Does corporate environmental performance enhance financial performance? An empirical study of indonesian firms

Author’s Accepted Manuscript Does corporate environmental performance enhance financial performance? an empirical study of indonesian firms Kimitaka NISHITANI, Nurul JANNAH, Shinji KANEKO, Hardinsyah www.elsevier.com/locate/envdev

PII: DOI: Reference:

S2211-4645(16)30332-3 http://dx.doi.org/10.1016/j.envdev.2017.06.003 ENVDEV356

To appear in: Environmental Development Received date: 12 December 2016 Revised date: 14 June 2017 Accepted date: 14 June 2017 Cite this article as: Kimitaka NISHITANI, Nurul JANNAH, Shinji KANEKO and Hardinsyah, Does corporate environmental performance enhance financial performance? an empirical study of indonesian firms, Environmental Development, http://dx.doi.org/10.1016/j.envdev.2017.06.003 This is a PDF file of an unedited manuscript that has been accepted for publication. As a service to our customers we are providing this early version of the manuscript. The manuscript will undergo copyediting, typesetting, and review of the resulting galley proof before it is published in its final citable form. Please note that during the production process errors may be discovered which could affect the content, and all legal disclaimers that apply to the journal pertain.

Does corporate environmental performance enhance financial performance? An empirical study of Indonesian firms a

Kimitaka NISHITANIa* , Nurul JANNAHb, Shinji KANEKOc, Hardinsyahd Research Institute for Economics and Business Administration, Kobe University, 2-1 Rokkodai Nada Kobe, 657-8501, Japan

b

Diploma Program, Bogor Agricultural University, Cilebende IPB Campus Jl Kumbang 14 Bogor West Java, 16151, Indonesia c

Graduate School for International Development and Cooperation, Hiroshima University, 1-5-1 Kagamiyama Higashi-Hiroshima, 739-8529, Japan

d

Faculty of Human Ecology, Bogor Agricultural University, Dramaga IPB Campus Jl Kamper Bogor West Java, 16680, Indonesia

*Corresponding author. Tel: +81-78-803-7032, Email: [email protected]

Abstract This paper, using data derived from a questionnaire survey of Indonesian firms, analyzes whether a firm’s environmental performance enhances its financial performance and why this happens. Due to the fact that the breakeven point of improving environmental performance will decrease in theory by implementing environmental management voluntarily rather than mandatorily, the relationship between environmental performance and financial performance is assumed to depend on the firm’s voluntary or mandatory stance on environmental management. The main findings of the regression analysis are as follows. First, firms that implement environmental management more aggressively are more likely to reduce greenhouse gas (GHG) and pollution emissions more. However, this does not mean that firms with a voluntary stance on environmental management are more likely to reduce these emissions by implementing environmental management than those with a mandatory stance. Second, firms that reduce GHG emissions to a greater extent are more likely to enhance profit further, whereas this is not the case for firms that reduce pollution emissions more. Third, firms that reduce GHG emissions more are more likely to improve productivity and are not more likely to increase sales. Accordingly, firms can enhance profit by reducing GHG emissions through reducing production costs and not by increasing sales. These results imply that although Indonesian firms enhance their financial performance through better environmental performance to some extent, the effect on financial performance is not large. This is because they do not successfully achieve environmental innovation and the breakeven point of improving environmental performance does not decrease sufficiently.

Keywords Environmental performance; Financial performance; Breakeven point; Voluntary or mandatory stance on environmental management; Environmental innovation; Developing countries

1. Introduction Since the latter half of the 1990s, many firms have not only mandatorily, but also voluntarily, implemented environmental management to improve their environmental performance, in response to increasing social environmental preferences and pressures, as well as environmental regulations. In this context, the debate about whether a firm’s environmental performance actually enhances its financial performance is ongoing. One argument is that because environmental management by a firm incurs additional costs, its improved environmental performance leads to higher prices and reduced competitiveness (Porter and Van der Linde, 1995). Another is that because a firm’s environmental management nurtures environmental innovation (not only product innovation, but also process innovation), its improved environmental performance leads to increased sales and cost reductions (Hui et al., 2001; Nishitani, 2011). Business theories, such as the resource-based view and the Porter hypothesis, provide some clues to help resolve the debate. The resource-based view argues that a firm’s performance depends significantly on firm-specific organizational resources and capabilities such as environmental technologies that have the potential to improve productivity and minimize environmental burdens simultaneously (Sharma and Vredenburg, 1998; Shrivastava, 2007). On the other hand, the Porter hypothesis suggests that properly designed environmental regulation can trigger innovation that can offset the cost of regulation compliance through improved efficiency (Porter and Van der Linde, 1995). However, according to economic theory, a firm’s environmental management strategy to improve environmental performance will be decided on based on a favorable cost–benefit relationship subject to environmental regulations (Alberini and Segerson, 2002; Potoski and Prakash, 2005; Nishitani 2011). Thus, because different firms take different stances on environmental management to enhance financial performance, not all firms enhance their financial performance through better environmental performance (Jaffe and Palmer, 1997). Previous studies, including Baas (1995), Sharma and Vredenburg (1998), and Aragon-Correa and Sharma (2003), suggested that firms that voluntarily (or proactively) implement environmental management beyond compliance with environmental regulations are more likely to enhance financial performance. These firms are more eager to implement research and development (R&D) activities and employee training programs related to environmental issues to nurture innovation, given that their expected marginal benefits associated with improving the environment outweigh the expected marginal costs. Conversely, if firms just mandatorily (or reactively) implement environmental management to comply with regulations, the benefits would not exceed the costs. As these discussions imply that the breakeven

point of improving environmental performance will decrease in theory by implementing environmental management voluntarily rather than mandatorily, the relationship between environmental performance and financial performance is assumed to depend on the firm’s voluntary or mandatory stance on environmental management1. This view is obvious in the discussion of the relationship in manufacturing processes between the end-of-pipe approach (mainly employed by environmentally reactive firms) and cleaner production approaches, mainly employed by environmentally proactive firms (Baas, 1995; Nishitani et al., 2011). Therefore, it is expected that if firms mandatorily implement environmental management only to meet environmental regulations, it will be relatively difficult for them to enhance financial performance through better environmental performance. In contrast, if firms voluntarily implement environmental management, it will be easier for them to do so. Although many previous studies which analyzed the influence of a firm’s environmental performance on its financial performance generally found a positive relationship (Section 2), these studies focused only on voluntary environmental performance, or did not consider the firm’s stance on whether environmental management should be implemented voluntarily or mandatorily. Furthermore, while environmental issues are global in scope and corporate environmental management is gaining more importance in developing countries, most studies have focused on developed countries (Jamali, 2014). This research question is applicable to firms in developing countries that have different cultural and sociopolitical aspects as well as those in developed countries where their businesses are globally connected (Kola-Lawal et al. 2014). Indeed, Indonesia, the target country of this paper, ranks in the top 30 countries in terms of merchandise exports (Roy and Yasar, 2015). Thus, firms in developing countries as typified by Indonesia should also have an incentive to implement environmental management not only mandatorily but also voluntarily to meet global standard. Besides, governments often provide policies (not direct regulations) to encourage firms to implement environmental management voluntarily. For example, in 2002, the Indonesian Ministry of the Environment launched an encouragement award called the Company’s Environmental Performance Rating Program (PROPER), which involves an annual evaluation and ranking of Indonesian firms into five categories according to their environmental management activities including air pollution control, hazardous waste management, marine pollution control, and environmental impact assessment (Arafat et al., 2012b). The aim of the PROPER is to motivate

1

The break-even point is the point at which total revenue equals total costs. At this point there is no profit or loss. If a firm’s environmental management implementation depends on a favorable cost-benefit relationship, firms implement environmental management to improve environmental performance only when the expected marginal profit exceeds expected marginal costs. Accordingly, total sales line shifts upward and/or total costs line shifts downward, which decreases the break-even point (namely, enhance profit). Otherwise, because only additional costs are required to implement environmental management, these lines shift in reverse (Figure 1.).

firms to implement environmental management voluntarily and to improve environmental performance by releasing the ranking results to the public. However, environmental management in developing counties is relatively less mature than in developed countries. Even in the 2000s, awareness of the concept of corporate social responsibility, (CSR) including environmental management, by Indonesian firms was very low, and the state of CSR in Indonesia is still at an early stage (Arafat et al., 2012a). As a firm’s environmental stance usually shifts from mandatory to voluntary, it is possible that environmental management, and its associated improvement in performance, has different influences on financial performance in developing countries. Clarifying whether a firm implements environmental management voluntarily or mandatorily and whether its environmental performance consequently enhances financial performance in Indonesia is important to provide a new insight into practice not only in developing countries but also in developed countries. However, these relationships have so far not been adequately clarified, especially in the context of developing counties. Therefore, this paper, using data derived from a questionnaire survey of Indonesian firms, analyzes whether a firm’s environmental performance enhances financial performance and why this happens. The main findings of the regression analysis are as follows. First, firms that implement environmental management more aggressively are more likely to reduce greenhouse gas (GHG) and pollution emissions more. However, this does not mean that firms with a voluntary stance on environmental management are more likely to reduce these emissions by implementing environmental management than those with a mandatory stance. Second, firms that reduce GHG emissions to a greater extent are more likely to enhance profit further, whereas this is not the case for firms that reduce pollution emissions more. Third, firms that reduce GHG emissions more are more likely to improve productivity and are not more likely to increase sales. Accordingly, firms can enhance profit by reducing GHG emissions through reducing production costs, and not by increasing sales. These results imply that although Indonesian firms enhance financial performance by better environmental performance to some extent, the effect on enhanced financial performance of environmental performance is not large. This is because they do not successfully achieve environmental innovation and the breakeven point for improving environmental performance does not decrease sufficiently. Thus, the novelty of this study lies in showing that environmental performance enhances financial performance even in the context of Indonesia. However, it is not sufficient for firms to merely implement environmental management (without strategic thinking) to improve environmental performance. This paper is divided into the following sections. Section 2 reviews literature concerning the relationship between environmental and financial performance and discusses the hypotheses given in the literature. Section 3 details the regression model, data and variables and Section 4 provides results. Section 5 presents a discussion and conclusion.

2. Literature review and hypotheses development Environmental management by firms both generates revenues and incurs costs. To examine whether the additional revenues from environmental management exceed the costs, many studies have empirically analyzed the relationship between a firm’s environmental and financial performance. This paper reviews studies published since 2010. Zeng et al. (2010) found that cleaner production activities positively influenced financial performance indicators in Chinese firms. Heras-Saizarbitoria et al. (2011) did not find that Spanish firms with ISO 14001 certification had better financial performance measured by return on assets (ROA) and sales. Iwata and Okada (2011) found that GHG reduction led to improved financial performance measured by ROA, return on investment, and return on invested capital, but reduced waste emissions did not in Japanese firms. Nishitani (2011) found that the implementation of an environmental management system increased a Japanese firm’s value added by increasing demand and improving productivity. Nishitani et al. (2011) found that a reduction of pollution emissions through the cleaner production approach increased a Japanese firm’s value added, but the end-of-pipe approach did not. Arafat et al. (2012b) found that environmental performance measured by the PROPER rating was positively related to ROA in Indonesian firms. Hatakeda et al. (2012) found that although there is a positive relationship between a Japanese firm’s GHG emissions and ROA, this relationship is mitigated if the firm has a positive stance on environmental management to reduce GHG emissions. Thoumy and Vachon (2012) found that environmental projects related to the main product or its underlying production process were financially more beneficial, whereas pollution prevention technologies and environmental project size were not in Canadian manufacturing firms. De Burgos-Jiménez et al. (2013) found that environmental proactivity and environmental performance enhanced ROA and return on sales (ROS), but environmental management did not in Welsh firms. Lin et al. (2013) found that environmental performance indicators were positively correlated with financial performance indicators in leading foreign motorcycle firms in Vietnam. Cheng et al. (2014) found that eco-organizational innovation had a positive effect on business performance indicators in Taiwanese firms. Ghisetti and Rennings (2014) found that environmental process innovation enhanced ROS in German firms. Nishitani et al. (2014) found that Japanese firms’ GHG emissions management enhances value added through increases in demand and improvements in productivity. However, the latter effect is conditional; although their efforts to maintain lower GHG emissions improved productivity, efforts to reduce GHG emissions further did not always improve it, especially for energy-intensive firms. Razafindrambinina and Sabran (2014) found that environmental aspects in CSR did not influence ROA in Indonesian nonfinancial firms. Qi et al. (2014) found that sulfur dioxide emissions per unit of industry value

decreased industry-level ROA in Chinese industrial sectors. Przychodzen and Przychodzen (2015) found that there was a positive relationship between environmental innovation and ROA and returns on equity in Polish and Hungarian firms. Thus, many studies have found a positive relationship between environmental and financial performance. If this is a continuous trend, the first hypothesis regarding the relationship between environmental and financial performance is:

Hypothesis1: Firms can enhance financial performance through better environmental performance, regardless of their firm’s stance on environmental management. Such a positive relationship is reasonable if a firm’s environmental management indeed nurtures environmental innovation. Environmental innovation is “the implementation of new, or significantly improved, products (goods and services), processes, marketing methods, organizational structures, and institutional arrangements which, with or without intent, lead to environmental improvements compared to relevant alternatives” (OECD, 2010). Environmental innovation and the level of proactive environmental management by firms are strongly related (Angelo et al., 2012). This relationship is empirically supported by, for example, Horbach (2008), Wagner (2008) and Rennings et al. (2006). Environmental innovation creates competitive advantage, and for that reason, firms are implementing environmental management proactively (or voluntarily) (Wagner, 2009). Thus, R&D activity and employee training programs in environmental issues are examples of specific environmental management activities for this purpose. However, a number of studies have obtained inconsistent results (namely, there is still a lack of consensus on the relationship between environmental and financial performance), which suggests that the benefits associated with improving the environment do not always outweigh the costs. This is because the decision to improve the environment is based on a favorable cost–benefit relationship subject to environmental regulations, and different firms take different stances on environmental management, as suggested in Section 1. Firms will have an incentive to improve the environment beyond the compliance level of environmental regulations only when the expected marginal benefits associated with improving the environment outweigh the expected marginal costs. In other words, one firm implements environmental management voluntarily beyond the compliance level associated with environmental regulations, and the other company implements it reactively just to show compliance with the regulations. As a result, differences in environmental performance because of differences in firms’ stances on environmental management can result in variation in financial performance, and firms that voluntarily implement environmental management beyond the compliance level associated with environmental regulations are potentially more likely to enhance financial performance via better environmental performance. In contrast, this is not the case for firms that implement environmental

management mandatorily. The Porter hypothesis suggests that environmental regulation triggers innovation, but firms do not realize potential improvements in financial performance associated with improved environmental performance through implementing environmental management voluntarily (Porter and Van der Linde, 1995). However, this does not mean that firms that implement environmental management mandatorily are potentially more likely to enhance financial performance via better environmental performance. If anything, the Porter hypothesis does not deny that firms that voluntarily implement environmental management beyond the compliance level associated with environmental regulations can innovate more successfully than those implementing environmental management mandatorily. Therefore, it is expected that the breakeven point of improving environmental performance will decrease by implementing environmental management voluntarily. For this reason, firms will potentially enhance financial performance by improving their environmental performance if they implement environmental management voluntarily. Hence, these discussions lead to a second hypothesis regarding the relationship between environmental and financial performance:

Hypothesis 2: Firms that voluntarily implement environmental management are more likely to reduce their environmental burden, and consequently they can enhance financial performance through better environmental performance.

On the other hand, it is widely believed that because the (local) governments of developing countries have an incentive to make environmental regulations less strict in order to promote foreign investment, less environmentally friendly firms can be induced to relocate to minimize costs (Wheeler, 2001). Furthermore, because only a small number of studies have analyzed firms environmental management in developing countries (only Zeng et al. (2010) and Lin et al. (2013) in Vietnam, Cheng et al. (2014) in Taiwan, and Qi et al. (2014) in China found a positive relationship in our literature review), it seems that voluntary environmental management in developing countries has not yet become the norm. Thus, a firm’s stance on environmental management in developing countries including Indonesia might be relatively more reactive than that in developed countries. As a result, we cannot yet discuss environmental management in developing countries in the same way as in developed countries. The fact that Razafindrambinina and Sabran (2014) did not find any relationship in Indonesian firms provides some evidence of this. Accordingly, the third and fourth hypotheses regarding the relationship between environmental and financial performance are:

Hypothesis 3: Although firms that voluntarily implement environmental management are more likely to reduce their environmental burden, they cannot enhance financial performance through better environmental performance.

Hypothesis 4: Firms cannot enhance financial performance through better environmental performance, regardless of a firm’s stance on environmental management.

There are two paths for environmental performance to enhance financial performance, and the breakeven point of improving environmental performance will decrease through these paths (Nishitani, 2011). The first is an increase in demand through strengthened customer loyalty and enhanced firm image (Hui et al., 2001). Better environmental performance provides positive information about environmentally friendly firms and their products to customers, which enables firms to increase their market share and/or charge higher prices for their environmentally friendly products (Khanna et al., 1998, Khanna, 2001). The second is an improvement in productivity through process innovation and improvements in staff morale (Hui et al., 2001). As poor environmental performance is regarded as reflecting poor management practices and a lack of innovativeness, potential cost savings are available by improving environmental performance (Porter and Van der Linde, 1995). Changes in process technology, raw material substitution, specific water consumption and waste profiles, specific energy consumption, process efficiency, and aesthetics are critical factors for improving the environment as well as productivity (Azbar, 2004). They enable firms to reduce their fixed and variable costs. The strength of the influence of environmental performance on financial performance may vary in terms of the extent to which environmental innovation functions properly. It is expected that firms that improve their environmental performance will enhance their financial performance through both an increase in demand and an improvement in productivity, if environmental innovation functions effectively through voluntary implementation of environmental management. On the other hand, it is expected that firms could enhance their financial performance through only one of these, or without either of these. However, it is obvious that improved financial performance through both an increase in demand and improvement in productivity is preferable than that through only one of them, because an increase in demand that shifts the total sales line upward and an improvement in productivity that shifts the total costs line downward will both work to decrease the breakeven point of improving environmental performance (Figure 1). Analyzing not only whether improved environmental performance from implementing environmental management voluntarily improves financial performance, but also how much environmental performance is required to achieve this (by both an increase in demand and improvement in productivity or either an increase in demand or an improvement in productivity)

helps to clarify whether a firm’s improved environmental performance enhances financial performance and why this happens, or does not happen, in Indonesian firms. Thus, testing the above hypotheses provisionally by using not only profit growth, but also increases in demand (sales) and improvements in productivity as proxies for financial performance enables us to clarify whether improved environmental performance by implementing environmental management voluntarily improves financial performance and how much environmental performance is required to achieve this. In addition, the hypothesis to be supported may differ among different environmental performance measures such as reductions of GHG and pollution emissions. GHG emissions are related to energy consumption and pollution emissions are related to materials consumption. Additionally, pollution emissions are usually more strictly regulated by government than GHG emissions.

3. Research design This section introduces the regression models used to test the above hypotheses, and the data and variables used in our regression models.

3.1 Regression model The influence of environmental management on environmental performance and that of environmental performance on financial performance are estimated simultaneously using an instrumental-variables ordered-probit model (IV-oprobit)2, to avoid capturing reverse causality in which firms that enhance their financial performance more are more likely to improve their environmental performance. Due to the fact that the studies reviewed in Section 2 do not always consider the causality between environmental and financial performance, we cannot deny the possibility that financial performance actually enhances environmental performance if these studies have an endogeneity bias. The two-stage method using an instrumental variable(s) has often been used to resolve this issue. The specific method to be employed, such as two-stage least squares or IV-oprobit, depends on the dependent variable, and IV-oprobit is the appropriate method when the dependent variables are measured using a five-point Likert scale as explained in Section 3.3.1. Regarding previous studies, Qi et al. (2014), employ a dynamic generalized method of moments instrumental variable model. Nishitani (2011) employs a fixed effects instrumental variable model and Nishitani et al. (2011, 2014) use a random effects instrumental variable model to avoid endogeneity bias derived from the theoretical model. The following three equations are employed because we use GHG emissions reduction and pollution emissions reduction as proxies of environmental performance (this is explained in Section 3.3.2).

2

We used Stata syntax cmp for the estimations (Roodman, 2011).

GHG  1EM   2 EMV  3CONTROL 

(1)

POLLUTION  1EM   2 EMV  3CONTROL u

(2)





FP*   1 GHG  2 POLLUTION  3CONTROL  

5  4  FP  3 2  1

if

μ4  FP*

if

μ3  FP*  μ4

if

μ2  FP*  μ3

if

μ1  FP  μ2

if

μ1  FP*

(3)

(4)

*

where GHG is GHG emissions reduction, POLLUTION is pollution emissions reduction, EM is environmental management, EMV is environmental management implemented voluntarily, 



FP* is a latent variable of FP , FP is financial performance, GHG and POLLUTION are

predicted values of GHG and POLLUTION, CONTROL is control variables (such as firm size and type of firm, that could also influence GHG , POLLUTION and FP* ),  ,  and  are estimation parameters, and  , u and  are error terms. Equation (1) estimates the influence of the environmental management on GHG emissions reduction, equation (2) that of the environmental management on pollution emissions reduction, and equation (3) those of GHG emissions reduction and pollution emissions reduction on financial performance.

3.2 Data The data used in the analysis are cross-sectional on 100 Indonesian firms operating in the mining, manufacturing, agriculture, and electricity, gas, and water supply industries. The data were obtained from a questionnaire survey conducted through the CSR Association of Indonesia during the period February 1–28, 2011 (see the Appendix for the questionnaire about the variables). The sample firms were selected randomly from each category of the PROPER in 2009. Thus, we regard them as a representative sample of all Indonesian firms. In the survey, firms are asked about their environmental activities, current business operations, firm characteristics, and so on.

3.3 Variables The descriptive statistics of the variables used in the IV-oprobit are provided in Table 1 and these variables are defined as follows.

3.3.1 Financial performance 

Profit growth



Sales increase



Productivity improvement The proxies for financial performance are profit growth, sales increase, and productivity

improvement. Profit growth can be achieved through sales increase and/or production costs reduction by means of productivity improvement. Profit growth is measured by the score in response to the following question using a five-point Likert scale ranging from (5) significantly improved to (1) significantly worsened: How is your firm’s current profit compared with five years ago? Sales increase is measured by the score in response to the following question using a five-point Likert scale ranging from (5) significantly increased to (1) significantly reduced: How are your firm’s current sales compared with five years ago? Productivity improvement is measured by the score in response to following question using a five-point Likert scale ranging from (5) significantly improved to (1) significantly worsened: How is your firm’s current productivity compared with five years ago?

3.3.2 Environmental performance 

GHG emissions reduction



Pollution emissions reduction The proxies of environmental performance are GHG emissions reduction and pollution emissions

reduction. GHG emissions reduction is measured by the score in response to following question using a five-point Likert scale ranging from (5) significantly reduced to (1) significantly increased: How are your firm’s current GHG emissions compared with five years ago? Pollution emissions reduction is measured by the score in response to following question using a five-point Likert scale ranging from (5) significantly reduced to (1) significantly increased: How are your firm’s current pollution emissions compared with five years ago? However, it is generally believed that it is easier to obtain a positive relationship between environmental performance and financial performance when subjective data are used for the analysis. This is because firms with better environmental performance and those with better financial performance are more likely to answer the questionnaire. Therefore, to avoid this bias as much as possible, if the value of GHG emissions reduction and pollution emissions reduction is scored at 5 or 4, we weight these values by the degree of the firm’s effort to reduce their environmental burden, where we assume that a firm’s environmental performance is largely related to its environmental

effort3. The weights for these environmental efforts are as follows. First, the degree of effort to reduce GHG or pollution emissions is measured on a four-point Likert scale ranging from (4) made considerable effort on reduction to (1) made no effort on reduction, respectively. Second, the weights are calculated by dividing the degree of effort plus 1 (because the degree of effort for these reductions is measured on a four-point not a five-point scale) into that of environmental performance; however, the weights should not exceed 1. For example, if the score of environmental performance is 5 and that for environmental effort is 3, then the weight is

4 . Accordingly, if the 5

scores (i.e., degrees) of effort for the environment and environmental performance are equivalent or the score of effort is larger than that of environmental performance, the weight is set at 1, and if the score of effort is smaller than that of environmental performance, the weight is set at less than 1. 3.3.3 Environmental management (instrumental variables)4 

Environmental management score



Environmental management score  Business strategy The proxies for environmental management are the environmental management score, and the

interaction term of the environmental management score and business strategy orientation. The environmental management score is measured by the score in response to the following question using a four-point Likert scale ranging from (4) very much to (1) not at all: Does your firm take the environment into consideration in its business operations? Although the wording of this question about environmental management may not seem specific enough, the question captures the characteristics of environmental management in a broad sense rather than a narrow sense. This is consistent with the focus of this study. Business strategy is measured by a dummy variable equal to 1 if the average score of business strategy and quality management is higher than that of moral and regulatory compliance, and 0 otherwise. The scores of business strategy, quality management, moral and regulatory compliance are obtained from the following four questions using a four-point Likert scale ranging from (4) very much to (1) not at all: Does your firm regard corporate environmental management as a business strategy?; Does your firm regard corporate environmental management as an element of quality management?; Does your firm regard corporate environmental management as improving moral/ethical responsibility?; Does your firm regard corporate environmental management as regulatory compliance? We assume that if firms regard environmental management as a key 3

The expected direction of the influences is (1) environmental management => (2) effort to improve environmental performance and environmental performance => (3) financial performance. 4 Nishitani et al. (2012) suggested that a firm’s environmental management indirectly influences its profitability through environmental performance. Therefore, we chose the environmental management score, and the interaction term of the environmental management score and business strategy as the instrumental variables.

component of their business strategy and quality management, they are voluntary oriented, and that if firms regard environmental management as moral and regulatory compliance, they are mandatory oriented. Accordingly, the interaction term of the environmental management score and business strategy captures the difference between the influence of the voluntary environmental management score and that of the mandatory environmental management score. 3.3.4 Control variables5 

Firm size



Domestic market orientation



Type of firm



Supply chain area



Type of industry The control variables that may influence firms’ environmental and financial performance are firm

size, domestic market orientation, type of firm, supply chain area, and type of industry. Firm size is measured by the logarithm of the number of employees. Domestic market orientation is measured by a dummy variable equal to 1 if a firm’s primary market is Indonesia. Type of firm is measured by a series of dummy variables that take the value of 1 if a firm is a national private firm, national state-owned firm, or multinational firm. The supply chain area is measured by a series of dummy variables that take the value of 1 if the firm is located on the upper, middle, or lower streams of the supply chain. The type of industry is measured by a series of dummy variables that take the value of 1 if the firm operates in mining, manufacturing, agriculture, utilities, or other industry. Note that the numbers of firms in the categories domestic market orientation, each type of firm, each supply chain area and each type of industry can be obtained by multiplying their respective mean (shown in Table 1) by 100 (the sample size) because domestic market orientation, type of firm, supply chain area and type of industry are dummy variables. For example, regarding the type of firm, there are 63 national private firms, 20 national state-owned firms, and 17 multinational firms.

4. Results Table 2 presents the estimation results. The proxy of financial performance is profit growth in Model (1), sales increase in Model (2) and productivity improvement in Model (3). The upper panel shows the influence of a firm’s environmental management score on GHG emissions reduction (Equation 1), the middle panel shows the influence of a firm’s environmental management score on 5

If we use five-year data on financial and environmental improvement, data on firm size from prior to that period should be used to explain the dependent variables. Thus, if anything, this paper analyzes the relationship between the recognition of environmental and financial performance by firms.

pollution emissions reduction (Equation 2), and the lower panel shows the influences of GHG and pollution emissions reductions on financial performance (Equation 3). The upper and middle panels show that Models (1) to (3) have the same estimation results. In the upper panels, the environmental management score is significantly positive at the 1% level. However, the interaction term of environmental management score and business strategy is insignificantly positive. In the middle panel, the environmental management score is significantly positive at the 1% level. However, the interaction term of environmental management score and business strategy is insignificantly negative. They suggest that firms having a mandatory stance on environmental management are more likely to reduce GHG and pollution emissions more by implementing environmental management more aggressively, and there is no significant difference in the influences on GHG and pollution emissions reduction of environmental management between firms having a mandatory stance on environmental management and those having a voluntary stance on environmental management. Therefore, firms that implement environmental management more aggressively are more likely to reduce GHG and pollution emissions more. However, this does not mean that firms with a voluntary stance on environmental management are more likely to reduce these emissions by implementing environmental management than those with a mandatory stance. Regarding the control variables, national private firms are significantly negative at the 1% level, national state-owned firms are significantly negative at the 1% level, mining is significantly positive at the 10% level and agriculture is significantly positive at the 1% level in the upper panel. These results suggest that national private firms and national state-owned firms are less likely to reduce GHG emissions than multinational firms, and firms in mining and agriculture industries are more likely to reduce GHG emissions than those in the manufacturing industry. Besides, national private firms are significantly negative at the 1% level, the upper stream is significantly positive at the 1% level and utility is significantly negative at the 10% level in the middle panel. These results suggest that national private firms are less likely to reduce pollution emissions than multinational firms, firms located on the upper stream are more likely to reduce pollution emissions than those located on the lower stream, and firms in the utility industry are less likely to reduce pollution emissions than those in the manufacturing industry. The lower panel presents the results for Models (1) to (3) using different dependent variables. In Model (1), GHG emissions reduction is significantly positive at the 1% level, and pollution emissions reduction is insignificantly negative. The results suggest that firms that reduce GHG emissions more are more likely to enhance profit whereas this is not the case for firms that reduce pollution emissions further. In Model (2), GHG emissions reduction is positive and pollution emissions reduction is negative; however, these influences are insignificant. These results suggest that firms that reduce GHG and pollution emissions are not more likely to increase sales. On the other hand, in Model (3), GHG emissions reduction is significantly positive at the 1% level, and

pollution emissions reduction is insignificantly negative. These results suggest that firms that reduce GHG emissions more are more likely to improve productivity, whereas this is not the case for firms that reduce pollution emissions more. Regarding the control variables, national state-owned firms are significantly positive at the 1% level in Models (1) and (3), and agriculture is significantly negative at the 10% level in Model (3). These results suggest that national state-owned firms are more likely to enhance profit and improve productivity than multinational firms, and firms in the agriculture industry are less likely to improve productivity than those in the manufacturing industry. Accordingly, firms can enhance profit by reducing GHG emissions through reducing production costs by means of improving productivity, and not by increasing sales by stimulating demand.

5. Discussion and conclusion This paper, using data derived from a questionnaire survey of Indonesian firms, analyzes whether a firm’s environmental performance improves financial performance and why this happens. Due to the fact that the breakeven point of improving environmental performance will decrease in theory by implementing environmental management voluntarily rather than mandatorily, the relationship between environmental performance and financial performance is assumed to depend on the firm’s voluntary or mandatory stance on environmental management. The main findings of regression analysis are as follows. First, firms implementing environmental management more aggressively are more likely to reduce GHG and pollution emissions. However, this does not mean that firms with a voluntary stance on environmental management are more likely to reduce these emissions by implementing environmental management than those with a mandatory stance. As a firm’s environmental stance will shift from “reactive” to “proactive”, this implies that voluntary environmental management in Indonesian firms has not yet become the norm. However, the interaction term of the environmental management score and business strategy is positive on GHG emissions reduction, and is negative on pollution emissions reduction, although these interaction terms are statistically insignificant. These results imply the possibility that some proactive Indonesian firms have already voluntarily implemented environmental management beyond compliance with environmental regulations to reduce at least GHG emissions even in such a situation. Second, firms can enhance profit only by GHG emissions reduction, regardless of a firm’s stance on environmental management. This supports Hypothesis 1 in the case of GHG emissions reduction, and Hypothesis 4 in the case of pollution emissions reduction. It is reasonable that firms do not enhance profit by pollution emissions reduction where firms with a voluntary stance on environmental management are not more likely to reduce pollution emissions by implementing

environmental management than those with a mandatory stance. However, contrary to expectation, firms enhance profit by GHG emissions reduction although firms with a voluntary stance on environmental management are not more likely to reduce environmental burden (GHG emissions) by implementing environmental management than those with a mandatory stance. This might be because some proactive Indonesian firms with a voluntary stance on environmental management actually aggressively implement environmental management to reduce GHG emissions, and their implementation may influence profit growth more strongly than expected. The positive relationship between GHG emissions reduction and profit growth is remarkable in terms of sustainable development in Indonesia, which ranks in the top 14 countries in terms of CO2 emissions from human activities in 2014, followed by some developed countries including the United Kingdom, Australia, Italy and France (Boden et al., 2017). The difference in the amount of influence on profit growth of GHG emissions reduction and pollution emissions reduction can be partially explained by the degree to which a firm decides to improve environmental performance given the strictness of environmental regulation in Indonesia. This is due to the fact that the decision to improve environmental performance is based on a favorable cost–benefit relationship subject to environmental regulations. Firms should have greater incentives to innovate, leading to higher profit growth under flexible environmental policy instruments as opposed to prescriptive regulations (Jaffe and Palmer, 1997). Namely, it is possible that the willingness of a firm to improve environmental performance will decrease under stricter regulations, and therefore it is relatively difficult for firms implementing environmental management voluntarily to enhance profit by better environmental performance where stricter regulations are given. Indeed, the strictness of environmental regulations (or policies) in Indonesia differs between GHG emissions and pollution emissions, and environmental regulations for pollution emissions are stricter than those for GHG emissions. There is no direct regulation that controls “individual firm level” GHG emissions in Indonesia, although there are some direct regulations to control “national level” GHG emissions such as the Presidential Decree 61/2011, which is a national action plan on GHG emissions. Conversely, the Indonesian government has tried to reduce a firm’s GHG emissions by establishing a green economy plan to: 1) reduce poverty, 2) provide proper jobs, 3) improve economic sustainability, and 4) incorporate environmental issues into all activities. Thus, if anything, it seems that the Indonesian government implements environmental policies to promote the reduction of GHG emissions voluntarily by firms, which implies that environmental policies to stimulate firms economically are appropriate. On the other hand, the Indonesian government has enacted direct regulations such as the Presidential Decrees 5/2006 and 32/2009 to control firms’ pollution emissions. In addition, the Indonesian government has also enacted the Presidential Decree 40/2007 to require CSR by direct regulation, which might indirectly influence a firm’s environmental management strategy to reduce pollution emissions. These direct regulations in

Indonesia force firms to implement environmental management to reduce pollution emissions mandatorily rather than voluntarily. Thus, such differences in the strictness of environmental regulations might indirectly reflect our findings that only GHG emissions reduction enhances profit, which is suggestive of the application of the Porter Hypothesis in the Indonesian context. Third, firms can enhance profit by reducing GHG emissions through reducing production costs, not through increasing sales. Because Hypothesis 2 is not supported, it is valuable to determine how much environmental innovation is functioning. This finding indeed suggests that environmental innovation does not function fully when implementing environmental management involuntarily. There is a lack of environmental innovation focusing on increases in demand and improvements in productivity for pollution emissions reduction, and increases in demand for GHG emissions reduction, and therefore it is necessary for Indonesian firms to compensate for this in order to balance environmental performance and financial performance. In these circumstances, a new policy mix to provide firms with economic incentives to innovate for the sake of the environment would be effective at least for innovation focusing on improvement in productivity, because GHG emissions reduction (under the environmental policies to promote the reduction of GHG emissions voluntarily) enhances profit through this path. As a result, for example, it would become easier for Indonesian firms to introduce cleaner production methods and use material flow cost accounting to achieve environmental innovation (focusing on improvement in productivity) success. Furthermore, firms’ environmental innovation to reduce GHG emissions and pollution emissions can also be accelerated by pressure from various stakeholders in the future. One of these stakeholder groups, especially for manufacturing firms, is customers which are in green supply chains. Green supply chain management concerns not only traditional management performance including timeliness, transaction costs, product quality, and effective communication, but also environmental management performance (Faruk et al., 2002). As a product’s end-of-life GHG emissions and pollution emissions in the upper stream of the supply chain influence those in the lower stream, customers assess suppliers’ GHG emissions and pollution emissions management and require them to undertake measures that ensure lower GHG emissions and pollution emissions from their products and processes (Arimura et al., 2011). For example, this can be found where the GHG protocol produced by the World Resources Institute and the World Business Council for Sustainable Development is widely accepted (Gentil et al., 2009). The protocol focuses on not only direct emissions (Scope 1) and emissions from direct purchases of energy (Scope 2), but also indirect emissions upper stream and lower stream in the supply chain (Scope 3) (Huang et al., 2009). Thus, the focus has shifted from reporting direct impacts from on-site processes toward reporting indirect impacts embodied in the supply chain of a firm (Wiedmann et al., 2009). When such lifecycle-based environmental management becomes the norm for trade, firms, especially manufacturing firms—both in developed and developing countries—have an incentive to innovate further, and

consequently they will be able to enhance their financial performance through not only an improvement in productivity such as energy efficiency, but also an increase in sales. Accordingly, these results imply that although Indonesian firms enhance financial performance by better environmental performance to some extent, they do not produce a large enough effect because they have not successfully achieved environmental innovation and their breakeven point of improving environmental performance does not decrease sufficiently. Thus, the novelty of this study lies in showing that environmental performance enhances financial performance even in the context of Indonesia. However, it is not sufficient for firms to merely implement environmental management (without strategic thinking) to improve environmental performance. In conclusion, we provide some suggestions for future research that address some of the limitations of this paper. It is generally believed that it is easier to obtain a positive relationship between environmental performance and financial performance when subjective data are used for the analysis. This is because firms with better environmental performance according to the questionnaire tend to achieve better financial performance, and vice versa. However, it is very difficult to obtain objective firm data for developing countries. Although our analyses can be improved in this respect, the bias derived from this issue might not be strong because our estimation results did not find a consistent positive relationship between environmental performance and financial performance. If objective data become available, the analysis would be improved. Thus, although this paper has some limitations, it provides a new insight into the current environmental management of firms in Indonesia. Accordingly, this study will hopefully encourage further research on corporate environmental management in developing countries.

Conflict of Interest The authors have no conflict of interest.

Acknowledgments We are grateful to Erna Puji Purwanti for her excellent research assistance.

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Total sales line

Cost and revenue

Profit

Total costs line

Breakeven point

Variable cost

Loss Fixed cost

Units

Figure 1 Breakeven point to improve environmental performance

Table 1 Descriptive statistics

Profit growth Sales increase Productivity improvement GHG emissions reduction Pollution emissions reduction Environmental management score Business strategy Environmental management score×Business strategy Firm size Domestic market orientation Type of firm National private firms National state-owned firms Multinational firms Supply chain area Upper stream Middle stream Lower stream Type of industry Mining Manufacturing Agriculture Utility Other

Obs 100 100 100 100 100 100 100

Mean 3.860 3.820 3.900 3.420 3.490 3.440 0.180

SD 0.739 0.809 0.732 0.554 0.643 0.656 0.386

100

0.590

100 100

Min

Max 2 2 2 3 1 1 0

5 5 5 5 5 4 1

1.311

0

4

5.962 0.760

2.198 0.429

2.079 0

11.225 1

100 100 100

0.630 0.200 0.170

0.485 0.402 0.378

0 0 0

1 1 1

100 100 100

0.210 0.200 0.590

0.409 0.402 0.494

0 0 0

1 1 1

100 100 100 100 100

0.130 0.170 0.030 0.270 0.400

0.338 0.378 0.171 0.446 0.492

0 0 0 0 0

1 1 1 1 1

Table 2 Estimation results

(1)

Coeffi cient Environmental management score

0.260

×Business strategy

0.017

Firm size

0.007

Domestic market orientation

0.054

(2)

SE 0.0 70 0.0 33 0.0 23 0.1 37

(3)

GHG emissions reduction Coeffi Coefficie SE cient nt * * 0.0 * * 0.260 0.260 70 * * 0.0 0.017 0.017 33 0.0 0.007 0.007 23 0.1 0.054 0.054 37

SE 0.07 0 0.03 3 0.02 3 0.13 7

* * *

0.17 6 0.19 9

* *

Type of firm National private firms

-0.399

National state-owned firms

-0.484

0.1 76 0.1 99

* *

-0.399

* *

-0.484

0.1 76 0.1 99

* *

-0.399

* *

-0.484

* *

Supply chain area Upper stream

0.068

Middle stream

-0.054

0.1 50 0.1 35

0.068 -0.054

0.1 50 0.1 35

0.068 -0.054

0.15 0 0.13 5

Type of industry Mining

0.278

Agriculture

0.545

Utility

-0.011

Other

-0.098

Constant

2.771

Coeffi cient Environmental management score ×Business strategy oriented Firm size Domestic market orientation Type of firm

0.307 -0.010 -0.031 0.169

0.1 66 0.1 42 0.1 59 0.1 43 0.3 89

*

0.278

* * *

0.545 -0.011 -0.098

* * *

2.771

0.1 66 0.1 42 0.1 59 0.1 43 0.3 89

*

0.278

* * *

0.545 -0.011 -0.098

* * *

2.771

Pollution emissions reduction Coeffi Coefficie SE SE cient nt 0.0 ** 0.0 ** 0.307 0.307 99 * 99 * 0.0 0.0 -0.010 -0.010 40 39 0.0 0.0 -0.031 -0.031 26 26 0.1 0.1 0.169 0.169 32 32

0.16 6 0.14 2 0.15 9 0.14 3 0.38 9

* * * *

* * *

SE 0.09 9 0.04 0 0.02 6 0.13 2

* * *

National private firms

-0.415

National state-owned firms

-0.060

0.1 45 0.1 83

* * *

0.1 39 0.1 20

* *

-0.415 -0.060

0.1 45 0.1 83

* * *

0.1 39 0.1 20

* *

-0.415 -0.060

0.14 5 0.18 3

* * *

0.13 9 0.12 0

* *

Supply chain area Upper stream

0.281

Middle stream

-0.028

0.281 -0.028

0.281 -0.028

Type of industry Mining

0.189

Agriculture

0.179

Utility

-0.280

Other

-0.198

Constant

GHG emissions reduction Pollution emissions reduction Firm size Domestic market orientation

2.842

0.1 87 0.1 76 0.1 56 0.1 48 0.3 92

Profit growth Coeffi SE cient 0.3 2.334 42 0.9 -1.426 22 0.0 -0.048 63 0.3 0.197 23

0.189 0.179 *

-0.280 -0.198

* * *

* * *

2.842

0.1 87 0.1 76 0.1 56 0.1 48 0.3 92

Sales increase Coeffi SE cient 1.9 1.754 75 2.6 -0.392 49 0.1 0.002 40 0.3 0.426 42

0.189 0.179 *

-0.280 -0.198

* * *

2.842

0.18 7 0.17 6 0.15 6 0.14 8 0.39 2

Productivity improvement Coefficie SE nt 0.63 2.245 2 1.42 -1.124 2 0.07 -0.039 9 0.35 0.152 3

*

* * *

* * *

Type of firm National private firms

0.290

National state-owned firms

1.102

0.4 85 0.4 00

0.428 * * *

1.012

0.6 06 0.6 57

0.495 1.208

0.65 5 0.40 5

* * *

Supply chain area Upper stream

0.088

Middle stream

0.245

0.4 33 0.3 66

-0.213 0.819

0.7 38 0.7 67

0.059 0.487

0.46 8 0.56 5

Type of industry Mining

-0.291

Agriculture

-0.774

Utility

-0.381

0.4 74 0.5 39 0.3 74

-0.367 -0.632 -0.194

0.4 80 0.9 03 0.7 77

-0.425 -0.889 -0.367

0.49 3 0.51 0 0.44 3

*

Other Observations Log pseudolikelihood F test of excluded instruments (GHG) (p-value) F test of excluded instruments (pollution) (p-value)

-0.111

0.3 09

-0.425

0.3 82

-0.140

0.33 2

100 -210.957

100 -210.593

100 -210.542

0.003

0.003

0.003

0.017

0.017

0.017

***, **, and * imply that the coefficient is significantly different from 0 at the 1%, 5%, and 10% levels, respectively.