. Proponents of this view argue that firms incur costs from engaging in socially responsible actions that put them at an economic disadvantage compared to the less responsible firms (Auperle et al., 1985; Ullman, 1985; Vance, 1975; Friedman, 1970). These are costs, as this class of scholars contends, that should be borne not by firms, but by individuals or government. A contrasting viewpoint is that firms may benefit from socially responsible actions as a result of increased

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employee morale and productivity. Compared to the benefits, proponents of this view maintain that the explicit costs of engaging in socially responsible actions are minimal (Parket & Eibert, 1985; Soloman & Hansen, 1985).

There is always an incentive for profit-maximizing firms to go for short-time profits and neglect to take into account social and environmental issues in their business operations. Continually doing so, however, is perilous for those firms. Speaking of such incentives, Welford (1998) puts it this way: “Environmental legislation is increasingly plugging the gaps which allow this to happen and firms attempting to hide their illegal pollution are now subject to severe penalties. Even before such legislation comes into force, however, businesses should recognize that it is not only ethical to be environmentally friendly, but with the growing consumer awareness in the environmental area, it will also be good business.” (p.5) Welford is not the only one who argues for the business case of sustainability. López and Toman (2006) assert that, “Modern growth theory shows not only that environmental sustainability is potentially compatible with positive economic growth but also, and perhaps more importantly, that failure to achieve environmental sustainability may become an obstacle to sustained economic growth.” (p.3).

For companies, the ultimate focus of sustainability strategies and programs must be long-term corporate financial performance. The impact of organizational performance can be effectively captured by converting the outputs of sustainability processes into monetary measures. “The impacts of sustainability actions should include present and future benefits and costs, represented through additional revenues to the organization or a reduction in costs (Epstein, 2008, p.55).

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Reputation. A good firm‟s reputation, i) improves corporate image which in turn generates

public goodwill, ii) enhances brand image which attracts and retain customers, iii) improves relations with regulators and other stakeholders which consequently reduces the risk of consumer boycotts and adverse publicity, and allows a better access to capital.

Operations. Benefits associated to sustainable company‟s operations include: i) improved

ability to attract, retain, and motivate employees, ii) Strengthened supplier relationships, iii) Reduced costs through improved productivity and efficiency, lower energy consumption, less packaging, reduced waste disposal, etc., iv) Secured company‟s licence to operate, v) Improved risk assessment and management.

Investment opportunities. In terms of investment opportunities, corporate sustainability

performance benefits include, i) improved investor relations contributing to stability and higher stock prices, ii) more business partners attraction and more capital availability.

II.4. Previous empirical research on CSP-CFP relationship

To test the validity of the above theoretical arguments, a significant amount of research has been conducted over the past three decades or so. A greater number of studies reports a positive relationship between corporate sustainability performance and corporate financial performance (see, for instance, Ruf et al., 2001; Orlitzky et al., 2003; Pava & Krausz, 1996; Waddock & Graves, 1997; Callan & Thomas, 2009; Dam et al., 2009).

An excellent review of the literature on CSP-CFP relationship is provided by Margolis & Walsh (2003) and Orlitzky et al. (2003). Out of the 127 studies published between 1972 and 2000 and reviewed by Margolis and Walsh (2003), 109 used CSP as an independent variable predicting CFP. In these studies, 54 founded a positive relationship between CSP and CFP; 28 reported a non-significant relationship, whereas 20 provided a mixed set of findings. Only seven studies reported a negative CSP-CFP relationship.

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advance the objective for which it is considered to be best suited, maximizing wealth. Although it can be argued that a company‟s resources might be used to produce even more wealth, were they devoted to some activity other than CSP, studies of the link between CSP and CFP reveal little evidence that CSP destroys value, injures shareholders in a significant way, or damages the wealth-creating capacity of firms.” (p.278). These studies‟ conclusions confirm an earlier review of the CSP-CFP literature by Pava & Krausz (1996). From the 21 studies reviewed then, 12 reported a positive CSP-CFP relationship; 8 reported no measurable association, while only 1 study reported a negative relationship.

Following the above discussion, we argue that benefits from CSP outweigh the costs, and therefore posit that:

Hypothesis 1: Corporate sustainability performance (CSP) is positively related to corporate

financial performance (CFP).

However, the present study differs from the previous ones in that most of them use a linear model to test the CSP-CFP relationship. In their recent study, Callan & Thomas (2009) point out this limitation but do not really correct it. They only apply the non-linear relationship on control variables and leave the main independent variable (CSP) unchanged ((see equations (4) and (6) on pp.67-68)).

The problem with the linear model is that it assumes an „indefinite‟ positive relationship between CSP and CFP which, in other words, means that the more a firm invests in CSP practices the more its profits will increase (indefinitely). This is a serious limitation and it demands for corrections. One should expect, instead, decreasing returns to scale as a firm invests (inefficiently) more in CSP activities. Therefore, the role of corporate managers should be to find a good balance between satisfying both stockholders‟ claims and other stakeholders‟ claims. Corporate financial performance depends on how the firm efficiently balances these claims (Jones, 1995; Freeman & Evan, 1990; Hill and Jones 1992). Using the previously mentioned techniques (cost-benefit analysis (CBA) and multicriteria analysis (MCA)), may be helpful for corporate managers to achieve that goal.

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concerns up to a certain point but decline thereafter, as the firm becomes “too responsible” to the point that the marginal costs dominate marginal benefits. This, they suggest, “requires the firm to balance the marginal benefits and costs. Theory and estimated parameters lead us to expect that profit efficiency increases (decreases) with more CSR strengths (concerns), but it decreases (increases) when pursued „excessively‟ by the firm.”(p.18).

From the above arguments, we therefore predict that:

Hypothesis 2: The positive relationship between CSP and CFP is expected to increase, but at

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III. Methods and Data

III.1. Theoretical Model

The objective of this research is to examine whether a positive relationship between CSP and CFP exits, as the majority of existing studies today suggest. As it has been previously argued, firms do well by doing good. Scholtens and Dam (2007) assert that, far from being merely window dressing, firms indeed benefit from adopting a responsible conduct. Benefits that come with such responsible conduct include a better reputation, larger consumer base access, the ability to charge a premium on a firm‟s products and services, and the potential to attract and retain high quality employees.

Opponents of this view, as argued previously, contend that a firm‟s responsibility is to make profit for its stockholders, not to engage in social practices which are, or should be, the government‟s responsibility. Therefore, according to this view, allocating resources into socially and environmentally related practices simply increases firms‟ costs and consequently work against the corporate objective of profit-maximization (Friedman, 1970).

As our hypotheses suggest, however, this research lends support to the view that factors supporting the CSP-CFP positive relationship (as discussed in section II) are stronger than those supporting Friedman‟s and his followers‟ view. This relationship is formalized in the following function:

CFPi= f (CSPi, X) (I)

in which,

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III.2. Data Description

All the data used in this study were obtained from KLD Research & Analytics, Inc. in the year 2002. In the 1990s this database covered the S&P500 Index and the Domini 400 Social Index. From 2001 to the present, it has been extended to include all firms in the Russell 3000. Except those firms that are members of S&P500 Index, all firms covered in this database are only US-firms. In this research, only data on firms listed on S&P500 Index were available for our analysis.

KLD uses multiple criteria to evaluate firms‟ practices. Comprised in this dataset are 80 CSR indicators which fall in two broad categories defined as: (1) Seven Positive Screens or the so-called Qualitative Issue Areas: Community Involvement, Corporate Governance, Diversity, Employee Relations, Environment, Human Rights, and Product; and (2) Six Negative Screens or the so-called Controversial Business Issues: Alcohol, Gambling, Tobacco, Firearms, Military, and Nuclear Power (KLD Research & Analytics, Inc., 2006). Community Involvement refers to corporate response to the community by donations, contribution to the economically disadvantaged and support of job training. Corporate Governance deals with how the firm is managed and directed. Diversity relates to the composition of the firm‟s workforce (e.g. the proportion of women, Blacks or Hispanics in the firm‟s top management team). Employee Relations refer to how relationships between the firm and its employees (e.g. how issues regarding employee compensation are dealt with, policies of no layoff plan). Environment refers to how good is the firm‟s environmental management and policies (e.g. use of products or services that minimize environmental damage or are environmentally safe. Human Rights relates to how the firm takes the rights of its various stakeholders when dealing with each of them. Product refers to strengths or concerns related to the firm‟s products. With respect to all the seven areas, KLD evaluate both strengths and concerns.

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screens, namely because they only focus on concerns, some studies have left them out of the analysis (Dam et al. 2009; Callan & Thomas, 2009).

Many scholars point out that KLD ratings are among the oldest and suggest that they are the most influential and are the most analysed by academics. The validity of KLD ratings have been discussed by scholars like Sharfman (1996) who concluded that KLD ratings sufficiently correlate with other measures of CSP. He suggests that, “researchers interested in studying corporate social performance can have confidence in the KLD measures and feel secure in the idea that this new data does tap into the core of the social performance construct.” (p.295 [also quoted in Dam et al., 2009]). Other studies that used KLD data include Graves & Waddock (1994, 2000), Hillman & Keim (2001), Waddock (2003). Woddock also concludes that KLD data can be regarded as “...the de facto research standard at the moment.”[also quoted in Dam et al., 2009, p.11].

III.3. Variables

III.3.1. Independent Variables

To simplify our empirical estimation, three different measures of CSP and their squares were created from averaging the seven positive screens and negative screens. These are defined as:

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is little support for the assumption that the groups surveyed to derive the weights are true experts in CSR (Kennelly, 2000). Because of these criticisms we do not use this method in our study, although it seemed appealing in the first place.

III.3.2. Dependent variables

To be sure of our results, three measures of CFP are used in our regressions: return on assets (ROA), return on equity (ROE), and return on sales (ROS).

ROA is widely used by market analysts as a measure of firm performance. It specifically measures the efficiency of a firm‟s assets in producing profit. It is obtained by the following formula:

ROA = [(Income Before Extraordinary Items + Interest Expense) x (1-Tax rate)]/(Average Total Assets)11.

ROE is used to measure firm performance relative to shareholder investment. It is obtained by the following formula:

ROE = Earnings Before Taxes/Total Stockholders‟ Equity. This measure was used, for instance, by Ruf et al.(2001).

ROS is used by market analysts as a measure of firm profitability. It is defined as: ROS = Net Income Before Taxes/Sales (see Ruf et al., 2001, p. 149).

Although these CFP measures are not the only measures used, they are, as pointed out in a previous discussion, some of the most extensively used in the CSP-CFP empirical studies. For instance, a close look at the previously mentioned studies reviewed by Orlitzky et al.(2003) shows that, out of the 52 studies reviewed, more than half of the studies (27) use at least one of the three as a measure of CFP. A similar trend appears in the review by Margolis & Walsh (2003), where more than 65 of the 127 studies reviewed use accounting measures including at least one the above CFP measures.

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III.3.3 Control variables

Control variables included in the X vector, as described in function (I), are those related to firm size; that is, total assets, number of employees and total sales.

Including firm size as a control variable follows in the line of what previous studies have done (see King & Lenox, 2001; Callan & Thomas, 2009; Waddock & Graves, 1997; Hillman & Keim, 2001; Ruf et al., 2001). Including total assets, sales and number of employees as measures of firm size follows the study by Ruf et al. (2001). As Hillman & Keim (2001) argue, size matters because it “...may be related to the urgency and salience of stakeholder relations.”[also quoted in Callan & Thomas, 2009, p.67].

Following the above discussion, our model can be extended as follows:

CFPi=f(CSPi, Sizei) (II)

III.4. Empirical model

To test the CSP-CFP relationships, the following models are used. First, using the variables CSP-1 and its square CSP-12 as a measure of CSP in a non-linear relationship, the following model is estimated12:

CFP = 0 + 1CSP-1 + 2CSP-12 + 3lnTOTALSALES + 4lnTOTALSALES2

+ 5lnTOTALASSETS + 6lnTOTALASSETS2 + 7lnEMPL + 8lnEMPL2 + 1 (1)

Similarly, using CSP-2 measures and testing for nonlinearity results in the following model specification:

CFP = 0 + 1CSP-2 + 2CSP-22 + 3lnTOTALSALES + 4 lnTOTALSALES2

+ 5lnTOTALASSETS + 6lnTOTALASSETS2 + 7lnEMPL + 8lnEMPL2 + 2 (2)

And finally, using the average (positive and negative screens) CSP measure results in the following estimation model:

12

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CFP = 0 + 1CSP + 2CSP2 + 3lnTOTALSALES + 4lnTOTALSALES2

+ 5lnTOTALASSETS + 6ln TOTALASSETS2 + 7lnEMPL + 8 EMPL2 + 4 (3)

III.5. Empirical Results and Analysis

In Table 1 descriptive statistics for the variables used are presented. After checking and eliminating observations with a lot of missing values, a sample of 456 firms is retained.13 Despite the handicap due to the limited amount of data14, the overall results support those found by previous studies. That is, a positive relationship between CSP and CFP is found. Each of the models was estimated three times, using different dependent variables; that is, ROA, ROE, and ROS. Results from the regression analyses are presented in Tables 3, 4, and 5. In all cases, each model is estimated using the ordinary least square (OLS) method. Overall, findings are consistent with our expectations. Although in some cases results are not statistically very significant, still we note a positive relationship between CSP and CFP in all three models.15

A review of the results from Table 2 leads to a couple of notable observations. First, in model (1), where ROA is used as the dependent variable, results show that a positive relationship between CSP-1 and CFP exits. This means that a firm‟s ROA increases with CSP-1; that is, a firm‟s investment in CSP activities is associated with an in increase in the firm‟s returns on assets. However, and consistent with our second hypothesis, the positive relationship is reversed when CSP-1 is squared, which suggests that firms should be socially and environmentally responsible, but not “too responsible” to the point that costs of doing so outweigh benefits from engaging in CSP activities (see Dam et al., 2009).

13

In some models less than this number was reduced due to few missing values.

14

Cross-sectional data are used in this study. Initially we hoped to be able to collect panel data. However, due to the fact that it is very expensive for students to access this kind of data we could not afford to do that.

15

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Second, model (2) specifications report interesting results. Contrary to what should be expected, a positive and even statistically significant relationship between CSP-2 and CFP is found. This means that non-responsible firms actually gain more than responsible firms in terms of returns on assets. There are two possible explanations to this. The first one is that it is possible for firms to hide their irresponsible behaviour, at least in the short to medium term.

Table 1: Descriptive Statistics

Variable N Mean Std. Dev. Min Max

Return on Assets 456 0.0175 0.2067 -2.9331 0.458 Return on Equity 455 0.0788 1.4615 -24.9877 7.0997 Return on Sales 447 0.0553 0.2158 -2.8529 0.8575 CSP-1 457 2.6915 2.4618 0 13 CSP-12 457 13.2910 22.9041 0 169 CSP-2 457 -29912 2.5105 -14 0 CSP-22 457 15.2363 25.5360 0 196 CSP 457 -0.1685 2.8905 -10 8 CSP2 457 8.3654 13.2858 0 100

Log Total Sales 457 15.5652 1.1979 10.6027 19.1991

Log Total Sales2 457 243.7089 37.3094 112.4176 368.6048 Log Total Assets 457 16.0856 1.3883 13.3547 20.8160 Log Total Assets2 457 260.6711 45.6169 178.3492 433.3066

Log # Employees 456 9.8986 1.3287 4.0604 14.1398

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Table 2: Regression Estimates – Dependent variable ROA

Independent variables Model 1 2 3

CSP-1 0.0065 (0.0098) CSP-12 -0.0008 (0.0010) CSP-2 0.3676*** (0.0102) CSP-22 0.0029*** (0.0010) CSP 0.0046 (0.0033) CSP2 -0.0001 (0.0007) Control variables Total sales 0.9671*** (0.2002) 0.9802*** (0.2070) 0.9427*** (0.2002) Total sales2 -0.0286*** (0.0064) -0.0291*** (0.0067) -0.0278*** (0.0064) Total assets -0.4885*** (0.1450) -0.4213*** (0.1436) -0.4558*** (0.1457) Total assets2 0.0136*** (0.0043) 0.0118*** (0.0043) 0.0126*** (0.0044) Number of employees -0.1895** (0.0879) -0.2073** (0.0877) -0.1855** (0.0878) Number of employees2 0.0089** (0.0045) 0.0101** (0.0046) 0.0087* (0.0046) Intercept -2.7824** (1.2512) -3.3328*** (1.2653) -2.8758** (1.2225) N 455 455 455 R2 0.095 0.121 0.098 NOTES:

Standard errors are given in parentheses.

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Table 3: Regression Estimates – Dependent variable ROE

Independent variables Model 1 2 3

CSP-1 0.0814 (0.0606) CSP-12 -0.0049 (0.0065) CSP-2 0.0463 (0.0635) CSP-22 0.0051 (0.0062) CSP 0.0247 (0.0203) CSP2 0.0030 (0.0045) Control variables Total sales -7.4602*** (1.2297) -7.2621*** (1.2936) -7.6183*** (1.2334) Total sales2 0.2223*** (0.0394) 0.2160*** (0.0417) 0.2277*** (0.0395) Total assets 1.0946 (0.8910) 1.0328 (0.8970) 1.0997 (0.8981) Total assets2 -0.0303 (0.0267) -0.0277 (0.0268) -0.0300 (0.0269) Number of Employees 6.3871*** (0.5401) 6.2797*** (0.5482) 6.3626*** (0.5413) Number of Employees2 -0.3014*** (0.0280) -0.2956*** (0.0285) -0.3000*** (0.0281) Intercept 19.0034** (7.6856) 18.4798** (7.9044) 20.2155*** (7.5324) N 454 454 454 R2 0.317 0.315 0.313 NOTES:

Standard errors are given in parentheses.

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Table 4: Regression Estimates – Dependent variable ROS

Independent variables Model 1 2 3

CSP-1 0.0018 (0.0045) CSP-12 -0.0001 (0.0001) CSP-2 0.0388*** (0.0106) CSP-22 0.0031*** (0.0010) CSP 0.0061* (0.0035) CSP2 0.0002 (0.0008) Control variables Total sales 1.0714*** (0.2064) 1.0603*** (0.2150) 1.0173*** (0.2072) Total sales2 -0.0315*** (0.0066) -0.0313*** (0.0069) -0.0298*** (0.0066) Total assets -0.5860*** (0.1515) -0.5247*** (0.1494) -0.5588*** (0.1515) Total assets2 0.0161*** (0.0045) 0.0145*** (0.0045) 0.0153*** (0.0045) Number of Employees -0.2247** (0.0908) -0.2342*** (0.0908) -0.2136** (0.0907) Number of Employees2 0.0108** (0.0047) 0.0114** (0.0047) 0.0101** (0.0047) Intercept -2.5502** (1.2897) -2.9223** (1.3164) -2.4170* (1.2701) N 456 456 456 R2 0.115 0.142 0.121 NOTES:

Standard errors are given in parentheses.

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In this way, obviously, as they do not incur costs related to CSP related activities, it makes sense that their returns on assets increase more than that of more responsible firms. Firms who engage in this kind of behaviour, however, do so at their own great peril, as the famous case of ENRON has shown. A second explanation is related to the fact that we use cross-sectional data in this analysis, which makes it difficult to capture all the effects of a firm‟s concerns (negative screens) on its financial performance in the short run.

Finally, findings from model (3) estimations and where the overall CSP (aggregate measure of CSP-1 and CSP-2) is used as dependent variable are consistent with our first hypothesis. There is a positive (although not statistically significant) CSP-CFP relationship. Moreover, as the second hypothesis suggests, when CSP is squared the direction of the relationship is reversed, suggesting that firm‟s ROA increases with CSP but at a decreasing rate.

In Table 3, where ROE is used as dependent variable, similar results are reported, although with few notable exceptions. First, as it can be observed from model (3) estimates, CSP is positively related to CFP, even when CSP is squared. Note that there is even a negative relationship with total sales. This, however, should not come as a surprise. Previous studies have found that effects of CSP on ROE take a longer period to appear than CSP‟s effects on other variables (see Waddock & Grave, 1997; Callan & Thomas, 2009; Hart & Ahuja, 1996). For instance, Hart and Ahuja (1996) point out that the lag between a firm‟s environmental performance and its effects on ROE is longer than that of ROA and ROS. This argument is also supported by Ruf et al. (2001) who did not find a positive CSP-CFP relationship until year 3 in their ROE model; therefore suggesting that effects of socially responsible decisions on a firm‟s ROE may appear with a significant lag.

Second, the relationship between CSP-2 and CFP remains positive but not significant anymore.

Third, all the coefficients are greater in value than in other cases (where ROA and ROS are used as dependent variables) and R2 is the highest. This suggests that models using ROE as a dependent variable, at least in this study, fit the data better than those using ROA and ROS.

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model (3) and that, as in the ROE models, its quadratic form does not reverse the direction of the relationship. The similarity between ROA and ROS is not new. It is also found in the study by Callan & Thomas (2009).

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IV. Discussion and limitations

This study aimed at examining whether there is, as a considerable amount of previous studies point out, a positive relationship between corporate sustainability performance and a firm‟s subsequent financial performance. We postulated that firms that improve their social and environmental performance experience a better financial performance with respect to some of to the most analysed financial measures, thus outperforming their non-socially and environmentally responsible competitors. Furthermore, we argued that linear models are subject to certain limitations as CSP-CFP relationship is not always a one-to-one linear relationship; which means that the concept of decreasing returns to scale should be taken into account.

From the results above, a couple of important observations emerge. First, we note that improvements in CSP have immediate financial impacts. That is, as a firm improves its social and environmental practices, it follows that that the firm‟s financial performance, as measured by return on assets (ROA), improves in the same year. This is proved by the positive relationship observed between CSP and CFP when ROA is used a measure of financial performance. This finding is supported by Ruf et al. (2001) who affirm that “companies achieve a competitive advantage when improving CSP even if it only for a short time period.” (p.151).

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medium period, perhaps ROS is a better measure, while ROE appears to be the slowest to show effects of CSP on CFP.

That being said, it is important to point out a number of limitations of this study. First, this study suffers from lack of access to more data on CSP. Access to the few currently existing databases is far expensive for students. (The university should make it easy for students to access these data by making them available on the university‟s accessible databases.) Further, companies should reveal the real numbers, not just words. What appears today is that almost every firm provides a yearly sustainability report. However, when one looks for the real numbers (for instance, how much they spend on reducing CO2 emissions or on improving the community where they operate), these are not readily available. Firms‟ managers should remember that Economists are not very much interested in mere words; facts speak louder than just nice texts.

Second, the findings of this study are limited to the year investigated; that is, 2002, the only year for which we could obtain data. Consequently, the CFP-CSP relationships we found may not be consistent with other time periods. Furthermore, as the use of ROS and ROE as financial measures has demonstrated, using cross-sectional data in this type of analysis does not go without serious flaws. Once the first limitation is removed (i.e., access to data made easier) our recommendation would be to always use panel data to test the CFP-CSP relationships.

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V. Implications and Concluding remarks

It pays to invest in socially and environmentally responsible practices. Although opponents of this view and sceptics may still argue the contrary, one thing seems to be evident and irreversible, as Pava & Krausz (1996) suggested more than a decade ago: “Nearly all empirical studies to date have concluded that firms which are perceived as having met social-responsibility criteria have either outperformed or performed as well as other firms which are not (necessarily) socially-responsible.” (Pava & Krausz, 1996, p.322). More than a decade previous to that, a number of scholars already held the view that social considerations in running business can enhance possibilities of better financial performance for firms (Bruyn,1987; Bowman & Haire, 1975; Sturdivant & Ginter, 1977; Kahneman et al.; 1986). If these arguments hold, findings of this study as well as many recent ones suggest they do, firms are not left with many choices than to adapt their way of doing business accordingly. It pays to “go green”. However, going green does not mean changing the colours of a firm‟s logo into green, as many firms seem to be doing today. It is easy to fool customers by doing so, but that has a little chance to stand the sustainability test. As the following statement attributed to Abraham Lincoln suggests, “You can fool some of the people all of the time, and all of the people some of the time, but you cannot fool all of the people all of the time.” Sustainability does not mean changing colours. Perhaps to be less misleading, the expression “going green” should be changed into “going clean”.

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