Chapter 2: Theoretical Perspective, Literature

Review and Research gap

“…. You have a bigger purpose than to merely earn profits. Just as you add value to your
shareholders’ wealth, it is equally important to add value to the society at large. You, as
conscientious industry heads, would do well to build this emerging gospel of doing business
into your corporate blueprint” – Honorable President of India Shri Pranab Mukherjee at
National summit on CSR’ at CII on April 29, 2015.

It has been well established in the Corporate Social responsibility literature of nearly 60 years
that organizations should not be solely driven towards profit making at the cost of neglecting
their responsibilities towards their employees, environment, and the society. A seminal work
in this area “Social Responsibilities of the Businessman” by Howard Bowen published in 1953.
It defines the social responsibilities of businesses: “It refers to the obligations of businessmen
to pursue those policies, to make those decisions, or to follow those lines of action which are
desirable in terms of the objectives and values of our society”.

Theoretical Perspectives

2.1.1 Stakeholder Theory

The seminal work of Freeman (1984) ‘Stakeholder theory of the Modern Corporation’
proposed the ‘Stakeholder Concept’. He gave a wider definition to the stakeholder concept and
included shareholders, employees, customers, suppliers, local communities, natural
environment, government, and general society and said that just like how shareholders have
expectations of a corporation, likewise all the other stakeholders too will have expectations.
Freeman in his paper says it is the local community that permits the company to build its
operations and also gets benefitted from the social and economic contributions of the
organization. It is expected to behave as a responsible citizen like any natural citizen would

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and not be unreasonable in its operations by exposing the community to hazardous pollution
and toxic waste. By doing so, it violates the implicit social contract with the community. This
concept is further extended to include environment too as a stakeholder since a company can
affect the environment in many ways during its course of existence. For example, the company
utilizes the natural resources for its production processes, releases by products during the
production process which could be harmful, pollution caused by the increase in traffic a volume
of activity due to its presence and activities like transportation (Crowther, 2008).

2.1.2 The 4-dimensional theory of CSR:

Carroll (1979) says “business encompasses the economic, legal, ethical and discretionary
expectations that society has of organization at a given point in time”. Carroll (1999) has
developed a pyramid which describes CSR by dividing it into four types of responsibilities
towards the society (Figure 1). As per this theory, the responsibilities as per the pyramid need
not be fulfilled sequentially but simultaneously by a company. Profitability has been considered
the foundation to fulfil the other types of responsibility: legal, ethical, and philanthropic
responsibilities. It is expected that businesses operate within the laws of the community in
which they function. Even though some actions may be legal they need not be ethically
acceptable. Thus, firms should avoid actions that affect the communities in which they
function. And hence, considering environmental impacts would be essential to fulfil both
ethical and legal responsibilities. Also, businesses as good corporate citizens must be
philanthropic and serve their communities. Thus, Carroll defines four types of social
responsibility keeping environment as a part of each layer while some others define CSR on
the following three dimensions: social, environmental, and economic (Hansford et al. 2003).

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 Carroll's Corporate Social Responsibility Pyramid

Philanthriopic -
Be a good corporate citizen

Ethical - Be ethical. Obligations to

do what is right and fair. Avoid
harm

Legal - Obey the law. Law is society's

codification of right and wrong

Economic - Be profitable, the foundation upon which all others

rest.

2.1.3 Agency Theory

The other school of thought is that businesses solely exist for the benefit of shareholders and
profit is all that matters (Friedman, 1962). To quote him “there is one and only one social
responsibility of business – to use its natural resources and engage in activities designed to
increase its profits so long as it stays within the rules of the game, which is to say, engages in
open and free competition without deception or fraud.” Regarding corporate giving Friedman
says that an agent when working for a principal has neither the legal nor moral right in utilizing
the capital of the principal for philanthropic purpses.

Agency Theory also offers explanation to the profit-making intent of organizations i.e
managers are mere agents of their principal – the shareholders. The decision-making process
of managers is governed by the wealth maximization objective.

In spite of the above opposite view that businesses are run solely for making profits, we cannot
ignore the fact that their operations can have a far-reaching impact. From an ethical perspective
too, there is an expectation of ethical corporate behavior. An infamous example of unethical
behavior could be the Bhopal Gas tragedy of the Union Carbide Plant in Bhopal, India or the
Exxon Valdez oil spill. Such an incident has impact on the generations to come.

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The Gaia Hypothesis (Lovelock, 1979) too stretches the concept to include every element of
the eco system and how all the living matter therein are connected with one another. This
philosophy looks at the system as a whole rather than an organization centric perspective. Also,
we can say that this theory can be linked to the Indian philosophy of Ahimsa where no harm
must be caused to the other living creatures in one’s pursuit of profit making or for that matter
in the course of one’s existence even.

It has now been accepted by most countries widely that it is important to run corporations on a
sustainable basis. To put it in the words of Tony Blair, UK Prime Minister “We are now, more
than ever, aware of the potentially negative impact of business on the environment, whatever
the nature or size of the business. There can only be positive results from development
sustainability – from benefitting you own bottom line to benefitting tomorrow’s industry to
benefitting the environment in which we all live.”

In the following paragraphs we look at the overall CSR literature and identify research gap and
our contribution to the literature.

Literature review

The academic accounting literature on CSR is broadly under four categories: 1) Determinants
of CSR, 2) Consequences of CSR, 3) CSR and Financial performance and 4) CSR disclosure
and assurance (Watson, L. 2015).

1) Determinants of CSR
There are various aspects which determine the levels of CSR orientation of a firm like
a managers’ personal philosophical, religious, and accountability orientations (Parker,
2014) or large firms with higher levels of growth and higher return on equity (Artiach,
2010) are also highly sustainable firms. CSR is also determined by the
Institutionalization mechanism. For example, in India the Companies Act, 2013 makes
CSR spending mandatory for companies meeting a particular threshold and regulations
regarding mandatory disclosure of ESG for NSE 500 companies by SEBI also
determine the level of disclosure and spending.

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2) Consequences of CSR
Researchers have documented the positive impact of CSR activities on firms. One of
them being mitigation of litigation risks, reputational risks, financial risks, and
environmental risks (Kurucz, Colbert, and Wheeler, 2009) and idiosyncratic risk
substantially (Lee and Faff, 2009; Oikonomou, I., Brooks, C., & Pavelin, S., 2012)).
On the other hand, neglecting Governance issues which is an integral part of ESG can
also have bizarre consequence and huge financial impact. Table below documents the
Fines imposed on companies due to neglect or improper governance activities.

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 LARGEST FINES AND SETTLEMENTS CONCERNING ESG ISSUES Feb (2015)
Company Year Sector Country In USD Million Cause
Financial Fraud leading up to and
Bank of America 2014 Financials USA 16,650
during the Financial Crisis
Misleading investors about
JP Morgan 2013 Financials USA 13,000 securities containing toxic
mortgages
Illegally processing Financial
BNP Paribas 2014 Financials France 8,970 transactions for countries subject
to US economic sanctions
Misleading investors about
Citigroup 2014 Financials USA 7,000 securities containing toxic
mortgages
Fraudulent conveyance designed
Andarko 2014 Energy USA 5,150
to evade environmental liabilities
Felony manslaughter:11people
killed; Environmental crimes: oil
spill in the Gulf of Mexico;
BP 2012 Energy UK 4,500
Obstruction: Misstatement about
the amount of oil being
discharged into the Gulf
Unlawful promotion of certain
prescription drugs; failure to
GlaxoSmithKline 2012 Pharmaceuticals UK 3,000 report certain safety data to
FDA; False price reporting
practices
Helping U.S taxpayers hide
Credit Suisse 2014 Energy Switzerland 2,800
offshore accounts from IRS
Misbranding Bextra (anti-
inflammatory drug that Pfizer
Pfizer 2009 Pharmaceuticals USA 2,300 pulled from the market in 2005)
with an intent to defraud or
mislead

Off label marketing and kickback

Johnson & Johnson 2013 Pharmaceuticals USA 2,200
to doctors and pharmacists.

Source: From the Stockholder to the Stakeholder (March 2015)

3) CSR and Financial performance

ESG related issues can have impact a Firm’s Financial performance by impacting its
performance potential, risk profile or its risk metrics. (Stockholder to the Stakeholder,
March 2015). If investments in ESG is to impact the financial performance of a firm
positively then product and process innovation are necessary and different industries
focus on different aspects of ESG. According to Porter hypothesis (Porter & van der
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 Linde, 1995) an appropriate CSR strategy would be to recover the additional cost
incurred by increasing revenue through innovations in products and processes. This
increased revenue in turn will have overall positive impact on Financial performance.
In a Research by Deloitte they state that “sustainability is firmly on the agenda for
leading companies and there is growing recognition that it is a primary driver for
strategic product and business model innovation.” (Deloitte Global Services Limited,
2012).
Innovations in building sustainable products can substantially improve the revenues of
the business. “Green Products” developed by Philips is one such classical example
which is focused on “Green Focal Areas” of energy efficiency, packaging, hazardous
substances, weight, recycling and disposal and lifetime reliability. These products
contributed to 51% share of their total revenues. (Source: Sustainability report of
Philips, 2014). Innovation at LanzaTech has enabled them to produce a low carbon fuel
by using a microbe as a natural biocatalyst that converts CO2 into ethanol which is

supplied as fuel for airline companies. (Source: Sustainability report of Lanzatech,

2014). Virgin Atlantic uses this low carbon fuel produced by LanzaTech and expect it
will enable the airline in meeting its pledge of a 30% carbon reduction per passenger
kilometer by 2020 (Source: Sustainability Report, 2012- Virgin Atlantic).

4) CSR disclosure and assurance

The disclosure literature focuses on both mandatory and voluntary disclosures. While
the voluntary sustainability disclosures have proven to reduce cost of capital,
information asymmetry, negative impact on share price, and enable forecasts by
analysts (e.g. Healy & Palepu, 2001; Hirst, Koonce, & Venkataraman, 2008) mandatory
sustainability disclosures due to regulatory requirements have shown improve firm
valuations represented by Tobin’s Q (Ioannis Ioannou and George Serafeim, 2014).

2.1.4 Causality relationship

There could be bidirectional causality between CSP and CFP too. Firms exhibiting high CFP
consistently over many years may also feel a sense of commitment to contribute back to the
society in which they operation and may also have unutilised resources which can used for

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community building. Such investment through CSR can lead to reversal of causality
relationship. (Orlitsky et al., 2003; Waddock and Graves, 1997).

2.1.5 CSR performance and Financial performance – The link

We delve deeper into the literature on CSR and Financial performance. Although the
stakeholder theory talks about the responsibilities of a company towards various stakeholders,
ultimately to meet the costs of CSR, it is imperative for a company to derive benefits out of it.
Researchers find that investment in CSR helps in enhancing the reputation of a company
resulting in positive influence on sales (Bowman and Haire, 1975), attracting talent to the
company and adding new customers (Porter & Kramer, 2011). This suggests that there need
not be conflict between shareholder interest and stakeholder interest (Jones, 1995). Studies
relating to the study of stock returns of portfolios with “Best in class” stocks employing ESG
ratings from MSCI research during the period 2006 -2010 outperformed the Benchmark returns
by at least 1.6 percentage points (RCM Systematic Equity Team, 2011). Such highly ranked
ESG firms also attract capital at a lower cost. (El Ghoul et al. 2011).

In a meta-analysis by Margolis et al. (2007) of 167 studies, the correlation between CSP and
CFP was found to be, r= +0.13. Further, it was found that accounting-based measures like RoA
had a correlation of +0.18 while market-based measures like Tobin’s Q had a correlation of
0.10

When compared across various types of CFP measures, r = +0.18 for accounting-based
measures such as return on assets and r = +0.10 for market-based measures such as Tobin’s q.

Positive relationship

Most of the studies in the literature show existence of a positive relationship between financial
performance (both Accounting-based and market-based measures) and CSR performance
(CSRP). (Pava and Krausz, 1996; Koh, Qian, and Wang, 2014). Wu and Shen (2013) in their
study of 162 banks from 22 different countries find a positive relationship between CSRP and
CFP (accounting-based measures). When there is high quality corporate governance
mechanism, it can lead to higher Tobin’s Q (Jo and Harjoto, 2011). Good CSR practices can

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positively impact the firm value of even controversial businesses (Cai, Jo, and Pan 2012). Good
CSR performance is also found to enhance operational performance of firms (Waddock and
Graves, 1997) which can happen through framing and implementing good CSR policies
(Cochran and Wood, 1984) or by attracting best talents to employee force thereby leading to
much higher productivity and reducing costs (Greening and Turban, 2000). Such operational
efficiencies lead to a competitive advantage in the long run (Hart and Milstein, 2003). For firms
exhibiting high consumer awareness, CSR impacts firm value as measured by Tobin’s Q
positively (Servaes and Tamayo, 2013). It has also been seen in a study of Malaysian firms that
ESG certification lowers a firm’s cost of capital, while Tobin’s Q increases significantly
(Wong, Woei Chyuan, et al. 2021). In another study from Korea it is found that CSR practices
positively and significantly affect a firm’s market (Yoon, Bohyun et al 2018).

Through the above paragraphs it becomes evident that when a firm incorporates Environment,
Social and Governance aspects in running a sustainable business, then end benefits of it are
cost reduction, resource efficiency, and increased revenues via innovative and sustainable
products and processes ultimately leading to higher profitability (Eccles and Serafeim, 2013;
Porter and van der Linde,1995a, 1995b). Innovation as measured through a company’s R&D
expenditure can lead to differentiation of a firm from its competitors in the industry (Hull and
Rothenberg, 2008).

Taking care of employees is an important aspect of Sustainability performance. This can be

identified through good corporate working environments. Some examples of companies which
are known for workforce attraction or great places to work for can be found in surveys such as
Fortune’s Best Companies to Work For8 and like Great Place to Work9. This in turn translates
into improved corporate financial performance by enhancing corporate reputation. At the same
time the approach to CSR by focussing first on the internal aspects like employee welfare and
work culture and then later slowly proceeding to external aspects like environment also
enhances the Financial performance (Tang et al., 2012). In conclusion, we can note that the
CSP-CFP relationship is moderated by its innovativeness, consistent and slow paced approach
to CSR implementation.

8 The annual lists of the best companies to work for are published on Fortune’s website at: http://fortune.com/best-comp

9 For more details consult the website of Great Place to Work: http://www.greatplacetowork.com.

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Negative Relationship and Neutral Relationship

Some studies have also established no or neutral relationship between CSP and CFP (Surroca
et al., 2010). Although some have observed through meta-analyses an indirect positive
correlation between CSP and CFP arising due to the moderation impact of including intangible
assets of a firm (McWilliams and Siegel, 2000) and Cornett, M.M., 2014). Some researchers
also claim that endogeneity issues not being tackled well in the existing literature studying the
relationship between CSP and CFP. By introducing instrumental variables to the relationship
between aggregate CSR Index and financial performance measure of ROE, ROA, Tobin’s Q,
and Market value added (MVA) becomes insignificant (Garcia-Castro et al., 2010).

2.2.3 Literature review in the Indian context

While examining the literature in the Indian context, we noticed that while there have been a
few Index studies like Vasal, 2009 looks at the performance of “S&P ESG India Index’ vis a
vis market index ‘S&P CNX 500 Index’ by looking at the excess returns for the period January
2005-September2008 and found that ESG Index has not underperformed compared to the
market.

R Singh (2013) in her paper analyses the S&P ESG India Index for the period from 1st January
1st 2005 to December 31st 2012. She has studied the Index behavior before, during and after
the financial crisis. In this paper, during the paired year 2007- 2008 the closing prices of S&P
ESG India Index falls although only slightly. However, post year 2009 in order to gain investor
confidence, companies started making efforts to not only improve their corporate governance
but also their environmental and social activities. Due to these efforts by the companies it is
found that the closing prices of the S&P ESG India Index companies is not change significantly.

Sudha, 2014 has done a risk return analysis of S&P ESG India Index vis a vis Nifty Index and
the market Index using CAPM model. The paper also examines the inherent conditional
volatility using generalized autoregressive conditional heteroscedasticity models. It is found
that the annualized returns of the S&P ESG Index are superior than the returns of Nifty or CNX
500 while the same thing cannot be said for the daily compounded returns since the returns of
the Indices are not statistically different. Chopra, 2016 has studied the relationship between
ESG INDEX and the foreign investment in Indian industry for the years 2005 to 2013.

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Some other papers like Sudha, 2014 have looked at the CSR performance using karmayog
ratings as proxy and CFP has been measured by share prices and the sample is cross-sectional
data for 2010 consisting of ratings of S&P 500 companies. Ordinary least squares regression
has been applied by the author and finds that CSR performance has a significant positive impact
on the firm valuation proxied by share prices. To avoid endogeneity issues she has used
instrumental variable approach by categorizing firms listed on the ESG Index as CSR leaders
and those firms that are not on the Index as laggards.

Also, Bedi (2009) has studied 37 Indian listed companies using karmayog ratings as proxy and
find that there is a positive relationship between NPAT and CSR for the period FY 2007-08.
Aggarwal (2013) has analyzed the relationship between impact of sustainability rating scores
of a company from CSRhub and financial performance measured by PBT, ROA, ROCE, ROE
and GTA (Growth in total Assets) and by controlling for size of the firm. Her sample consists
of non-financial firms only from the S&P CNX Nifty 50 Index (20 firms) for the period FY
2010-11 and FY 2011-12. Her paper also analyzes the individual impact of each of the key
components of sustainability namely Community, Employees, Environment and Governance
on firm financial performance.

Ghosh, 2013 and Chelawat, 2016 have considered the membership in S&P ESG India Index as
proxy for CSR performance. Chelawat, 2016 using panel regression in their paper study the
relationship between environmental, social and governance (ESG) performance and firm
financial performance. Their study has used a sample of NSE 100 companies during the sample
period of 2008 to 2013. Their membership in S&P ESG India Index is considered as proxy for
ESG performance and studied its impact on Financial performance of these Indian companies.
The authors have used membership in S&P ESG India Index as the indicator variable giving
‘1’ for companies which have been a member throughout the sample period and ‘0’ for
companies which are not members during the sample period. This resulted in a sample of 93
companies, 39 of them were ‘high ESG performers’ and 54 of them were ‘low ESG performers.
In the regression equation tested, the dependent variable is the Financial performance measure
of ROCE/Tobin’s Q while the main independent variable is the indicator variable for ESG
while controlling for variables like Debt equity ratio and log of Total assets for size. Ghosh
(2013) has done an extensive study by using the membership in S&P ESG India Index as the
proxy for CSR performance and controlled for variables like size, Leverage, Cash flows, R&D
Intensity, Advertisement expenditure, Industry effects, business group affiliation. Her study
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focuses on top 200 NSE companies during 2009 to 2012 and uses random effect probit
specifications and looked at the impact on ROA, ROE for accounting-based measures and
Tobin’s Q for market-based measure using Ohlson’s model. The paper finds that CSP has
positive significant impact on ROA, ROE and Tobin’s Q.

Research gap

In the Indian context, there are a very few studies which look at the relationship between CSP
and CFP. We find that most studies restricted to the S&P ESG India Index which has been
discontinued since October 2013. Other studies like Ghosh, 2013 and Chelawat, 2016 have
looked at the direct relationship between CSR performance and Financial performance while
using membership in the ESG Index as the proxy for measuring CSR performance. Some of
the gaps found in the literature like using an appropriate proxy for measuring CSR
performance, measuring the linear and nonlinear relationship between the variables, study of
the ESG score at a disaggregated level and also seeing whether the ESG disclosures and
performance improve the information environment by reducing the information asymmetry.
We have explained how these research gaps have been addressed by us in the following
paragraphs.

2.1.6 Measuring CSR performance:

CSR performance has been measured using ESG performance score 10 computed by Bloomberg
from various sources apart from annual reports as a proxy for measuring the Corporate
sustainability performance. ESG performance score computed by Bloomberg is not a widely
used proxy in the literature and thus, our study aims to provide new insights regarding the
effects of CSP on CFP using this new score. Also, while measuring the performance of leaders
and laggards we have classified firms based on the median scores rather than a membership in
an Index as has been done in Literature. We study in chapter 3, the relationship between ESG
score and financial performance measures; we also study the difference in impact on FP

10
“Bloomberg Professional Service provides the ESG information collected from firms' annual reports,
sustainability reports, press releases, and third‐party research and covers information on board structure, such as
the percentage of women on the board and independent directors. The transparency of ESG information is
indicated by the index called the ESG performance score, in which every data point is weighted in terms of
importance and tailored to different industry sectors”. Source – Bloomberg website
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measures for firms with high scores and low scores and the difference in impact on FP measures
between firms with scores and firms without scores.

2.1.1 Non-Linear Relationship:

This is first to study the non-linear relationship between CSP and CFP in the Indian context.
Nollet, 2016 has established a U-shaped relationship between the CSRD and CFP leading to
the explanation that CSP leads to an improvement in CFP only after a threshold CS investment
has been reached. Similar results have been obtained by with regard to the Korean firms by
Jae-Joon Han, Hyun Jeong Kim and Jeongmin Yu (2016). We test this in Chapter 3.

2.1.2 Disaggregated Analysis:

Given that CSR is a multidimensional concept and effects of one dimension sometimes cancels
out opposing effects of another dimension, it is advantageous to have disaggregated data
available (Brammer et al., 2009; Margolis et al., 2009). Thus, in this study we disaggregate the
ESG performance score into its three sub-components, namely, the environmental performance
(E), social performance (S) and governance performance (G). This disaggregation provides us
with the advantage to assess which CSR component is the key driver for improving CFP (Nollet
2016). We test this in Chapter 4.

2.1.3 Information Asymmetry:

Also, since the ESG performance score is said to rate companies on the transparency of the
ESG information. Hence, it is expected to reduce information asymmetry between sellers and
buyers. We test this aspect in chapter 3.

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 2.4 Contribution to the literature

The literature in the global context establishes well the link between CSR performance and
Firm performance. However, most of these studies have been made in the context of US or
European markets. There is a need to study the above aspects in a developing market too so as
to understand the behavior of the market and thereby make the legal framework and reporting
requirements more robust. We can say that we addressed this research gap in the thesis.

We can say that our work contributes to the literature in following ways – 1) It is the first to
use ESG performance score computed by Bloomberg to measure ESG performance not only
with respect to Indian companies but also test the whether these disclosures lead to increase in
transparency through the reduction in information asymmetry. 2) It is the first to directly
examine the relationship between performance score i.e. the quality of sustainability
performance and financial performance of Indian firms rather than use an instrumental variable
like membership in an Index 3) It is also the first to test the relationship between CSP and CFP
at both the aggregate level as well at the disaggregate level with respect to Indian data. 4)
Lastly, it is the first to test the non-linear relationship between the two.

The rest of the thesis is organized as follows:

In chapter 3, we test the relationship between CSR disclosures and information asymmetry to
find out whether the CSR disclosures have increased the transparency of the Annual reports.

In chapter 4, we test the relationship between CSR and Financial performance by examining
empirically the linear relationship between aggregated sustainability scores (ESG scores) and
FP measures of ROA, ROE, ROCE and Tobin ‘s Q and by controlling for other firm specific
variables.

In chapter 5, we test the relationship between CSR and Financial performance by examining
empirically the linear relationship between disaggregated sustainability scores (E, S and G
scores separately) and FP measures of ROA, ROE, ROCE and Tobin ‘s Q and by controlling
for other firm specific variables.

Lastly in Chapter 6, we summarize the results of the empirical tests and the major findings and
conclude the thesis.
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