Does CEO power moderate the link between ESG performance and financial performance?
A focus on the German two-tier system Patrick Velte
Faculty of Business and Economics, Leuphana University of Lüneburg, Lüneburg, Germany Abstract
Purpose – Based on stakeholder and upper echelons theory, this study aims to analyze whether the link between environmental, social and governance (ESG) performance and financial performance is moderated by chief executive officer (CEO) power.
Design/methodology/approach – Listed corporations with reference to the German two-tier system (HDAX and SDAX) for the business years 2010-2018 (775 firm-year observations) have been included. Fixed effects panel regression analysis was conducted to analyze the link between ESG performance (in total and its three pillars) and financial performance (ROA), with special reference to the interaction of a CEO power index.
Findings – While ESG performance has a positive impact on financial performance, the link is more pronounced by CEO power. Thus, in line with prior research on the one-tier system, CEO incentives can positively contribute to the CSR-business case in the German two-tier system. The results remain constant after conducting several robustness checks.
Originality/value – A key contribution to the empirical CSR literature can be stated, as the moderating role of CEO power in the ESG–financial performance link is rather neglected in prior studies. Thus, corporate governance and sustainability should be classified as interactive aspects for the business case of a successful stakeholder management.
Keywords Corporate social responsibility, ESG performance, Financial performance, Corporate governance, Stakeholder theory, CEO power, Business ethics and sustainability
Paper type Research paper 1. Introduction
After the financial crisis of 2008-2009, (inter)national standard-setters initiated several reform measures to strengthen corporate governance and corporate social responsibility (CSR) in public interest entities (PIEs). As the term “CSR” is heterogeneously used, we refer to the triple bottom line concept and the business case model, indicating that economic, environmental and social aspects should be integrated equally in stakeholder management (Carroll, 1999). A major regulation of sustainable corporate governance is linked with the Directive 2014/95/EU in the European member states (Johansen, 2016; Monciardini, 2016), as specific PIEs must prepare a nonfinancial declaration and a diversity report since the business year 2017. However, sustainable corporate governance tools have a long tradition within the European capital market, especially in Germany with its social market economy, its co-determination rules, stakeholder- oriented code law system and its mandatory two-tier system(management board and supervisory board) for corporations.
CSR can be classified as a major element of a modern stakeholder management by PIEs because stakeholder demands for a decision-useful nonfinancial reporting increased during the recent years. Both corporate governance and CSR reporting should inform stakeholder properly, but the quality of those reports can be decreased by two major risks: information overload and greenwashing behavior (Mahoney et al., 2013). In line with short-term business case strategies and opportunistic motivation, top management can use nonfinancial reporting for self-impression management (e.g. theVW“dieselgate” scandal). With regard to the reduced reputation of nonfinancial reports since the financial crisis of 2008-2009, the aforementioned EU regulation should incentivize top managers to establish a stakeholder management tool that monitors environmental, social and governance (ESG) issues. However, the new EU directive was a political trade-off because a “full” CSR report according to international frameworks (e.g. Global Reporting Initiative [GRI]) is not mandatory yet. Thus, harmonization of nonfinancial reporting within the EU member states is not realized.
From a research perspective, measuring the link between CSR performance and financial performance is highly attractive (Ambec and Lanoie, 2008; Margolis and Walsh, 2003; Orlitzky et al., 2003; Griffin and Mahon, 1997). Positive, negative, insignificant results and different causal relationships can be stated (Margolis and Walsh, 2003; Orlitzky et al., 2003).
Heterogeneous variables of CSR performance and financial performance decrease the comparability of recent research (Wu, 2006). As the reliance on external ratings is dominant in empirical research on that topic, we include the ESG performance measure by Asset4 ESG data glossary (2019). ESG rating databases are well-established in empirical research (Li et al., 2018).
ESG performance represents:
[. . .] a business organization’s configuration of principles of [environmental,] social [and governance] responsibility, processes of [environmental,] social [and governance]
responsiveness, and politics, programs and observable outcomes as they relate to the firm’s societal relationships (Wood, 1991).
Financial performance can be classified as “financial visibility, or the extent to which a company achieves its economic goals” (Orlitzky et al., 2003, p. 411). Financial performance can be measured by accounting-based variables (e.g. return on assets [ROA]) and marketbased items (e.g. Tobin’s Q). Literature stresses that the link between CSR and financial performance may be linked with a time lag of at least one year (Scholtens, 2008). Finally, ESG performance is an aggregate measure that arises from many CSR activities. Thus, the three main pillars ESG performance should also be tested separately. Moreover, as CSR and corporate governance are complementary disciplines, corporate governance variables may influence the impact of CSR on financial performance. During the past few years, individual characteristics of top management members, especially of the chief executive officer (CEO), have been included in empirical CSR research (Habib and Hossain, 2013). In view of the huge impact of the CEO on CSR and financial strategies (Cordeiro et al., 2006; Fehre and Weber, 2016), certain CEO characteristics, e.g. CEO power, should be analyzed. According to upper echelons and stakeholder theory, we
assume that a powerful CEO can positively influence the ESG–financial performance relationship.
In view of these remarks, the aim of our analysis is to ascertain whether CEO power moderates the impact of ESG performance on financial performance in the German two-tier system. As the CEO is the most important person within the management board, he has a major influence on strategic decisions within the company (Busenbark et al., 2016). For example, the CEO mainly influences the financial and nonfinancial reporting and thus financial and nonfinancial performance. In our analysis, we refer to CEO power as an impact of the CEO on both (non) financial reporting and performance strategies (Javeed and Lefen, 2019). We see interdependencies between CEO power and CEO incentives. CEO power can be linked with CEO incentives, but both cannot be used as synonyms (Busenbark et al., 2016). For example, CEO compensation can be classified as power and incentive dimension in business practice, e.g.
stock (option) compensation systems. Stock (option) compensation should overcome conflict of interests between CEO and shareholders as incentive alignment (Jensen and Meckling, 1976). If the compensation contract of the CEO mainly differs fromthe other executive directors and the amount is significantly higher (pay slice), CEO power increases. Thus, the incentive and the power dimension can be simultaneously effective within CEO compensation variables.
Since the past few years, empirical research on the link between CEO power and CSR performance increased (Jouber, 2019; Sheikh, 2019; Muttakin et al., 2018). Our intention is to connect this strength of research with the CSR–financial performance link. Thus, we analyze whether a positive impact of CSR performance on financial performance will be influenced by CEO power. In line with Sheikh (2019) and Muttakin et al. (2018) we decide to use a CEO power index instead of one item and include three important CEO power variables (pay slice, ownership and tenure) to include three different dimensions of CEO power (structural, ownership and expert dimension). We only identify two recent studies with a similar research question for UK (Li et al., 2018) and Pakistan (Javeed and Lefen, 2019). Javeed and Lefen (2019) analyze the impact of social contribution value per share as CSR performance measure on ROA and return on equity (ROE) with CEO power variables (annual compensation, managerial ownership, and ownership concentration) as moderators. They found that the positive CSR–
financial performance link is more pronounced by CEO power. Li et al. (2018) rely on Bloomberg’s ESG performance and Tobin’s Q as financial performance measure. The authors analyze the moderating impact of the CEO power model by Veprauskaite and Adams (2013) on the CSR–financial performance link und found positive results. With regard to the financial performance variables, we also include ROA (for main regressions), ROE and Tobin’s Q (for robustness checks). Our paper makes a clear contribution to the existing literature. Different from Li et al. (2018) and Javeed and Lefen (2019), we are interested in the moderating effect of CEO power on the relationship between ESG performance and financial performance in a developed economy with stakeholderoriented code law tradition and a two-tier system. In the UK, a case law tradition and a mandatory one-tier board system with increased shareholder rights is quite different from Germany. Pakistan is a developing country with one-tier board system and has no long CSR tradition. Thus, the results of the two existing studies cannot be
easily transferred to developed regimes with a two-tier system such as Germany. Thus, we identify a major research gap which should be addressed in this study.
CEO power mainly differs between one- and two-tier systems (Jouber, 2019). From an international perspective, the one-tier system that brings together management and control represents “best practice” in comparison to the two-tier system. As a clear separation between management and control is not present in one-tier systems, the famous CEO duality model (the CEO is also chair of the board) can lead to an increased CEO power. Such a constellation is not possible in a two-tier system, as management and control are strictly separated by a management board and a supervisory board. A CEO duality model (personal duality as member of management and supervisory board) is not allowed in the two-tier system. Thus, a decreased CEO power is assumed in two-tier systems by tendency. We stress a major research gap in analyzing CEO power in the two-tier system. Furthermore, we see major differences between case law and code law regimes with regard to CEO power. Case law regimes are more shareholder focused and thus not so much focused on nonfinancial performance (Velte, 2017b).
As a consequence, CEO may only engage in CSR activities if there is a clear link to financial output. Code law regimes, on the opposite, are more related to broader stakeholder interests.
Thus, huge CEO engagements in CSR can lead to lower financial performance and be in contrast to (short-term) shareholders’ interests of high dividends. We also see a research gap in analyzing CEO power in code law systems. Germany is chosen as the main representative of the Continental European code law system and of the two-tier system with mandatory co- determination within supervisory boards. This setting is special in the international corporate governance regimes and should be addressed in more detail. Moreover, since the financial crisis 2008-2009, German listed corporations must include nonfinancial issues in their management strategy and their stakeholder communication, e.g. sustainable management compensation systems or nonfinancial information in their management report (Velte, 2017a, 2017b).
Furthermore, German listed companies have an increased compliance rate to the German Corporate Governance Code (GCGC) and are active in voluntary CSR disclosure according to the standards of the Global Reporting Initiative (GRI) and voluntary external assurance (KPMG, 2017).
In our study, 775 firm-year observations for the business years 2010-2018 are included.
We refer to the German Prime standard of the Frankfurt Stock Exchange (HDAX and SDAX) because those companies contribute to better CSR and financial performance by tendency in view of increased stakeholder pressure. We control for relevant firm and corporate governance variables (e.g. firm size, firm risk, management board size). Fixed effects panel regressions are conducted and indicate that ESG performance has a positive and significant impact on financial performance (ROA) and that CEO power strengthens this link. Thus, in line with prior research on the one-tier system, CEO power can positively contribute to the business case on CSR in developed two-tier systems with code law tradition. Our results remain constant after robustness checks. Our analysis contributes to prior research as we focus on the moderating effect of CEO power on the relationship between ESG performance and financial reporting in a developed
economy with stakeholder-oriented code law tradition and a two-tier system (Li et al., 2018;
Javeed and Lefen, 2019).
The article is structured as follows. First, we present a stakeholder and upper echelons theoretical framework. This will be the starting point for deducting our hypotheses. Second, the data and methodology of the empirical analysis will imply the sample selection, the main variables and the regression models. The research results of the correlation and regression analysis are focused then. Finally, the results are discussed together with major limitations and research recommendations in the summary section.
2. Theoretical framework, literature review and hypotheses
The relationship between CSR performance, corporate governance and financial performance can be justified by a variety of different theories. With regard to the increased importance in recent empirical research, we concentrate on stakeholder theory (Freeman, 1984). According to this concept, satisfaction of the needs of different coalition partners (stakeholders) of the firm will lead to long-term success of products and services of a firm (Freeman, 1984). Stakeholder theory contrasts classical principal agent theory (Ross, 1973; Jensen and Meckling, 1976), as a firm constitutes a subset of society which means that generating public value is in principle measured by the fulfilment of specific CSR expectations. Unfortunately, stakeholders’ interests are heterogeneous and dynamic so that the management has to cope with these conflicts of interests (e.g. by selecting primary stakeholders as employees, suppliers and customers). The inclusion of public expectations in strategic decisions requires the establishment of a stakeholder and sustainability management. One major part of sustainability management is decision-useful stakeholder communication with a combined view of financial and nonfinancial issues in line with the triple bottom line concept (Roberts, 1992). If stakeholders are satisfied with stakeholder relations concepts of the company, better CSR and corporate governance reporting will be connected with increased sustainability performance (Clarkson et al., 2008). Finally, increased financial performance (e.g. on the stock market) by better firm reputation and by attracting new (sustainable) shareholders should be the consequence.
While empirical research on the CSR–financial performance stated mixed and contradictory results (Orlitzky et al., 2003), meta-analyses (Endrikat et al., 2014; Friede et al., 2015; Hang et al., 2018) as well as literature reviews (Albertini, 2013) on that topic support the assumption of a positive impact of CSR performance (or single aspects of it) on financial performance. With regard to Germany, Fischer and Sawczyn (2013) observe a positive linear relationship between CSR performance and accounting-based financial performance (ROA) and conclude that this relationship is affected by the degree of innovation. Velte (2017b) adds a market-based measure of financial performance (Tobin’s Q); he finds that ESG performance has a positive linear impact on ROA, but does not observe a significant result on Tobin’s Q.
According to stakeholder theory and former empirical research results, we assume that ESG performance is positively related with financial performance (ROA). Successful CSR activities will lead to better firm reputation and CSR performance. Stakeholder theory assumes that positive reputational effects from CSR strategies might need to accrue to a certain point until
firms fulfill stakeholder expectations (Roberts and Dowling, 2002). Consequently, past empirical research finds evidence for a positive impact of CSR performance on financial performance (Brammer and Millington, 2008; Hang et al., 2018). Hence, we hypothesize:
H1. ESG performance will lead to increased financial performance.
As we already indicate the great interdependencies between corporate governance and CSR activities of a firm, a moderating influence of corporate governance on the CSR–financial performance link is realistic (Habib and Hossain, 2013). Traditional economics theories and empirical research on the business case of CSR dominantly address group-, firm- and country- specific governance factors and neglect individual characteristics within the board of directors or top management team (Habib and Hossain, 2013). Behavioral economics, however, assumes that CSR strategies and performance will be dominantly influenced by incentives and characteristics of top management team members. Especially the main impact of CEO variables on CSR and financial performance can be justified by the upper echelons theory (Hambrick and Mason, 1984;
Hambrick, 2007). During the past decade, a variety of empirical studies on the impact of CEO incentives (e.g. compensation, power, duality) and CEO characteristics (tenure, gender, education, ability and experience, values, overconfidence and narcissism) on CSR and financial performance has been conducted (Busenbark et al., 2016; Berns and Klarner, 2017; Habib and Hossain, 2013; Krause et al., 2014; Winschel and Stawinoga, 2019) with heterogeneous results.
The majority of those studies combines stakeholder theory and upper echelons theory. The most important CEO variable in prior research is compensation (Winschel and Stawinoga, 2019).
Upper echelons theory assumes that the influence of a CEO is intensive within a top management team and within the firm to influence CSR activities and performance significantly.
Not only grouprelated determinants within the board of directors but also the central role of the CEO itself may be the crucial factor in establishing a successful CSR strategy (Hambrick and Mason, 1984; Hambrick, 2007). If CEO behavior is in line with stakeholder demands (e.g. by a sustainable CEO compensation system), the CEO should be more interested in establishing successful CSR activities. Also, increased degree of power can be helpful if the CEO will be motivated to establish a stakeholder management that will increase firm reputation, CSR and financial performance. In contrast to stakeholder theory, according to managerial power theory (Bebchuk and Fried, 2004, 2006), CEO power can be also classified as an opportunity for CEO discretion and opportunistic behavior that contrasts stakeholder demands (Bebchuk and Fried, 2006). In view of these remarks, it is not surprising, that empirical research on the impact of CEO power on CSR is growing during the past few years. Table I gives a summary on prior research.
The majority of empirical research concentrates on the impact of CEO power on CSR performance on the US-capital market (Sheikh, 2019; Walls and Berrone, 2017; Li et al., 2016;
Jiraporn and Chintrakarn, 2013). Others rely on developing countries such as Pakistan (Javeed and Lefen, 2019) or Bangladesh (Muttakin et al., 2018). The only cross-country study is conducted by Jouber (2019), whereas Li et al. (2018) focus on the UK. As the results of prior research are heterogeneous, the positive impact of CEO power on ESG performance is
controversial. A recent study by Jouber (2019) was linked to 1,440 firm-year observations in USA, Canada, France and Spain for the business years 2010-2017 and stated a positive link between CEO power (by the model by Bebchuk et al., 2011) and CSR disclosure score. The link is more pronounced by investor protection, case law and corporate governance score (Jouber, 2019). In contrast to this, Jiraporn and Chintrakarn (2013), based on 4,489 firm-year US observations for the time frame 1995-2007, stated a non-linear relationship between CEO power (model by Bebchuk et al., 2011) and CSR performance (Kinder, Lyndenberg, Domini & Co database) as an inverted U-shaped link. Muttakin et al. (2018) concentrated on 1,005 firmyear observations in Bangladesh for the business years 2005-2013. They found a negative impact of their CEO power index (CEO duality, ownership, tenure, family) and CSR disclosure score.
Sheikh (2019), based on 15,386 firm-year US observations between 2003 and 2005, differentiated between structural (pay slice, duality), ownership (equity ownership, founder or related to founding family) and expert (tenure) aspects of CEO power. According to this study, structural and ownership CEO power dimensions are negatively related to CSR performance (KLD database). The expert dimension has no significant impact on CSR performance in this study.
In contrast to those studies, we identify only two studies that include CEO power as a possible moderator of the CSR–financial performance link (Javeed and Lefen, 2019; Li et al., 2018). Li et al. (2018) analyzed the impact of ESG performance (Bloomberg ratings) on financial performance (Tobin’s Q) and included 2,415 firm-year UK observations between 2004 and 2013.
CEO power was included as a moderator variable with reference to the model by Veprauskaite and Adams (2013). Javeed and Lefen (2019) conducted a follow-up study in Pakistan (133 firms with regard to the business years 2008-2017). The authors refer to social contribution value per share as CSR performance item and ROA and ROE as financial performance measure.
Compensation-based CEO power, managerial ownership and ownership concentration were included as moderators. According to Li et al. (2018) and Javeed and Lefen (2019), the positive impact of CSR on financial performance is more pronounced by CEO power. Finally, Walls and Berrone (2017), based on 1,320 firm-year US observations between 2001 and 2007, studied the relationship between shareholder activism (based on the EthVest database) and environmental performance (Trucost rating). They included three types of CEO power (information environmental power, formal power over the top management team and formal power over the board of directors) and stated a moderator effect of all types on the shareholder activism–
environmental performance link.
We recognize that CEO power is a complex topic in recent research and it cannot be operationalized in one specific item properly. Thus, we decide to refer to the approach by Sheikh (2019) and differentiate between structural, ownership and expert dimensions of CEO power.
CEO pay slice as structural component, CEO ownership and CEO tenure as expert dimension are included as our CEO power index and CEO power should strengthen the positive relationship between ESG performance and financial performance. On the one hand, literature states that CEO power as more entrenched CEO can have adverse effects on management behavior
(managerial power theory; Bebchuk, 2002). A powerful CEO may influence the decision-making process within the board to their own personal benefits in contrast to stakeholders’ interests. On the other hand, if CEO incentives are implemented, e.g. by incentives-based compensation, CEO power may positively contribute to stakeholder demands. In comparison to market-based corporate governance systems such as the USA or UK, the amount and structure of CEO compensation systems mainly differs in Germany. First, CEO compensation in German listed corporations is significantly lower on average (Fockenbrock and Wallace, 2018). Second, variable management board compensation must be linked to a sustainable development and must include long-term incentives (Velte, 2017b). In view of these special circumstances in Germany and in accordance with prior research, CEO pay slice, CEO ownership and CEO tenure are characterized as complementary variables (Sheikh, 2019) and will lead to increased CEO power.
Thus, their influence on (non) financial disclosure and performance will be higher. There are no indications in prior research that the influence of one item is stronger in comparison to the other two variables. Thus, an increased CEO pay slice, the amount of CEO ownership and longer CEO tenure positively moderate the ESG–financial performance link. In line with stakeholder and upper echelons theory and prior studies, we assume the following moderator effect of CEO power:
H2. The link between ESG performance and financial performance will be positively moderated by CEO power.
3. Data and methodology 3.1 Sample selection
We already mentioned that empirical research on the moderating impact of CEO power on the CSR–financial performance link has not been conducted for the German capital market; only the impact of CSR performance on financial performance has been addressed (Fischer and Sawczyn, 2013; Velte, 2017b). Moreover, in contrast to two prior studies on that topic (Javeed and Lefen, 2019; Li et al., 2018), we used a CEO power index with more than one item.
Listed corporations on the German Prime Standard (DAX30, TecDAX, MDAX, SDAX) represent our sample for the study. As stakeholder trust was decreased after the 2008-2009 financial crisis, we intend to analyze the reactions of the firm, especially of the CEO. The German setting is rather stakeholder-oriented (code law system) and linked with a mandatory two-tier system with co-determination of the supervisory board, and the legislator is quite active in corporate governance and CSR regulations. As an example, since the business year 2010, variable management board compensation must be connected with a sustainable business development. Moreover, CSR reporting according to GRI standards represents a “best practice”
in German PIEs since the financial crisis of 2008-2009 (KPMG, 2017). The companies in our sample are connected with the strictest disclosure rules on the German capital market and increased stakeholder pressure, so that we expect an adequate nonfinancial reporting. Because the main variables are obtained from the Thomson Reuters databases, missing variables lead to a decrease in firm-year observations. This is mainly related to the lack of data points in ESG performance. Additionally, financial service firms (banks and insurances) have been excluded
from the analysis because of their specific accounting and corporate governance regulation and capital structure. Table II provides an overview of the final sample of 775 firm years- observations.
3.2 Main variables
ESG is a proxy for ESG performance and represents our independent variable. Data was collected by Thomson Reuters Eikon in the category ESG – Asset4 for the business years 2010- 2017. The total ESG score is an aggregated value of performance in many environmental, social and governmental items, e.g. employment quality, health and safety, training and development, human rights and community. The overall ESG score implies an equal weighting of all relevant data points, z-scoring and comparing them with the data points of all other companies to obtain a relative measure of performance expressed as a percentage ranging from 0 to 100 per cent (a z- score is a relative measure indicating the value in numbers of standard deviation of a given observation from the mean value of all other observations) (Asset4 ESG data glossary, 2019). As we are not only interested in the total ESG score, we define the environmental score (ENS) as environmental performance, the social score (SOS) as social performance and the governance score (GS) as governance performance, as pillars for our separate regressions.
ROA is the relevant proxy for financial performance in the main model as dependent variable. ROA is the most famous accounting-based variable of financial performance, representing the profitability of the company in relation to its total assets. Moreover, ROA is well established in the CSR–financial performance research (Javeed and Lefen, 2019). We decided to integrate a market-based measure (Tobin’s Q) of financial performance as robustness check in line with prior research (Choi and Wang, 2009). Firm level data on ROA and additional variables (as controls) for the years 2010-2018 were collected from Datastream.
Our moderator variable is CEOPower. CEO power is often measured by the Bebchuk et al. (2011) pay slice model. While researchers on CEO power regularly use the pay slice model by Bebchuk et al. (2011), similar models have been established (Veprauskaite and Adams, 2013). Some researchers also chose a rather complex CEO power index with a mixture of other incentives measures (e.g. CEO duality, compensation) or a rather easy measure (ratio between annual compensation of the CEO and total annual compensation of the board of directors) (Sheikh, 2019). No single measure is likely to capture every possible dimension of CEO power;
however, we decided to use a CEO power index by integrating three power items: CEO pay slice (CEOP) (Bebchuk et al., 2011), CEO ownership (CEOO) and CEO tenure (CEOT) This strategy is in line with Sheikh (2019) and Muttakin et al. (2018), who also include a combination of different CEO dimensions as power index. We rely on Sheikh (2019), who differentiates between structural, ownership and expert dimensions of CEO power. CEO pay slice represents our structural component of CEO power. As our German setting is linked with a mandatory two- tier system, it is not possible to include the famous CEO duality variable in comparison to research on one-tier systems as famous structural element of CEO power. CEOP is measured as the fraction of the aggregate compensation of the top (five) executive team captured by the CEO and is linked with an increased CEO influence on firm strategy. CEO stock ownership represents
our ownership component of CEO power and should contribute to an incentive-based CEO behavior in line with stakeholders’ interests. CEOO is the percentage of company stock held by the CEO. As we already noted, CEO compensation variables may simultaneously indicate incentives and power. A clear separation is not possible (Sheikh, 2019). Thus, we integrate CEO tenure as expert dimension of CEO power and assume a positive impact on the ESG–financial performance link because the CEO has more firm-specific knowledge. CEOT is the number of years the CEO has been in office. We create indicator variables that equal 1 if CEOP, CEOO and CEOT are above the industry median because the CEO power dimensions are sensitive to industry. As we are interested in the overall effect of those three dimensions, we build a CEO power index (CEOPOWER) as the addition of indicator variables that ranges between 0 and 3.
We assume that pay slice, ownership and tenure as CEO power moderate the positive ESG–
financial performance link.
Control variables and industry and year fixed effects are included in our research design (Li et al., 2018; Javeed and Lefen, 2019) to address endogeneity concerns. As firm characteristics, which might influence financial performance, we include R&D, which represents the technological knowledge as the R&D intensity. The data was generated from the R&D expenses in the financial statements. In line with former studies, a positive result is expected (Kogut and Zander, 1992). Firm risk is separated into a systematic and an unsystematic risk item:
the beta factor (BETA) as a proxy measure for systematic risk and the ratio of total debt to total assets (DEBT) as a proxy for unsystematic risk (Fischer and Sawczyn, 2013). Firms with an increased level of ESG performance are perceived as less risky with regard to “insurance effects”
and will be connected with lower costs of debt capital (Orlitzky and Benjamin, 2001). The next control variable is firm size (SIZE), measured by the natural logarithm of total assets, because large size often brings economies of scale or scope, which may be difficult to imitate (Roberts and Dowling, 2002). Prior studies found that firm size can be related to the extent to stakeholders’ interests about the CSR activities of the firm. The direction of the relationship between firm size, CSR performance and financial performance can be both negative or positive.
Percentage change of sales as GROWTH indicates if the specific company has been growing (percentage change in sales) in comparison to the previous year. We assume a positive impact on financial performance. PPE is the ratio of property, plant, and equipment to total sales. As this measure indicates a lack of working capital management, a negative impact on financial performance can be assumed (Li et al., 2018). CASH presents cash divided by total assets and indicates power of liquidity. Thus, a positive impact on financial performance is stated (Li et al., 2018).
We also include corporate governance and audit variables as controls in our model and assume a positive impact on financial performance. Corporate governance and audit measures should lead to increased shareholder trust, firm reputation and increased firm value. BIGFOUR is a dummy variable and states that the firm is audited by a Big 4 audit firm. IND and EXP represent the percentage of independent members and financial experts on the supervisory board.
The supervisory board monitors the management board, e.g. the CEO. Finally, we control for the size of the management board (MSIZE) and assume a negative impact on financial performance.
An increased size of the management board indicates that the influence of the CEO may be reduced and this can be linked with reduced financial performance.
A positive impact of ESG performance on ROA and a moderating influence of CEO power is assumed in our main regressions. Furthermore, we separate between the three pillars of ESG performance. All variables are fully explained in Table III.
3.3 Regression model
Our main regression model analyses whether ESG performance (ESG) has a positive impact on financial performance (ROA) and whether this link is moderated by CEO power (CEOPOWER).
The assumptions of regression (linearity, homoscedasticity of residue, normal distribution of error term, multicollinearity) in accordance with the approach of Hair et al. (2009) were tested.
We apply regression statistics in STATA 13. Based on significant Lagrange multiplier tests, F- tests for overall significance and Hausman Tests, we use panel data regression with firm and time fixed-effects. The Durbin–Wu–Hausman test is the model most commonly used to check for endogeneity and the choice of relevant regressions models. We thus conducted this test to choose either the random effects or fixed-effects model for the various regression analyses[1]. In view of our results, we choose the fixed-effects model. Regression analysis with fixed-effects minimizes the risk of omitted variable bias. Additionally, a test for reverse causality was conducted, showing an insignificant of ROA on ESG. We calculated variance inflation factors (VIF) to test for multicollinearity. If the VIF is higher than 10 severe multicollinearity problems might occur (Hair et al., 2009). However, in our data, no VIF exceeds 2.98, thusmulticollinearity should not affect our results.
The following regression model applies for our hypotheses:
ROAit+1 = α + β1ESGit + β2ESGit + β1CEOPOWER*it + β3ESG_ β1CEOPOWER*it + β4R&Dit +
β5BETAit + β6DEBTit + β7SIZEit+ β8GROWTHit + β9PPEit+ β10CASHit+
β11BIGFOURit+ β12INDit + β13EXPit+ β14MSIZEit +
β15YEAR_FIXED_EFFECTt+ β16INDUSTRY_FIXED_EFFECTi + εit
*with regard to Regression Models 6-8, CEOPOWER is substituted by CEOP (Model 6), CEOO (Model 7) and CEOT (Model 8).
4. Research results 4.1 Descriptive statistics
Table IV provides an overview of the descriptive statistics for the ESG performance measures (panel A), the financial performance variable (panel B), the moderator variable (panel C) and the control variables (panel D). The ESG performance scores in panel A range from 0 to 1. The mean (median) scores in our sample are 0.543 (0.565) for total ESG, 0.501 (0.482) for GS, 0.544 (0.551) for ENS and 0.612 (0.603) for SOS. Insofar, SOS scores are higher in comparison to the others. Furthermore, financial performance indicates a mean (median) of 0.053 (0.054) for ROA.
Descriptive statistics for our moderator variable (CEO power index; panel C) state a low mean
(median) of 1.152 (1.000). Panel D represents descriptive statistics for our controls. Interestingly, on average, the companies in our sample are audited by a big 4 audit firm. Independence and financial expertise on the supervisory board is also quite moderate (mean: 0.254; 0.276; median:
0.276; 0.353).
4.2 Correlation results
Table V presents the Pearson correlation matrix for the dependent, independent, as well as the control variables. GS, ENS and SOS as pillars of the ESG total score are highly positively significantly linked to each other. Thus, we have to run separate regression models. As supposed, CEOPOWER, R&D and BIGFOUR are positively significantly correlated with ROA. Moreover, in line with our prior assumptions, we find that BETA, DEBT and MSIZE are negatively significantly related with ROA.
4.3 Regression results
The results of the multivariate regression analysis are explained in Table VI. ESG as total score in model 1 and GS, ENS and SOS as three pillars in Models 2-4 are positively and significantly related to ROA. No pillar of ESG is mainly different from the others with regard to its significance. Thus, H1 is supported. Model 5 represents the inclusion of the interaction between CEOPOWER and ESG (ESG_CEOPOWER). We note that the significant positive link between ROA and ESG will be more pronounced by CEOPOWER (p<0.01). This result is in line with our H2. Moreover, with reference to our controls, SIZE, IND and EXP are positively significantly related to ROA. DEBT and PPE are negatively significantly related to ROA. The degree of R2 is satisfactory. As our main regression models rely on the CEO power index, we also test the influence of the three individual CEO power variables CEOP, CEOO, and CEOT as moderator variables on the ESG–financial performance link (regression Models 6-8). We found that also the three pillars of our CEO power index significantly moderate the positive link between ESG performance and financial performance. Finally, we also test the influence of all three interaction variables CEOP, CEOO, and CEOT (Model 9).
4.4 Robustness checks
To test the sensitivity of our regressions, we conduct several robustness checks. Table VII gives a summary of the results of our robustness checks. First, we run regressions with regard to the individual contribution on the sub-pillars of the ESG performance score (E, S and G scores) (not tabulated) and found supportive results. Second, we changed our financial performance item by ROE (Model 10).We already mentioned that financial performance can be measured both accounting or market-based. Literature states that both types should be integrated into empirical quantitative research (Choi and Wang, 2009). Therefore, we run robustness checks of our models by Tobin’s Q as the ratio of the physical asset’s market value, divided by the replacement value of physical assets (model 11). However, as it is difficult to evaluate the replacement value, in line with prior literature (Velte, 2017b), Tobin’s Q is measured as the market value of equity and liabilities divided by its book values. We note that the link between ESG and Tobin’s Q is more pronounced by our CEO power index. Finally, we increase our time lag of ESG performance on
financial performance by one year (Model 12). Thus, by analyzing financial performance, we start with the business year 2012. We do not find significant results for the two-year time lag model.
5. Summary and limitations
This study analyzed the impact of ESG performance on financial performance by recognizing CEO power as a moderator variable. Stakeholder theory and upper echelons theory indicate that the CSR–financial performance link will be mainly influenced by individual corporate governance variables. In view of the huge impact of the CEO on strategic decisions that relates to future firm value, we see a major contribution to prior research to analyze the effect of CEO power in a well-known twotier and Continental European code law system such as Germany’s.
We selected listed corporations from the HDAX und SDAX (775 firm-years observations) covering the business years 2010-2018. After conducting fixed effects panel regressions, ESG performance in total and the three components, the environmental, social and the governance performance scores, have a positive impact on financial performance (ROA). Thus, successful CSR engagement leads to increased financial output. Moreover, the positive link between ESG and financial performance is more pronounced by our CEO power index (measured by CEO pay slice, CEO tenure and CEO ownership). A powerful CEO within the management board who is assumed to have a better influence on (non) financial performance and disclosure is able to strengthen the ESG–financial performance relationship. Our results are robust after conducting additional regression for alternative financial performance measures (ROE, Tobin’s Q) and separating between our three CEO power variables. However, a two-year time lag was not significant in our model. Furthermore, our results are in line with recent studies on that topic in UK (Li et al., 2018) and Pakistan (Javeed and Lefen, 2019) that also state a positive impact of CEO power on the CSR–financial performance relationship.
In this section, we like to stress implications for researchers, regulators and practice to strengthen the incentives for CSR activities and supporting the role of the CEO (Cordeiro et al., 2006; Fehre and Weber, 2016). As the last regulations since the 2008-2009 financial crisis aim to increase the quality of sustainable corporate governance, an increased research activity for the European member states will be expected. Nonfinancial reporting will be established as the second major component of business reporting next to financial reporting and will be more standardized (e.g. by the GRI) in the long run. But major challenges of nonfinancial reporting, e.g. corporate governance and CSR reports, have to be kept in mind: the prevention of information overload and green washing behavior. Otherwise, stakeholder trust may be decreased and the business case for CSR fails. In our German sample, the VW group is included.
Referring to the “diesel gate scandal,” the new CEO Herbert Diess, who was elected in 2018, currently tries to implement a radical strategy towards electric cars to build new firm reputation.
As the diesel gate scandal decreases reputation of the general automobile industry, the influence of CEOs such as Diess on leadership styles is of practical relevance. Stakeholder pressure in the automobile industry is currently very high in Germany. This can be justified by current discussions by Chancellor Merkel and CEOs of listed companies in this industry. Thus, we
encourage researchers to include more individual characteristics (e.g. compensation, tenure, education) within the board of directors according to our upper echelons- and stakeholder theoretical framework, focusing on CEO and CFO variables. We also mention that a linear connection between CSR and financial performance seems not realistic; however, researchers should consider the relevance of non-linear relationships (optimal level of CSR activities instead of a maximum/ minimum). Additionally, as the European Commission is currently planning a major regulation in sustainable investment and finance to reach the UN climate goals, the pressure of sustainable investors (e.g. Principles for Responsible Investments [PRI]) on ESG performance and their relevance for other stakeholders should be integrated in future research.
Say on pay votes on CEO compensation represent a key corporate governance tool which has been subject to current regulations on the international and national level. As compensation range and structure is of key relevance in measuring CEO power, firms must be aware of the recent regulations on board compensation in the EU member states and especially in Germany.
Despite of a long tradition of compensation reports, some German listed firms do not show their individual compensation amounts per management board member during the past few business years. Furthermore, say on pay voting was not mandatory in Germany until the transformation of the new EC shareholder rights directive 2017 this autumn. For the next years, shareholders are required to vote on compensation systems of the board of directors (at least every four years) and on the compensation report (annually). The current discussion in Germany to implement compensation caps for the management board has to be discussed with caution as our results indicate that increased CEO pay in comparison to other top management team members may be linked to better ESG–financial performance relationships. In comparison to the UK or US capital market, compensation of German CEOs is significantly lower because of the decreased liability regime. Another controversial discussion relates to stricter time limitations of management board memberships. We see that CEO tenure which relates to greater experience, may support the ESG–financial performance relationship in Germany. Furthermore, in contrast to the US capital market, the ratio of managerial ownership and stock options is significantly lower in Germany because of the traditional social market economy. Thus, as CEO equity ownership contributes to the positive ESG–financial performance link in our analysis, not only the range, but the compensation structure may be important.
In this context, major limitations of our study should be mentioned. As regulatory effects after the financial crisis of 2008-2009 should include learning effects of the firms, our time period (2010-2018) seems rather short. This is also important for analyzing the market effects of the EU Directive 2014. Moreover, our ESG performance measure with a focus on Thomson Reuters’ database is not free of subjective influences (“black box character”). But other common used variables, e.g. own CSR disclosures scores by individual content analysis of CSR reports, are also questionable. Furthermore, we stress the need to analysis the moderating impact of CEO power with regard to related disclosure topics, e.g. climate change reporting or integrated reporting. As CSR reporting has been controversially discussed with regard to greenwashing and information overload, integrated reporting may contribute to an increased decision useful financial and nonfinancial reporting (Velte and Stawinoga, 2017). As integrated reporting is
voluntary and based on managerial discretion, CEO power may have a huge impact on the decision to implement integrated reporting and on integrated reporting quality. Last but not least, as we already address endogeneity concerns in our study, advanced models such as the Heckman two-stage estimation procedure together with instrumental variable approach (Wintoki et al., 2012), should be used in future research.
