Rethinking the effect of ESG practices on profitability through cross-dimensional substitutability

Abstract

Over the last thirty years, sustainable business practices and ESG ratings have become increasingly popular in the business context and academic debate. Nonetheless, due to differences in methodological and theoretical approaches, more consensus has yet to be reached in the economic literature on the relationship between ESG practices and financial performance at the firm level. This work addresses the question empirically, focusing on a sample of firms listed in the Euro Stoxx 300 index. Three novel indicators are proposed to measure the firm's sustainable practices and capture the business's Environmental, Social, and Governance (E, S, G) dimensions. These indicators combine qualitative ratings on adherence to ESG standards with quantitative observations on ESG data disclosure to account for strategic behaviors on the part of firms. A dynamic panel model is implemented, considering the three dimensions of ESG practices separately and introducing interaction terms to identify cross-dimensional substitutability/complementarity relations. The results indicate that environmentally friendly business practices are associated with increased profits, while trade-offs across ESG dimensions are revealed.