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Does CSR Reduce Firm Risk? Evidence from Controversial Industry Sectors

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Abstract

In this paper, we examine the relation between corporate social responsibility (CSR) and firm risk in controversial industry sectors. We develop and test two competing hypotheses of risk reduction and window dressing. Employing an extensive U.S. sample during the 1991–2010 period from controversial industry firms, such as alcohol, tobacco, gambling, and others, we find that CSR engagement inversely affects firm risk after controlling for various firm characteristics. To deal with endogeneity issue, we adopt a system equation approach and difference regressions and continue to find that CSR engagement of firms in controversial industry sectors negatively affects firm risk. To examine the premise that firm risk is more of an issue for controversial firms, we further examine the difference between non-controversial and controversial firm samples, and find that the effect of risk reduction through CSR engagement is more economically and statistically significant in controversial industry firms than in non-controversial industry firms. These findings support the risk-reduction hypothesis, but not the window-dressing hypothesis, and the notion that the top management of U.S. firms in controversial industries is, in general, risk averse and that their CSR engagement helps their risk management efforts.

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Notes

  1. Firm risk can also be considered as the combination of business risk and financial risk. Firm’s business risk is usually defined as the equity risk that is inherent in a firm’s operations and comes from the nature of the firm’s operating activities, such as the firm’s cost structure, product demand characteristics, and intra-industry competitive position (Modigliani and Miller 1958). Indeed, business risk is inevitable in a firm’s daily operations. Firm’s financial risk, on the other hand, is the extra risk that arises when firms use debt financing. Thus, if firms do not use debt financing, then firm risk is equal to the business risk.

  2. To examine the relation between the manifestation of CSR and shareholder wealth, Godfrey (2005) argues that good deeds earn chits. Specifically, he establishes three core assertions: (1) that corporate philanthropy can generate positive moral capital among communities and stakeholders, (2) that moral capital can provide shareholders with "insurance-like" protection for many of a firm's idiosyncratic intangible assets, and (3) that this insurance-like protection contributes to shareholder wealth.

  3. We follow the definition of the “sinful” (e.g., tobacco, gambling, weapons, alcohol, adult entertainment) industries based on Hong and Kacperczyk (2009). For other controversial firms, such as environmental or ethics related firms, we follow the description and suggestion provided by the call for paper for the special issue of JBE for CSR in conversial industry sectors: “How is it possible for organizations in “controversial industry sectors,” which often are marked by social taboos, moral debates, and political pressures, to maintain reasonable socially responsible standards? For industry sectors typically characterized as “sinful”, as well as for those that inherently entail persistent or emerging environmental, social, or ethical issues (e.g., nuclear, oil, cement, biotech), this special issue aims to provide some answers. How can these organizations employ CSR-related policies and practices to meet their public legitimacy requirements?” In short, following the JBE special issue guideline, we define controversial firms as the combination of sinful industries and other controversial firms.

  4. See the overview studies of the empirical relation between CSR engagement and financial performance (Orlitzky et al. 2003; Margolis and Walsh 2003; Allouche and Laroche 2006; Beurden and Gössling 2008; Lindgreen et al. 2009; Baron et al. 2011). See also the empirical study examining the relation between CSR engagement and firm value of controversial industry sectors (Cai et al. 2012).

  5. Consistent with the risk reduction argument, a negative association is found between company-unique idiosyncratic risk and CSR (Boutin-Dufresne and Savaria 2004; Lee and Faff 2009) and between systematic risk and CSR (Oikonomou et al. 2010).

  6. SIC and NAICS codes for relevant industries are displayed in Table 11 in Appendix.

  7. The CAPM beta measures the systematic risk of the firm relative to the risk of the stock market in general, i.e., the market portfolio.

  8. Upon measuring risks, we also attempted to take standard deviation of earnings before interest and taxes (EBIT), but then the relationship between CSR and risk was found to be insignificant. So as to be mentioned later on, it may be given as evidence that CSR plays a role to decrease firms’ macro-level, financial risks, while it does not affect firms’ business risk because standard deviation of EBIT measures firm’s business risk (Brigham and Ehrhardt 2008).

  9. When we run the short-term regressions using 1-year lag or contemporaneous VOLATILITY, the coefficients on the change of CSR engagement in the change of VOLATILITY regressions are still negative, but statistically insignificant.

  10. The Chow test is a statistical and econometric test of whether the coefficients in two linear regressions on different data sets are equal or different.

  11. When we examine whether our main results are also preserved in triumvirate sinful industries of Alcohol, Tabacco, and gambling, following Hong and Kacperczyk (2009), we find that the impact of CSR engagement on firm risk is positive. This result suggests the possibility that the market participants interpret the CSR programs of sinful industry firms as untrustworthy, possibly due to their damaged corporate image and reputation. However, because the sample size of sin firms is small, statistical power is relatively weak. This result is available upon request.

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Acknowledgments

This paper is conducted while Jo was visiting Korea University Business School (KUBS) during his sabbatical period. Jo appreciates sabbatical support of the Leavey School of Business at Santa Clara University and partial financial assistance provided by the Asian Institute of Corporate Governance at KUBS. We appreciate co-editor of the special issue, Adam Lindgreen and two anonymous referees for many valuable comments.

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Authors and Affiliations

  1. Department of Finance, Leavey School of Business, Santa Clara University, 500 El Camino Real, Santa Clara, CA, 95053-0388, USA

    Hoje Jo

  2. School of Business, Korea University, Seoul, South Korea

    Haejung Na

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  1. Hoje Jo
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Correspondence to Hoje Jo.

Appendix

Appendix

See Tables 9, 10, and 11.

Table 9 List of the strength and concern items in the KLD Database
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Table 10 Calculation of the CSR Index
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Table 11 List of the SIC/NAICS codes for relevant industries
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Jo, H., Na, H. Does CSR Reduce Firm Risk? Evidence from Controversial Industry Sectors. J Bus Ethics 110, 441–456 (2012). https://doi.org/10.1007/s10551-012-1492-2

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