Does corporate sustainability matter for the capital structure puzzle in OIC countries? Evidence from the COVID-19 pandemic

Hasan Tekin (Department of Finance and Banking, Karabuk University, Karabük, Turkiye)
Ali Yavuz Polat (Gulf University for Science and Technology, Hawally, Kuwait)

Journal of Asian Business and Economic Studies

ISSN: 2515-964X

Article publication date: 19 December 2024

213

Abstract

Purpose

This study assesses the impact of environmental, social and governance (ESG) certification on capital structure decisions considering the COVID-19 pandemic.

Design/methodology/approach

The study utilizes the annual Asset-4 and Datastream data of Thomson Reuters Eikon for non-financial firms in member states of the Organization of Islamic Cooperation (OIC). Firm-fixed effects are used to avoid unobserved heterogeneity.

Findings

Firms with higher corporate sustainability have a higher leverage ratio. The positive impact of ESG scores on book leverage became more significant during the COVID-19 pandemic. These findings imply that ESG activities might serve as a signalling tool, especially considering the pandemic: ESG activities mitigate financial constraints when they are most pronounced and impactful.

Practical implications

Firms should invest in ESG activities to alleviate financial constraints. Researchers and practitioners are encouraged to explore how ESG and macro-specific factors jointly affect debt financing. Policymakers should incentivize ESG investment to reduce agency conflicts. Regulators in OIC countries should support firms that are encountering obstacles in obtaining ESG certification.

Originality/value

To date, the role of ESG investing in capital structure policy by considering the recent pandemic has not been assessed in OIC countries.

Keywords

Citation

Tekin, H. and Polat, A.Y. (2024), "Does corporate sustainability matter for the capital structure puzzle in OIC countries? Evidence from the COVID-19 pandemic", Journal of Asian Business and Economic Studies, Vol. ahead-of-print No. ahead-of-print. https://doi.org/10.1108/JABES-01-2024-0029

Publisher

:

Emerald Publishing Limited

Copyright © 2024, Hasan Tekin and Ali Yavuz Polat

License

Published in Journal of Asian Business and Economic Studies. Published by Emerald Publishing Limited. This article is published under the Creative Commons Attribution (CC BY 4.0) licence. Anyone may reproduce, distribute, translate and create derivative works of this article (for both commercial and non-commercial purposes), subject to full attribution to the original publication and authors. The full terms of this licence may be seen at http://creativecommons.org/licences/by/4.0/legalcode


1. Introduction

In recent years, firms, consumers and investors have shown growing concern for environmental, social and governance (ESG) issues, driven partly by regulatory pressures from developed countries (Huang and Ye, 2021). Firms, particularly those in advanced economies, actively engage in and publicize their ESG efforts to meet investor concerns and receive potential incentives (Bassen et al., 2006). ESG practices are seen as positive signals by investors for reducing perceived risks (Lee and Kim, 2016; Sassen et al., 2016; Benlemlih et al., 2018) and enhancing firm value (Lins et al., 2017). Moreover, ESG initiatives foster trust with stakeholders, help firms navigate crises (Albuquerque et al., 2020; Ding et al., 2021) and act as an insurance mechanism (Bae et al., 2019). ESG activities are also linked with improved firm performance by easing financial constraints and lowering the cost of capital (El Ghoul et al., 2011; Goss and Roberts, 2011; Cheng et al., 2014).

Lins et al. (2017) show that during the global financial crisis, firms with strong corporate social responsibility (CSR) activities benefited from higher profitability and growth owing to the trust they built with stakeholders. This suggests that investors value high-CSR firms during trust crises. While ESG investments may not always seem profitable, they can provide crucial protection during market downturns (Huang and Ye, 2021).

Investment in ESG activities is not limited to financial expenditure. It also encompasses dedicating time and effort to improve management practices, corporate governance and operational processes (Eccles et al., 2014). Enhanced corporate governance (Michelon and Parbonetti, 2012) and transparency are critical components of ESG that can significantly reduce perceived risks (Ioannou and Serafeim, 2019) and improve access to financing.

This study adopts the following conceptual framework. While the relationship between ESG initiatives and corporate debt structures requires empirical validation, the fact that ESG engagement relaxes financial constraints holds a theoretical basis (Tang, 2022). In agency theory, external financing challenges are exacerbated by information asymmetry, thereby making external finance more expensive. Firms, therefore, employ strategies to mitigate this asymmetry and signal their quality to potential investors.

ESG commitments, characterized by enhanced information disclosure, suggest improved transparency, which potentially elevates a firm’s reputation. Such enhancements could lower perceived risk among investors, which then improves the firm’s creditworthiness. This improvement could expand access to financial markets and secure favourable borrowing terms (Zhang and Liu, 2022). Especially during periods of economic downturn, ESG activities might serve as a signalling tool, mitigating financial constraints when they are most pronounced and impactful (Zhang et al., 2023).

The Organization of Islamic Cooperation (OIC) plays a vital role in emerging markets. As a multinational entity consisting of 57 member nations spanning four continents, the OIC fosters economic, political, and social collaboration among its member states, a significant portion of which are categorized as emerging markets. Especially, most of the largest countries in the OIC have introduced ESG disclosure guidelines for companies listed on their stock exchanges and encouraged firms to adopt good governance practices (Billah et al., 2024).

This study examines the relationship between ESG and capital structure for firms in 20 OIC countries from 2003 to 2021, using the COVID-19 pandemic as a natural experiment. As an unprecedented exogenous shock, the COVID-19 pandemic exacerbated challenges for financially constrained firms and increased default risk. Therefore, its impact on ESG activities and capital structure merit investigation. Focusing on OIC countries may offer additional insights (Tekin, 2024).

Our results show that firms with higher ESG scores have a higher leverage ratio, which is in line with prior findings (El Ghoul et al., 2011; Cheng et al., 2014). Moreover, firms in Oman and Saudi Arabia with lower ESG scores have higher leverage during the pandemic, whereas firms in Malaysia with higher ESG have lower leverage. Consumer discretionary and energy firms with higher ESG also have higher leverage. Nevertheless, industrial firms with higher ESG scores decrease their leverage during the pandemic.

Our study offers several contributions. First, unlike previous studies that focused only on ESG-certified firms in developed countries (Hamrouni et al., 2019; Nguyen et al., 2020; Ho et al., 2021; Bai and Ho, 2022), we examine the impact of ESG certification on capital structure across both ESG- and non-ESG-certified firms. Second, ESG certification may serve as a signal to reduce information asymmetry among stakeholders (Wu et al., 2022) and indicate a firm’s commitment to ESG activities, potentially easing financial constraints (Wong et al., 2021; Lai and Zhang, 2022). Lastly, given that previous samples are dominated by developed countries, potentially biasing results, this study explores ESG’s relevance to capital structure in developing countries.

Our results have several implications. For one, companies should contemplate allocating resources to ESG initiatives, which can alleviate financial constraints. Future research and practitioners could explore the combined influence of ESG and macro-specific factors on debt financing. In terms of policymaking, promoting ESG investment can mitigate agency conflicts. Thus, policymakers should encourage firms to prioritize ESG-related activities. Moreover, regulators in OIC countries should assist companies that are encountering challenges in obtaining ESG certification.

The rest of the paper is organized as follows: Section 2 reviews the literature and introduces relevant theoretical and empirical frameworks. Section 3 presents the data and methodology. Section 4 gives the empirical findings. Section 5 concludes the paper.

2. Literature review

2.1 Theoretical framework

After Modigliani and Miller (1958) presented their irrelevance theorems, a vast and growing body of literature has focused on the deviation from the Modigliani and Miller world. Three main capital structure theories aim to explain firms’ choice of capital structure: agency, trade-off and pecking order theories (Jensen, 1986; Myers, 2001). Of these, trade-off theory focuses on the costs and benefits of debt. Debt brings tax advantages compared with equity finance (Modigliani and Miller, 1963); however, higher debt levels imply greater risks and financial distress.

Firms determine optimal debt levels by balancing the benefits and costs, where the marginal gain from additional debt is offset by its marginal cost (Myers, 2001). According to the pecking order theory by Myers and Majluf (1984), firms prioritize financing options by first using internal funds, then debt and finally equity when faced with information asymmetry in external finance. Retained earnings are preferred because they pose the least risk of adverse selection, whereas equity is the least preferred owing to its higher adverse selection costs (Myers and Majluf, 1984; Brealey et al., 2014). This theory mainly applies to small firms with limited external funding access.

In the context of ESG, the literature often focuses on agency theory, suggesting that ESG disclosure can discipline managers to prevent inefficient resource allocation. Agency theory claims that in a firm, stakeholders have an inherent conflict of interest. As a tool to mitigate agency costs, firms choose their debt ratio strategically. Higher leverage implies less free cash flow for opportunistic managers (Jensen, 1986). That is, managers cannot divert funds for their own benefit if the firm has a high debt ratio. A natural implication of this argument is that leverage can serve as a disciplinary tool (La Porta et al., 2000; Tekin and Polat, 2021, 2023).

Agency cost literature argues that if managers are left with free cash flow, they have an incentive to use it for their own interests rather than investing in value-adding projects, thereby creating a conflict of interest for shareholders (Jensen, 1986). ESG activities can play an essential role in addressing agency problems. The available empirical evidence shows that ESG activities can discipline managers by reducing information asymmetries (Bénabou and Tirole, 2010; Martínez-Ferrero et al., 2018) because ESG requires a higher level of information disclosure (Dhaliwal et al., 2012).

Considering that contracts between shareholders and managers are typically implicit or incomplete in nature, shareholders need to trust the managers and believe that the institutional environment is fair (Guiso et al., 2008). The role of trust has become more important during unprecedented times, such as the global financial crisis and pandemic-induced crisis in recent years (Lins et al., 2017).

2.2 Related literature

A large body of research focuses on the relationship between ESG practices and firm performance. Although some studies offer contradictory evidence, most empirical evidence shows that ESG positively impacts the financial performance of firms (Van Beurden and Gossling, 2008). Earlier studies also provide evidence of the positive relationship between ESG and firm value (Servaes and Tamayo, 2013), especially when customers are more aware of the ESG activities of the firms. Albuquerque et al. (2019) mention that ESG contributes to firm performance by decreasing the systemic risk of high-ESG-rated firms.

During the COVID-19 pandemic [1], the insurance role of ESG activities is strengthened – ESG activities limit the significant decline in values, which can be considered an immunity to risk during unprecedented times (Albuquerque et al., 2020; Ding et al., 2020). Thus, the present research on the impact of the pandemic on ESG activities and capital structure decisions is timely and interesting, given that the pandemic created a different type of crisis in modern history.

Studies on ESG and capital structure (Ould Daoud Ellili, 2020; Al Amosh et al., 2022; Al-Hiyari and Kolsi, 2021) have tended to focus on either a single country or a region with a small sample. As such, their sample is not big enough to generalize their results. The present study uses a sample of 20 OIC countries with 26,805 firm years.

To date, evidence on the role of ESG in corporate debt remains limited. Yang et al. (2018) analyse the effect of CSR on the capital structure of Chinese listed firms. Hamrouni et al. (2019) examine whether ESG positively affects access to debt financing among French firms. In the context of the COVID-19 pandemic, Bai and Ho (2022) assess the relation between corporate social performance and firm debt levels using international evidence. Notably, the impact of ESG certification and ESG scores on capital structure decisions has yet to be investigated in developing countries with a large sample. Therefore, our study fills the gap by examining whether ESG matters in OIC countries’ capital structure puzzle in the context of the COVID-19 pandemic.

ESG activities require higher information disclosure, implying improved transparency, which may improve a firm’s reputation. This may lead to reduced perceived risk by investors and improve the firm’s credit rating, which broadens financial channels and helps the firm borrow at better terms. Zhang et al. (2023) examine the impact of COVID-19 on the financial constraints of listed Chinese firms and investigate how adherence to sustainable development goals (SDGs) contributes to economic resilience. Analysing data from 2019 to 2021, including firm-level accounting, ESG scores and COVID-19 case numbers, Zhang et al. (2023) reveal that firms committed to SDGs and with high ESG scores experience fewer financial constraints and navigate shocks better.

Moreover, Tang (2022) examines the relationship between ESG performance and corporate innovation, particularly in China’s A-share listed companies. Using panel data and linear regressions, Tang (2022) finds that ESG performance significantly enhances both the quantity and quality of corporate innovation, mediated by mitigating financial constraints and agency costs. Zhang and Liu (2022) investigate how ESG performance affects financial flexibility for Chinese listed firms. They find a significant enhancement, with financing constraints mediating the relation. Additionally, they suggest that environmental uncertainty and market attention positively moderate these effects, supporting instrumental stakeholder theory, signalling and the social impact hypothesis.

Financial constraints indeed imply limitations on both debt and equity financing. However, firms with higher ESG scores might exhibit different behaviours in their capital structure decisions for several reasons. Firstly, higher ESG performance can serve as a positive signal to debt markets. Firms with strong ESG performance are perceived to have lower operational risks, better management practices and more sustainable long-term strategies. These perceptions can reduce the cost of debt and make debt financing more attractive (Oikonomou et al., 2014).

Apergis et al. (2022) analyse the relation between the ESG scores and the cost of debt in firms. The study finds that firms with higher ESG scores benefit from lower bond spreads and better bond ratings, leading to a lower cost of unsecured debt. The research, conducted on S&P 500 firms from 2010 to 2019, demonstrates that strong ESG performance reduces perceived risk and supports calls for greater transparency in ESG reporting.

Then, although higher ESG performance also sends positive signals to equity markets, which could support equity financing, firms may still prefer debt for several reasons, such as tax benefits and agency costs. Specifically, debt financing provides tax benefits through the interest tax shield, which is not available with equity financing. This case can be a significant consideration for firms looking to optimize their capital structure (Graham, 2000). Sharfman and Fernando (2008) investigate how improved environmental performance can reduce the cost of equity capital, encourage a shift from equity to debt financing and engender higher tax benefits owing to increased debt capacity. They conclude that better environmental performance reduces perceived risk, thus lowering the cost of capital and making debt financing more attractive for firms.

Houqe et al. (2020) examine how ESG performance influences firms’ cost of debt across different countries. They found that firms with higher ESG scores benefit from lower debt costs, indicating that strong ESG performance reduces perceived risk among lenders and improves access to debt financing. They underscore the financial advantages of adopting robust ESG practices in a global context. Ioannou and Serafeim (2019) explore the impact of sustainability disclosure regulations on firms’ governance processes and valuations. Their study highlights how mandatory sustainability reporting can improve internal governance mechanisms and organizational transparency, thus enhancing a firm’s reputation and reducing perceived risk.

Third, debt can mitigate agency problems between managers and shareholders. Higher leverage forces managers to commit to more disciplined cash flow management and can align their interests with those of debt holders (Jensen, 1986; Abbassi et al., 2024). Michelon and Parbonetti (2012) investigate the impact of board composition, leadership and structure on sustainability disclosure, drawing on stakeholder theory. They argue that good corporate governance and sustainability disclosure are complementary mechanisms that companies use to communicate with stakeholders. They found that the effect of board composition on sustainability disclosure is influenced by the specific characteristics of each director rather than simply by the traditional distinction between insider and independent directors.

Lastly, empirical evidence points to the role of ESG during financial crises and the COVID-19 pandemic. During periods of financial instability, such as the global financial crisis and COVID-19 pandemic, firms with better ESG scores could access debt markets more easily and at lower costs, supporting higher leverage ratios (Broadstock, 2021). Abbassi et al. (2024) show that firms with strong CSR performance opt for bond debt during crisis periods because it allows them to leverage their enhanced reputation for better access to capital markets, leading to lowered borrowing costs. Additionally, bond debt provides tax benefits through interest deductions and mitigates agency costs by imposing discipline on managerial actions.

2.3 Hypothesis development

Agency theory claims that information asymmetry makes external financing costly (Myers, 2001). As such, firms try to find tools to signal their quality to investors in an attempt to alleviate the information asymmetry problem. ESG activities require a higher level of information disclosure, implying improved transparency, which may improve a firm’s reputation. This may lead to reduced perceived risk by the investors and the firm’s improved credit rating, which may broaden financial channels and make the firm borrow with better terms (Zhang and Liu, 2022). Considering the mechanism mentioned above, ESG activities may act as a signalling device for firms, especially during significant downturns, when financial constraints become more relevant and tighter (Yang et al., 2018). Thus, we hypothesize that a positive relationship exists between the ESG score and leverage ratio for firms.

H1.

Firms with higher ESG scores are likely to have a higher leverage ratio.

3. Data and methodology

3.1 Sample composition

We collect firm-level data from the Thomson Reuters Datastream database for firms in 20 OIC countries (Bahrain, Bangladesh, Bosnia, Egypt, Indonesia, Iraq, Jordan, Kazakhstan, Kuwait, Lebanon, Malaysia, Morocco, Oman, Pakistan, Palestine, Qatar, Saudi Arabia, Tunisia, Türkiye and the United Arab Emirates). We exclude financial and utility firms, which have different accounting structures (Tekin, 2021). The sample consists of 2,219 firms in 20 OIC countries between 2003 and 2021, equivalent to 26,805 firm years (see Table A8 [2]).

3.2 ESG sample

We retrieve corporate sustainability data from the Thomson Reuters ESG database. When we include the ESG score, nine countries are eliminated from the sample. Thus, 11 countries (Bahrain, Egypt, Indonesia, Kuwait, Malaysia, Morocco, Oman, Qatar, Saudi Arabia, Türkiye and the United Arab Emirates) comprise the ESG subsample. Table A1 [2] demonstrates the composition of the ESG sample; it reports the means of ESG scores and number of observations (N) and firms by country. Morocco (0.559) and Türkiye (0.482) have the highest ESG scores, whereas Bahrain (0.276) and Qatar (0.316) have the lowest ESG scores.

3.3 Variable definitions

To measure the capital structure of firms, we employ market leverage (MLEV), defined as the total debt scaled by the sum of total debt and market capitalization (Frank and Goyal, 2009). To ensure robustness in our analysis, we also use the book leverage (BLEV), including short- (short-term book leverage (SLEV)) and long-term (long-term book leverage (LLEV)) book leverages (e.g. Köksal and Orman, 2015).

We separate the ESG-certified and non-ESG-certified firms using a dummy variable, ESG certified (ESGCER), that takes 1 for firms with an ESG score and 0 otherwise (Wong et al., 2021; Lai and Zhang, 2022; Wu et al., 2022). Next, we employ ESG score (ESGS) to capture the ESG disclosure of ESG-certified firms. We utilize a dummy variable to evaluate how capital structure decisions differed during the COVID-19 pandemic (COV) period.

Regarding the control variables, we employ firm size (SIZE), tangibility (TAN), market-to-book ratio (MBR) and profitability (EBIT) (Rajan and Zingales, 1995). Following Frank and Goyal (2009), we include the industry median of market leverage (IM-MLEV) to control for industry impact. As more recent research (Tekin, 2021) includes cash holdings (CASH) and dividends (DIV), and we also add both variables to our models. Table A2 [2] presents the variable definitions.

3.4 Methodology

We use the sample of Thomson Reuters Datastream for firms in 20 OIC countries. Given that the entire sample includes big i (group) and small t (time), firm-fixed effects may overcome the unobserved heterogeneity. Thus, we include firm-fixed effects. The baseline model is as follows:

(1)MLEVi,t=β0+β1COVt+β2SIZEi,t+β3TANi,t+β4MBRi,t+β5EBITi,t+β6CASHi,t+β7DIVi,t+β8IM_MLEVi,t+αiFi+εi,t
where MLEVi,t refers to market leverage for firm i at time t; COVt, COV being 1 for years 2020–2021 and 0 otherwise; SIZEi,t, firm size for firm i at time t; TANi,t, tangibility for firm i at time t; MBRi,t, market-to-book ratio for firm i at time t; EBITi,t, profitability for firm i at time t; CASHi,t, cash holdings for firm i at time t; DIVi,t, dividends for firm i at time t; IM_MLEVi,t, industry median of market leverage for firm i at time t; Fi, firm-fixed effects and ɛi,t, the error term.

To elucidate how ESG certification affects the determinants of capital structure, we utilize an ESGCER dummy and its interactions with other factors:

(2)MLEVi,t=β0+β1ESGCERi+β2COVt+β3SIZEi,t+β4TANi,t+β5MBRi,t+β6EBITi,t+β7CASHi,t+β8DIVi,t+β9IM_MLEVi,t+αiFi+εi,t
(3)MLEVi,t=β0+β1(ESGCERixCOVt)+β2ESGCERi+β3COVt+β4SIZEi,t+β5TANi,t+β6MBRi,t+β7EBITi,t+β8CASHi,t+β9DIVi,t+β10IM_MLEVi,t+αiFi+εi,t
where ESGCERi indicates the ESG certification for firm I and ESGCERi x COVt refers to the interactions between ESGCER and COV.

Next, we employ the sample of Thomson Reuters Asset-4 for firms in 11 [3] OIC countries to assess how ESG scores influence capital structure choices during the health crisis (COV). We use the following models:

(4)MLEVi,t=β0+β1ESGSi,t+β2COVt+β3SIZEi,t+β4TANi,t+β5MBRi,t+β6EBITi,t+β7CASHi,t+β8DIVi,t+β9IM_MLEVi,t+αiFi+εi,t
(5)MLEVi,t=β0+β1(ESGSi,t×COVt)+β2ESGSi,t+β3COVt+β4SIZEi,t+β5TANi,t+β6MBRi,t+β7EBITi,t+β8CASHi,t+β9DIVi,t+β10IM_MLEVi,t+αiFi+εi,t
where ESGSi,t refers to the ESG score for firm i at time t and ESGSi,t x COVt represents the interactions between ESGS and COV.

4. Empirical findings

Figure A1 [2] presents the trend in MLEV across non-ESG and ESG-certified firms from 2003 to 2021. In non-ESG-certified firms, MLEV decreased between 2003 and 2007 but sharply increased in 2008. They also showed a decline in MLEV during the COVID-19 pandemic. Meanwhile, in ESG-certified firms, MLEV shows an increasing trend until 2018 but then decreases during the pandemic.

4.1 Univariate analyses

Table A3 [2] shows how MLEV and its firm-level determinants differ from the pre-pandemic to the pandemic periods across ESG- and non-ESG-certified firms. In the pre-COVID-19 pandemic period, ESG-certified firms were larger and had higher growth opportunities, profitability, CASH, dividends and lower leverage. ESG-certified firms remain larger and have higher profitability and dividends during the pandemic. In comparison, non-ESG-certified firms have lower tangibility, profitability and dividends and higher firm size, growth opportunities and CASH from the pre-pandemic to the pandemic periods.

4.2 Multivariate analyses

Table A4 [2] shows the determinants of capital structure for all firms in our sample, non-ESG and ESG-certified firms. As shown in column 1, firms with higher size, tangibility and industry median have higher leverage, whereas firms with lower growth opportunities, profitability, CASH and dividends have lower leverage. The results in column 2 are qualitatively similar to those in column 1. However, the results are different for ESG-certified firms (column 3) – COV is insignificant. This implies that the COVID-19 pandemic has no significant impact on the leverage choice of ESG-certified firms. Furthermore, larger firms and firms with higher tangibility, lower profitability and lower CASH have higher leverage over the period 2003–2021.

Instead of splitting the sample across non-ESG and ESG firms, we employ a dummy variable (ESGCER) to differentiate the two subsamples. As shown in column 1 in Table A5 [2], ESGCER is negative with a significance of −0.018 at 1%. That is, non-ESG-certified firms have higher leverage. This result aligns with previous research (Lai and Zhang, 2022). However, when we interact ESGCER with COV in column 2, the sign and significance of ESGCER remain. The interaction term ESGCER x COV is positive, with a significance of 0.024 at 1%. In other words, firms with ESG certification increased their leverage during the COVID-19 pandemic.

To investigate whether ESG scores impact the capital structure, we regress the ESG score and its interactions with COV on MLEV. Table 1 shows that ESG score (ESGS) is positively related to MLEV, which suggests that firms with higher ESG scores have higher MLEV. This result also confirms previous research (Yang et al., 2018; Hamrouni et al., 2019; Bai and Ho, 2022). However, the influence of ESG scores remains consistent even during the COVID-19 pandemic, as indicated by insignificant coefficients for the interaction between ESG scores and the pandemic. We also obtain qualitatively similar results by employing the BLEV, excluding the interaction term. ESGS x COV is positive with a significance of 0.067 at 5%. That is, the positive impact of ESGS on leverage becomes more significant during the COVID-19 pandemic. Therefore, we generalize that the positive association between corporate sustainability and capital structure in OIC countries does not depend on the measurement of the capital structure. However, this positive impact of sustainability loses its significance on SLEV and LLEV, which are reported in Table A9 [2].

4.3 Additional analyses

We rerun Model 2 in Table 1 using 11 countries and 8 industries, as shown in Table A6 [2] and Table A7 [2], respectively. Regarding the country-based analysis in Table A6 [2], firms with higher ESG scores have higher leverage in Indonesia, Malaysia and Saudi Arabia. Firms in Oman and Saudi Arabia with lower ESG scores have higher leverage during the pandemic, whereas firms with higher ESG scores in Malaysia have lower leverage. The significance of control variables varies depending on the country, but their signs differ slightly. Specifically, SIZE, TAN and IM_MLEV are positively associated with leverage, whereas MBR, EBIT, CASH and DIV are negatively associated with leverage. Considering the sign of control variables, trade-off theory better explains the behaviour of ESG-certified firms in OIC countries.

In Table A7 [2], the positive relationship between ESGS and MLEV is slightly significant for consumer discretionary firms and highly significant for energy firms. ESGS x COV is only significant for industrial firms, with a coefficient of 0.066 at 1%. That is, during the COVID-19 pandemic, industrial firms with higher ESG scores decreased their leverage more. The significance of control variables [4] changes depending on the firms’ industry. EBIT, CASH and DIV are negative and significant, whereas SIZE, TAN and IM_MLEV are positive and significant. However, contrary to the claims of trade-off theory, consumer discretionary and telecommunication firms have higher leverage. This result supports the pecking order theory. Similarly, trade-off theory generally explains firms’ capital structure policy across industries in OIC countries.

5. Concluding remarks

Employing 26,805 firm years from 20 OIC countries, this study assesses whether the ESG figures are a piece in the capital structure puzzle, considering the COVID-19 pandemic as a natural experiment. Exogenous shocks boost the default risk of the companies and erode the level of trust in financial markets. Nevertheless, the pandemic itself did not start as a financial sector crisis but rather emerged as a health crisis. Thus, our work is timely and relevant to elucidate the impact of the pandemic, as a different type of crisis in modern history, on ESG activities and capital structure.

Our findings indicate that firms with higher ESG scores have a higher leverage ratio, in line with claims in earlier literature. Regarding the country-specific analysis, firms with higher ESG scores have higher leverage levels in Indonesia, Malaysia and Saudi Arabia. Firms in Oman and Saudi Arabia with lower ESG scores have higher leverage during the pandemic, whereas firms with higher ESG in Malaysia have lower leverage. Consumer discretionary and energy firms with higher ESG have higher leverage. Meanwhile, industrial firms with higher ESG scores decreased their leverage during the pandemic.

The results have several implications. First, firms should consider investing in ESG activities, which may help to relax financial constraints. Researchers and practitioners may extend the literature by investigating the joint impact of ESG and macro-specific factors on debt financing. Regarding policymaking, ESG investment helps to mitigate agency conflicts; therefore, policymakers should incentivize firms to focus on ESG-related activities. Furthermore, OIC countries’ regulators should support firms that face obstacles in obtaining ESG certification.

This study has successfully demonstrated the link between corporate sustainability and capital structure, but it has certain limitations in terms of the sample construction. Of the 57 OIC countries, only 20 countries have accessible data in Datastream. Future research may raise the number of OIC countries in the sample by checking other databases, such as Bloomberg and Compustat.

Does ESG score matter on capital structure puzzle?

Dependent variable: MLEV
Interaction with COV
(1)(2)
ESGS x COV −0.007(0.012)
ESGS0.051***(0.017)0.056***(0.017)
COV0.023***(0.008)0.007(0.019)
SIZE0.058***(0.007)0.015***(0.007)
TAN0.151***(0.033)0.120***(0.033)
MBR−0.006**(0.003)−0.011**(0.003)
EBIT−0.344***(0.045)−0.359***(0.045)
CASH−0.188***(0.046)−0.198***(0.046)
DIV−0.111(0.079)−0.130*(0.079)
IM_MLEV0.409***(0.082)0.562***(0.082)
Constant−0.830***(0.123)−0.103*(0.123)
R20.828 0.829
Hausman test73.47*** 66.20***
Firms205 205
Observations1,528 1,528

Note(s): This table reports the regression results examining the determinants of market leverage (MLEV) for ESG-certified firms. Firm FE included in all models. Variables are defined in Table A2. *** and ** signify significance at 1 and 5%

Notes

1.

The COVID-19 pandemic sharply affected the financial markets (Mugaloglu et al., 2022; Aysan et al., 2023).

2.

Please see it on the Online Appendix.

3.

The ESG data of Thomson Reuters Asset-4 exists for eleven countries, as shown in Table A1.

4.

Following reviewers’ comment, we also assess the impact of the corporate tax on leverage in Table A10 (in the Online Appendix), and we find that corporate tax has no effect on leverage.

Supplementary material

The supplementary material for this article can be found online.

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Corresponding author

Hasan Tekin can be contacted at: hasantekin@karabuk.edu.tr

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