How Competitive Pressure Shapes Firms’ ESG Performance

In the face of competitive pressure, is there a trade-off between a company’s financial performance and its commitment to environmental, social, and governance (ESG) activities? Is ESG a source of competitive advantage, or do managers simply spend other people’s money on sustainability to become “good”? In a new paper, we seek to answer those questions by looking at the impact of domestic product-market competition and foreign-import competition on companies’ ESG scores

Numerous academic studies suggest that ESG engagement and the associated reputation for corporate responsibility can serve as sources of competitive advantage. This could be because customers, employees, or investors value ESG. There is also evidence that good ESG performance can enhance a firm’s access to capital markets. Yet, better ESG performance entails costs and hence represents a trade-off against other potential uses of funds. Competitive pressures may exacerbate these constraints, compelling firms to prioritize the core needs of their operations.

This prompts the question: Do businesses operating in especially competitive environments have an incentive to invest more in ESG to set themselves apart from their peers? Or does competitive pressure force management to focus on profits and cut back on sustainability?

In our study, we use ESG scores from Refinitiv Eikon as the main measure of ESG performance. To measure U.S. firms’ exposure to domestic product market competition, we use a product fluidity index, based on descriptions of firms’ products, to measure the similarity between their products and rivals’ products. A higher fluidity implies that a firm’s products are closer to its competitors’ products, leading to more competitive pressure. We also use firms’ exposure to rising Chinese imports as a shock to foreign competition.

Our main finding is that firms under greater domestic and foreign competitive pressure have lower ESG scores. This finding is robust to controlling for a large number of firm characteristics. An increase in import competition is associated with a reduction in ESG scores over time, showing that our results are not driven by different industries having different levels of competition and ESG. The economic magnitude of the effect is not trivial. A one standard deviation increase in product fluidity is associated with a nearly 4 percent reduction in ESG score.

If heightened competition curtails ESG investment due to constraints on capital allocation, we might expect this effect to be more pronounced among financially constrained firms. Our results support this expectation. The negative relationship between product fluidity and corporate ESG performance is more pronounced among financially constrained firms and in more capital-intensive industries. Collectively, these findings suggest that firms face a trade-off between ESG and other investment needs.

To see how changes in competitive pressure affect ESG, we study the economic shock of the surge in Chinese imports into the United States since China’s accession to the WTO in 2001. Our sample period, commencing in 2002, coincides with this influx, primarily attributed to supply-side dynamics in China. In line with our domestic competition findings, we find that an escalation in export competition from China is associated with significant reductions in firms’ ESG scores. Interestingly, when we segment the sample based on product fluidity, we see that increasing import competition has a larger effect on firms with lower exposure to domestic product-market competition. This suggests that firms with less exposure to competition may have more latitude to curtail their ESG investments in response to increasing foreign import competition.

A deeper look at the components of ESG scores shows that the lower ESG scores amid competition apply to each element of ESG: environmental, social, and governance. We also look at specific activities contributing to these scores. Higher product fluidity is most significantly linked with activities likely to incur substantial costs for the firm. These activities include environmental investment, environmental products, human rights initiatives, quality management systems, supplier ESG training, and external sustainability audits. Conversely, activities less affected by fluidity tend to be those that likely require less investment.

Finally, we explore the role of local social norms and attitudes toward climate in moderating the effect of competitive pressure. We use county-level data on opinions about climate change and proxies for the strength of social norms. We find that the impact of product fluidity on ESG scores is more pronounced in areas where climate action by citizens and corporations is considered less important. Using a social capital index and the categorization of industries as “sin industries” versus other industries as proxies for social norms corroborate these findings. The effect of competition on ESG is larger when the social norms in the firm’s headquarters location are weaker or when the firm is in an industry perceived as less ethical.

Overall, our findings suggest a trade-off between profitability and ESG – at least in the short term. Increasing competitive pressure does not lead to increased investment in ESG but instead appears to curb ESG activities. Hence, while competition undoubtedly fosters positive outcomes such as lower prices and enhanced quality, it may also bear potentially negative societal consequences by diminishing firms’ commitment to sustainability. This also suggests challenges to policymakers attempting to balance antitrust concerns with calls for more sustainable businesses.

Vesa Pursiainen is Assistant Professor at University of St. Gallen and Swiss Finance Institute.

Hanwen Sun is an Associate Professor of Finance at School of Management, University of Bath.

Yue Xiang is PhD Candidate in Management (Finance and Accounting) at University of Bath.

This post was first published on Columbia Law School's Blue Sky blog.