Balancing ESG Practices and Profitability: Lessons from India
Investors, corporate executives, and policymakers need to carefully evaluate the equilibrium between social responsibility, environmental responsibility, and governance (ESG) practices and profitability
Corporations have incorporated environmental, social, and governance (ESG) practices into their operations recently. ESG factors are key for companies to attract investors and promote economic activity. Research has uncovered a clear correlation between strong ESG performance and positive financial outcomes, including higher return on equity (ROE), improved cost of capital, and enhanced stock price performance. But do these benefits reflect equally in the long and short-term?
Given the growing importance of ESG factors in the corporate landscape, further research on the interplay between ESG practices and financial outcomes of businesses operating in the context of fast-growing economies, such as India, is needed. Lessons from India can interest other developing economies in Asia and Latin America.
We look into this topic in the article “Good for the planet, good for the wallet: the ESG impact on financial performance in India” (Finance Research Letters, 2023), co-authored with my colleagues Amar Rao (Shoolini University of Biotechnology and Management Sciences), Vishal Dagar (Great Lakes Institute of Management), Kazi Sohag (Ural Federal University) and Leila Dagher (American University of Beirut). We examine the impact of ESG practices on the financial performance of the Nifty 50 – the benchmark indicator for the Indian stock market— from 2015 to 2022. Lately, we have found a notable increase in ESG disclosure among Nifty 50 firms.
This study’s robust, reliable, and novel methodology helps us understand the impact of ESG pillars –social, governance, and environmental— on different ROE components. Our findings have significant implications for investors, corporate executives, and policymakers.
For investors and corporate executives, it is crucial to consider the impact of social responsibility on profitability. High scores obtained in the social pillar are associated with lower short-term ROE. However, companies with higher social pillar scores have the potential to establish a strong reputation for social responsibility, leading to long-term benefits.
Similarly, companies prioritizing environmental responsibility may experience reduced short-term profitability. So, investors must carefully assess the trade-off between environmental responsibility and profitability, considering the potential long-term advantages of environmentally conscious practices.
Concerning corporate governance, the consistently negative association between the governance pillar and ROE indicates a trade-off between governance and profitability. Investors should acknowledge that companies with stronger governance practices may sacrifice short-term profitability for long-term gains and reputation. Consequently, when making investment decisions, evaluating the equilibrium between governance and profitability is vital.
From a policymaking perspective, our findings offer valuable insights. Policymakers should carefully consider balancing social responsibility and profitability when formulating regulations and frameworks. While encouraging companies to prioritize social responsibility is essential, policymakers must ensure that the implemented measures do not excessively burden companies with short-term profitability challenges.
Similarly, policies promoting environmental responsibility should be designed to strike a balance between sustainability objectives and short-term profitability concerns.
Policymakers must recognize that companies with robust governance practices might face short-term profitability concerns. So, it is crucial to strike a balance by promoting effective governance structures while providing support and incentives to mitigate potential negative impacts on short-term profitability.
Ultimately, policymakers should create an environment that fosters sustainable and responsible business practices while considering the economic implications for companies. Given the intricate relationships between social responsibility, environmental responsibility, corporate governance, and profitability, policymakers must adopt a nuanced approach to policymaking, ensuring long-term sustainability and economic growth.
The author is Professor of the Department of Finance and Business Economics at EGADE Business School.
