Received: 5 May 2020 Revised: 19 May 2021 Accepted: 2 June 2021

DOI: 10.1002/bse.2850

RESEARCH ARTICLE

Environmental, social and governance disclosure and

default risk

Muhammad Atif1 | Searat Ali2

1
Department of Accounting and Corporate
Governance, Macquarie University, Sydney, Abstract
New South Wales, Australia We investigate whether environmental, social and governance (ESG) disclosure is
2
School of Business, University of
related to default risk. Using a sample of US nonfinancial institutions from 2006 to
Wollongong, Wollongong, New South Wales,
Australia 2017, we find that ESG disclosure is positively related to Merton's distance to default
and is negatively related to the credit default swap spread, which suggests that firms
Correspondence
Searat Ali, School of Business, Faculty of with a higher ESG disclosure have lower default risk. Our analysis further indicates
Business and Law, University of Wollongong,
that the inverse effect of ESG disclosure on default risk is through increased profit-
Northfields Ave, Wollongong, NSW 2522,
Australia. ability and reduced performance variability and cost of debt. We also document that
Email: searat@uow.edu.au
the negative impact of ESG disclosure on default risk is existent only for mature and
older firms. These results are important for all stakeholders of firms, including share-
holders and bondholders to consider firm's ESG disclosure in conjunction with life
cycle stage before making their investment decisions.

KEYWORDS
corporate life cycle, cost of debt, default risk, ESG disclosure, performance variability

1 | I N T RO DU CT I O N Corporate default, generally defined as a firm that is failing to make

This study has examined whether disclosures of environmental, social
and governance (ESG) affect default risk in firms in the US context.
Nonfinancial performance evaluated by ESG disclosure continues to
attract the attention of practitioners, investors, customers, employees
and suppliers, as well as scholars. All major stakeholders source infor-
mation from ESG disclosure: about product safety (Deegan &
Rankin, 1996), employee rights and welfare at
(Waddock, 2008) and firms' relationship with society.1 Growing
empirical evidence regarding the influence of ESG disclosure on firm
performance (e.g., Endrikat et al., 2014; Horv
athov

a, 2010) suggests a
positive impact on cash flows and a reduction in cost of capital
(Plumlee et al., 2015). Extant evidence also suggests that ESG disclo-
sure has an impact on firms' financial risk management (e.g., Plumlee
et al., 2015; Limkriangkrai et al., 2017). However, the role of ESG dis-
closure in influencing default risk has received limited attention in the
literature (e.g., Boubaker et al., 2020). Default risk is one of
the important yardsticks of firm financial health (Rego et al., 2009).
contractual payments to debt holders (Valta, 2016), can lead to devas-
tating results for stakeholders (e.g., investors, creditors, customers,
employees and regulators).2 The likelihood of default depends on
whether the firm's future cash flows are sufficient to cover both its
debt service costs (interest payments) and the principal amount. In
general, the likelihood of default increases when a firm experiences a
downward shift of its average future cash flows or when the future
workplace cash flows become more volatile. Given the significance of default risk
for investors and other stakeholders, it is imperative to examine
whether ESG disclosure can help firms to mitigate default risk.
We use the resource-based theory (RBT) to conjecture the associ-
ation between ESG disclosure and default risk. RBT (Barney, 1991)
asserts that firms are capable of managing internal dynamic factors
that affect their success. Firms with higher dynamic capabilities may
combine ESG strength with other corporate strategies to successfully
capitalize ESG benefits in their financial risk management (Teece
et al., 1997). For instance, ESG disclosure is associated with brand
value and with customer satisfaction that leads to higher sales and

Abbreviations: ESG, environmental, social and governance; GFC, global financial crisis; OLS, ordinary least square; PSM, propensity score matching; RBT, resource based theory.

Bus Strat Env. 2021;1–23. wileyonlinelibrary.com/journal/bse © 2021 ERP Environment and John Wiley & Sons Ltd. 1
2 ATIF AND ALI
thus to profitability (Brown & Dacin, 1997; Luo & cycle following the Dickinson (2011) model. We find that the negative
Bhattacharya, 2006). Such customer loyalty helps to ensure a stream
of consistent cash flows, reducing a firm's financial distress. Moreover,
in case of negative events, firms continue to enjoy stable future cash
flows due to moral capital among customers. Further, disclosure of
ESG information contributes to a reduction in information asymmetry
(Cho et al., 2013), leading towards investors trust and loyalty. The
symmetric flow of information increases the availability of debt capital
and reduces the cost of funds (Cheng et al., 2014; El Ghoul
et al., 2011; Waddock & Graves, 1997). We therefore argue that ESG
disclosure reduces firms' default risk by increasing their level of profit-
ability and by decreasing their performance variability and cost of
debt capital.3
We extend this baseline idea to examine if the ESG–default link-
age is moderated by firm life cycle stages. Existing literature suggests
distinct capabilities and resources, cash flow volatilities and policy
decisions in firms at different life cycle stages (e.g., Faff et al., 2016;
Miller & Friesen, 1984; Porter, 2008). For instance, firms in the early
stages of their life cycle are financially constrained, lack liquid
resources, may experience uncertainties about future cash flows and
may have difficulty in raising additional capital, all of which raises the
likelihood of default (Hasan et al., 2015). Younger firms, due to their
implicit concerns about achieving financial objectives, are less likely to
focus on ESG disclosure than on showing legitimacy with key stake-
holders (Ramaswamy et al., 2007). Firms in their mature phase have
greater competitive advantage, sufficient resources and more cer-
tainty of future cash flows (Hasan & Habib, 2017), leading to lower
chances of default. In addition, mature firms are more likely to
embrace ESG disclosure due to their reputational concerns and
greater interaction with key stakeholders, including regulatory author-
ities (Hasan & Habib, 2017). Given this evidence, we expect to find
that the inverse relation between ESG disclosure and default risk
should be relatively stronger (weaker or insignificant) for firms at
mature stage (younger and other stages) of the life cycle.
Using a panel of nonfinancial firms from 2006 to 2017, we find
that ESG disclosure is negatively related to default risk, as proxied by
Merton's distance to default and credit default swap spread in base-
line estimations. This finding is robust to alternative variable specifica-
tions and to alternative estimation methods, including lagged
independent variables, instrumental variable approach and propensity
score matching (PSM). We further explore mechanisms through which
ESG disclosure reduces default risk. Using the profitability mechanism,
we find that the inverse effect of ESG disclosure on default risk is
through increased profitability (measured through return on assets
and return on equity) and reduced performance variability (measured
through quantile-based risk metrics) (see, e.g., Konstantinidi &
Pope, 2016). In addition, we examine whether ESG disclosure reduces
default risk via cost of debt (measured as a ratio of interest expense
divided by average interest-bearing debt). We find specific evidence
that firms with a lower cost of debt have a lower default risk and that
firms with a higher ESG disclosure have a lower cost of debt. Finally,
we investigate whether the relationship between ESG disclosure and
default risk relationship is magnified in different stages of a firm's life
impact of ESG disclosure on default risk exists mainly in mature and
older firms.
Our study makes two important contributions to the literature.
First, we contribute to the stream of research that explores the deter-
minants of firms' default risk. This recent strand of literature has identi-
fied important determinants of default risk: for example, stock market
liquidity (Brogaard et al., 2017; Nadarajah et al., 2020), incentive struc-
ture (Bennett et al., 2015), innovation performance (Hsu et al., 2015),
debt maturity choice (Goyal & Wang, 2013), stock market return and
volatility (Giesecke et al., 2011) and corporate governance characteris-
tics including CEO compensation, board independence, gender
diversity and ownership structure (see, e.g., Acrey et al., 2011; Ali,
2017; Ali et al., 2018, 2021; Chiang et al., 2015; Chiu & Wagner, 2012;
Kabir et al., 2020; Miglani et al., 2015; Nadaraja et al., 2020; Schultz
et al., 2017; Switzer & Wang, 2013; Vallascas & Hagendorff, 2013). We
extend this literature by providing robust evidence regarding the role of
aggregate ESG disclosure as a critical determinant of default risk for US
nonfinancial firms. Prior studies investigate the effect of ESG on vari-
ous firm-level outcomes including firm performance, cost of capital and
financial distress (e.g., Boubaker et al., 2020; Endrikat et al., 2014;
Horv
athov

a, 2010; Plumlee et al., 2015). However, our study goes
beyond cause-and-effect relationship between ESG and default risk
and differs from existing studies in at least three ways. First, our data
are sourced from Bloomberg, which uses the Global Responsible Initia-
tive (GRI) and the United Nations (UN) guidelines in collating ESG dis-
closure information. Second, our default risk measures are based on
market data, rather than on accounting information that lacks currency.
Third, we examine various mechanisms through which ESG disclosure
affects default risk, and document that higher profitability, lower per-
formance variability and lower cost of debt are the channels through
which ESG disclosure reduces default risk.
Second, we contribute to the firm life cycle literature. Previous lit-
erature on the firm life cycle has described its role in influencing divi-
dend policy (DeAngelo et al., 2006; Grullon et al., 2002), equity
offerings (DeAngelo et al., 2010), merger and acquisitions (Owen &
Yawson, 2010), cash flow patterns (Dickinson, 2011), firm financial
policies (Faff et al., 2016) and financial resources and corporate social
responsibility (Hasan & Habib, 2017). We show that the corporate life
cycle moderates the effect of ESG disclosure on default risk. Specifi-
cally, we find that firms in their mature stage have a significantly
higher level of ESG disclosure and thus have lower default risk.
Overall, our study complements the current discussion regarding
the importance of ESG disclosure for firms and for investors and
stakeholders. This study offers new insights for policy makers into the
business case for ESG disclosure (i.e., doing well by doing good). More
specifically, the role of ESG disclosure in reducing default risk
strengthens its importance for firms and regulators. Our findings also
provide insights to shareholders and debtholders for considering a
firm's disclosure about sustainability initiative before making invest-
ment decisions. Given our findings, policy makers aiming at sustain-
ability should encourage firms to disclose their sustainability
initiatives.
ATIF AND ALI
The rest of the paper is organized in seven sections. Section 2
reviews the literature then develops the hypotheses. The sample
selection and summary statistics are discussed in Section 3. Sections 4
and 5 present the main empirical results. Section 6 shows additional
analysis. Section 7 concludes the study.
2 | LITERATURE REVIEW AND
HYPOTHESES
Default is an abrasive event in the life of a corporation. It causes dis-
ruptions in the productivity of firms through supply chain; it deters
employee and customer retention; it increases legal and administra-
tive costs (Brogaard et al., 2017). The risk of default increases if firm
cash flows are shaky, and/or there is no access to market. This type of
peril becomes a yardstick to evaluate a firm's financial health (Rego
et al., 2009). The literature concurs that debtholders carry special
interest in firms while shareholders are residual owners (Anderson &
Mansi, 2009). This implies that debtholder will be mainly impacted in
case of a firm's likelihood of financial distress. Given the importance
of default risk in a firm's financial journey, it has received wider atten-
tion in the literature.4
Default risk is considered to be an important factor in firm evalua-
tion. Investors and debtholders take into account such risk in their
investment screening process (Campbell et al., 2008; Dichev, 1998).
As capital market is the largest source of external funding and to
ensure availability of sufficient funds in future at relevant cost, man-
agers endeavour to keep default risk lower (Anderson & Mansi, 2009).
In turn, lower default risk may foster market confidence, resulting in a
lower cost of capital ensuring smooth operations.
Prior research has found an array of factors associated with
default risk, including a firm's operational and production efficiency
(Becchetti & Sierra, 2003; Rendleman, 1978), cash flow uncertainty
(Chava & Purnanandam, 2010), information asymmetry (Bhojraj &
Sengupta, 2003), brand loyalty (Rego et al., 2009), customer satisfac-
tion (Anderson & Mansi, 2009) and social factors (Allen et al., 2004).
All those factors are associated directly or indirectly with future cash
flows and firm performance. For instance, customer satisfaction and
brand loyalty demonstrate the stability of future incoming cash flows.
Such a manifestation is considered among major determinants of
default risk (Acharya et al., 2006; Asvanunt et al., 2007;
Merton, 1974). Moreover, business-related factors (e.g., business
cycle and economic) and social factors both play an important role in
default risk (Allen et al., 2004). In summary, default risk reflects market
confidence and a firm's internal strength to minimize the risk associ-
ated with a number of factors, including those that are social, eco-
nomic and business-related (e.g., life cycle).
ESG signals firm-specific information regarding environmental,
social and governance initiatives towards society (Brown &
Dacin, 1997). Those initiatives provide information about the firm rev-
enue prospectus (Lev et al., 2010), including employee welfare and
labour relations (Edmans, 2011; Waddock & Graves, 1997) and envi-
ronmental and social compliance initiatives, based on firm operations
3
(Brown et al., 2006). ESG disclosure also represents a firm's strategic
investment towards its integrity (McWilliams et al., 2006). These soci-
etal initiatives improve the welfare of society (Davis &
Blomstrom, 1975, p. 6). All those important activities help in creating
a firm's integrity and its better linking with stakeholders and society at
large. Therefore, ESG disclosure enhances a firm's ability to create
reputation and to enjoy the benefits of such internal strength in its
financial risk management. RBT embraces this argument: that a firm's
internal strength, along with its corporate strategies, helps to capital-
ize the benefits for firms in their financial risk management.
However, investment on societal initiatives is considered to be an
expense for shareholders. For instance, prior studies suggest that the
main objective of a firm is to maximize its shareholders' wealth while
focusing on profit making (e.g., Berle, 1930; Friedman, 1970), rather
than spending their wealth on stakeholder orientation. To that end,
some traditional studies offer support for shareholder-only orienta-
tion, while regarding societal and environmental consideration to be
undesirable. However, earlier literature provides strong support for
stakeholder orientation, contemplating that firms exist not only
for profit making but also to offer social services (Dodd, 1932). More
recent studies have shown a positive impact of ESG disclosure on firm
outcomes, including on performance (Endrikat et al., 2014), on finan-
cial returns and risk-taking (Limkriangkrai et al., 2017; Sassen
et al., 2016) and on cost of debt (Plumlee et al., 2015). This study,
which focuses on the impact of ESG disclosure on default risk, is con-
sistent with this area of the literature.
ESG disclosure may help firms in reducing default risk in several
ways. First, it is directly linked with brand value and with the customer
satisfaction that leads to higher sales turnover and results in higher
profitability (Brown & Dacin, 1997; Luo & Bhattacharya, 2006). Prior
literature concurs that propensity to default has a direct association
with incoming cash flows because a reliable stream of liquidity pro-
vides support to operations and prevents firms from financial distress
(D'Aveni & Ilinitch, 1992). ESG disclosure ensures consistency of cash
flow and is therefore likely to affect the default risk.
Second, firms may experience default in cases of volatile cash
flows because infrequent income flows create cash shortfall in critical
operational requirements (Chava & Purnanandam, 2010). ESG disclo-
sure helps in stabilizing financial performance through corporate
image, reputation and better relationship with governments and finan-
cial markets (Carter, 2005; Cornell & Shapiro, 1987; McGuire
et al., 1988). For example, in the case of a negative event, stake-
holders are more likely to punish the firm; however, a firm with ESG
known initiatives is less likely to have a negative effect on cash flows
due to its image and its moral capital among stakeholders
(Godfrey, 2005). ESG disclosure creates loyalty and trust, as well as
brand equity among customers; thus, income stream and profitability
are less volatile, even during the time of a crisis (Godfrey, 2005;
Godfrey et al., 2009). In addition, performance variability is less likely
to happen when there are stable cash flows. Therefore, ESG disclo-
sure acts as an ‘insurance’ for firms, protecting them from default by
ensuring stable cash flows. Prior literature has also supported the
notion that socially responsible investors (SRI) are less sensitive than
4 ATIF AND ALI
conventional fund providers to negative events (Bollen, 2007;
Renneboog et al., 2011), suggesting a continuous supply of funds to
firms with better ESG disclosure.
Third, ESG disclosure reduces agency cost and information asym-
metry in firms (Cormier et al., 2011). The availability of symmetric
information across the market mitigates several risks: regulatory, con-
troversy, managerial and reputational. Investors evaluate firms based
on the availability of nonfinancial information to determine default
probability. The provision of such firm-specific information to the
market builds investors' trust and loyalty, which increases the avail-
ability of funds at relatively lower cost and reduces the cost of capital
(Cheng et al., 2014; Cormier et al., 2010; El Ghoul et al., 2011;
Waddock & Graves, 1997).5
In a nutshell, ESG disclosure represents important initiatives that
create a valuable image, that increase cash flow, that decrease perfor-
mance volatility and that garner support for the easy availability of
low-cost funding, leading towards a reduction in default risk. There-
fore, we hypothesize as follows:
H1. ESG disclosure is negatively associated with a
firm's default risk.
H2. ESG disclosure is negatively associated with a
firm's default risk through increased profitability and
reduced performance variability and cost of debt.
3 | DATA AND METHOD
3.1 | Sample and data
Our sample, for the period from 2006 to 2017, is sourced from
Bloomberg and Singapore National Universal liquidity data for US
firms listed in the New York and Chicago exchanges.6 First, we collect
the ESG disclosure scores and firm characteristics from Bloomberg,
disregarding the difference in industries, and receive 9455 firm-year
observations.7 Since our research is not applicable to financial service
firms, we receive 7412 firm-year observations. The selection of firms
is also based on the availability of aggregate and individual ESG disclo-
sure scores, as well as on firm characteristics. Second, we collect the
default risk variables from the Singapore National University data for
all the US firms and merge them with the ESG data. We eliminate the
missing firm-year observations across all the variables. Finally, we
receive 5206 firm-year observations as our selected sample.
Appendix A presents the detail of our sample selection criteria.
3.2 | Measuring ESG
In order to measure a firm's ESG disclosure following prior literature
(e.g., Cheng et al., 2014; Sassen et al., 2016), we use ESG disclosure
scores as an umbrella measure provided by Bloomberg to examine the
effect on the firm's default risk. ESG disclosure scores are provided in
the form of numbers ranging from 0.1 to 100. Our additional analysis
employed the individual scores of environmental, social and gover-
nance separately. These individual scores represent firm performance
on each factor individually. For instances, environmental scores are
based on firm performance relating to climate change policies, hazard-
ous wastes, nuclear energy, and sustainability indicators. Social scores
are based on firm performance relating to consumer protections,
diversity, human rights, animal, welfare, child labour and employee
health and safety indicators. Governance scores are based on firm
performance of management structure, executive compensation and
conflict of interest indicators.
3.3 | Measuring default risk
Our first measure of default risk, Merton's (1974) distance to default
(DD), remains the most widely used market-based credit risk metric
and performs better than accounting-based approaches for the esti-
mation of default risk (Bharath & Shumway, 2008; Das et al., 2009;
Duan et al., 2012; Duan et al., 2018; Hillegeist et al., 2004; Jessen &
Lando, 2015; Miao et al., 2018).8 Merton's (1974) structural models
used option pricing methods to compute a probability of default from
the level and volatility of the market value of assets, with a strike price
equal to the face value of the firm's liabilities (Bharath &
Shumway, 2008). The larger the positive distance between firm value
and firm liabilities, the lower would be the probability of default. In
other words, the higher the DD, the lower the default risk, meaning
more firm stability.
Our second proxy of default risk is the credit default swap (CDS)
spread. CDS are credit derivatives that allow the transfer of the firm's
default risk between two agents for a predetermined time period. In a
typical CDS contract, the protection seller offers the protection buyer
insurance against the default of an underlying bond issued by a certain
company (the reference entity). In the event of default by the reference
entity, the seller commits to buy the bond for a price equal to its face
value from the protection buyer. In exchange for the insurance, the
buyer pays a quarterly premium, called the CDS spread, which is quoted
as an annualized percentage of the notional value insured. Therefore,
by definition, the CDS spread is the pricing of the default risk (Das
et al., 2009). The higher the default risk of the reference entity, the
higher is the CDS spread. We extract the CDS spread from the National
University of Singapore's Credit Research Initiative (CRI) database. In
that database, CDS spread, or ‘Actuarial Spread’, is constructed using
the traditional CDS design but without an upfront fee, on the assump-
tion that market participants are risk neutral. Thus, actuarial spread has
the same features as the standard CDS spread. This adjustment allows
the calculation of CDS spread for a large number of firms.
3.4 | Measuring control variables
Following prior studies (e.g., Ali et al., 2018; Chiang et al., 2015;
Schultz et al., 2017), we control for several variables which might
ATIF AND ALI
potentially influence default risk. We first control for firm size (SIZE),
measured as the natural log of total assets in millions of US$. In gen-
eral, larger firms are more stable and consequently have less default
risk; thus, we expect a negative relationship between firm size and
default risk. Second, we control for leverage, the ratio of total debt to
total assets (TLTA). Leverage reflects the capital structure of the firm:
that is, how a firm finances its assets, as well as the ability of the firm
to meet its financial obligations. Leverage increases the financial risk
of firms and is thus expected to have a positive relationship with
default risk (Chiang et al., 2015; Schultz et al., 2017). Third, we control
for firm profitability using return on assets (ROA), which is equal to
the ratio of net income to total assets. ROA, based on accounting
information, indicates the ability of a firm to generate sufficient
returns for the smooth functioning of the firm. Higher ROAs would
indicate lower default risk. Fourth, we control for liquidity (LIQ), which
indicates the ability of the firm to pay its short-term obligations.
Default risk should be less in firms that have a higher liquidity ratio
than in those with a lower liquidity ratio. We capture liquidity through
the current ratio (current assets divided by current liabilities).
Our fifth variable, Tobin's Q (TOBINQ), considers the market infor-
mation and is arguably a better measurement of both performance
and growth opportunity. Tobin's Q, measured by summing fair market
value and total liabilities divided by total assets, is expected to have a
negative impact on default risk since better performance leads to
higher stability (Chiang et al., 2015). The sixth control variable, the
sales to asset ratio (SALES), is measured as the ratio of sales to total
assets. SALES represents management efficiency and is expected to
have a negative influence on the default risk (Miglani et al., 2015).
Seventh, we control for tangibility (TANG), measured as the ratio of
net property plant and equipment divided by total assets. Tangibility
is found to be negatively related to firm value (Fukui &
Ushijima, 2007; Nakano & Nguyen, 2013). Hence, we expect tangibil-
ity variables to be positively related to default risk (Chiang
et al., 2015).
To reduce the influence of outliers in our estimates, we have win-
sorized all other control variables at 1%. We keep the key indepen-
dent variable (ESG) at its original values as we observed no problem of
outlier in the descriptive statistics. We also keep the dependent vari-
ables (DD and CDS) at their original values, as extreme values on DD
and CDS indicate worst performance (bankruptcy).
3.5 | Estimation model
We estimate the following model to examine the effect of ESG disclo-
sure on firm default risk:
Default riskit ¼ α þ βX
1 ðESG_disclosureÞit þ β 2 ðControls
X Þit
þ δ3 ðindustry effectsÞi þ δ4 ðyear effectsÞt þ εit ,
ð1Þ
where dependent variable default risk is measured by Moreton's dis-
tance to default (DD) and credit default swap spread (CDS). ESG
5
disclosure is measured as the aggregate environmental, social and
governance disclosure scores of firm i in year t. Controls represents
control variables as defined in Section 3.4. Industry effects
represents the two-digit industry codes based on global industry clas-
sification standards (GICS), and year effects shows the sample years
(2006–2017). See Appendix B for the description of variables.
3.6 | Descriptive statistics
Table 1 presents the summary statistics of various measures of ESG dis-
closure, default risk and firm-specific variables. The ESG disclosure vari-
ables show that, on average, the overall ESG score is 19.94, the
environmental score is 22.49, the social score is 19.46 and the gover-
nance score is 52.29. The default risk variable shows that the average
DD is 5.88 in the full sample. The mean DD of firms with high ESG dis-
closure (i.e., 6.60) is considerably higher than the mean DD of firms with
low ESG disclosure (i.e., 5.24), suggesting that the firms with more ESG
disclosure have lower default risk. The average size (SIZE) of the firm-
specific variables is 11,899 million USD. On average, the sample firms
have 2% profit (ROA), have 2.58 USD in current assets to repay 1 USD
of current liabilities (LIQ), have 52% debt in their capital structure (TLTA)
and have 0.97 sales as a proportion of total assets. Asset tangibility
(TANG) and growth opportunities (TOBINQ) average 0.27 and 2.07,
respectively. Those firms with high ESG scores are larger, more profit-
able and levered and have more tangibility. However, these firms are
less liquid, with lower sales to total assets and lower growth.
3.7 | Correlation analysis
Table 2 presents the pairwise correlation among the variables used in
empirical analysis. The correlation between CDS and DD is .49,
which is not very high, suggesting that these are the alternative prox-
ies of default risk. In the relationship between ESG and default risk,
the ESG scores have a significant negative (positive) correlation with
the CDS (DD), as anticipated. These results suggest that for firms
with a greater ESG score, the default risk is lower. However, the corre-
lation analysis does not control other factors that affect default risk,
so these results should be viewed with caution. For correlation
between the control variables and default risk, we find that large firms
with more profitability (ROA), firm value (TOBINQ), sales and liquidity
(LIQ) have a lower default risk. However, leverage (TLTA) and tangibil-
ity (TANG) increase default risk. The correlation analysis also indicates
that collinearity is generally moderate between the explanatory vari-
ables. As a rule of thumb, a correlation of .70 or higher in absolute
value may indicate a multicollinearity issue. The highest correlation
coefficient (.63) is between ESG and SIZE variables. Thus,
multicollinearity may not be an issue in our analysis.
Figure 1 presents the industry-wide differences in the average
DD between firms with high and low ESG scores. It is evident from
the figure that the firms with high ESG disclosure have a lower default
risk than the firms with low ESG disclosure for all industries. However,
 6

TABLE 1 Descriptive statistics

Whole sample Low ESG High ESG

Variables Obs. Mean SD Min p25 p50 p75 Max Mean SD Mean SD
ESG 5206 19.94 12.86 1.24 11.16 14.05 22.31 76.03
E factor 2048 22.49 18.28 1.38 6.98 16.67 35.66 82.17
S factor 3452 19.46 15.49 3.13 8.77 14.04 28.07 79.69
G factor 5240 52.29 6.38 3.57 48.21 51.79 55.36 85.71
DTD 5206 5.88 3.22 0.96 3.52 5.38 7.75 24.99 5.24 2.94 6.60 3.37
CDS 5206 7.96 25.12 0.00 0.35 1.73 6.91 388.62 8.52 19.23 7.49 30.89
CDS (Ln) 5206 0.30 2.26 11.87 1.04 0.56 1.93 5.96 0.78 2.03 0.23 2.40
SIZE 5206 7.50 2.11 1.07 6.09 7.63 9.00 13.59 6.32 1.72 8.86 1.64
SIZE ($) 5206 11,899 41,286 3 443 2066 8127 797,769 1971 4800 23,208 58,136
ROA (%) 5206 0.02 0.18 1.18 0.02 0.05 0.09 0.40 0.01 0.23 0.05 0.09
TLTA (%) 5206 0.52 0.23 0.07 0.37 0.52 0.66 1.31 0.48 0.25 0.58 0.19
LIQ 5206 2.58 2.22 0.37 1.30 1.94 2.98 14.95 3.11 2.57 1.97 1.53
TANG (%) 5206 0.27 0.24 0.00 0.09 0.19 0.39 0.90 0.23 0.23 0.32 0.25
SALES 5206 0.97 0.65 0.00 0.50 0.83 1.28 3.70 0.99 0.67 0.93 0.63
TOBINQ 5206 2.07 1.56 0.67 1.22 1.59 2.27 13.75 2.23 1.87 1.89 1.08

Note: This table presents summary statistics for the sample of 5206 firm-year observations over the period 2006–2017. Definitions of all variables are described in Appendix B.
ATIF AND ALI
ATIF AND ALI 7

TABLE 2 Correlation analysis

DD CDS ESG SIZE ROA TLTA LIQ TANG SALES TOBINQ
DD 1.00
CDS .49 1.00
ESG .26 .30 1.00
SIZE .19 .23 .63 1.00
ROA .33 .24 .15 .32 1.00
TLTA .24 .09 .21 .39 .09 1.00
LIQ .06 .06 .24 .42 .18 .49 1.00
TANG .06 .04 .14 .22 .07 .16 .32 1.00
SALES .02 .05 .12 .13 .27 .01 .14 .11 1.00
TOBINQ .25 .10 .05 .27 .28 .05 .22 .25 .03 1.00

Note: This table shows the correlation analysis among the independent and dependent variables. See
Appendix B for variable definitions.

FIGURE 1 Industry-wise default risk for firms with high and low ESG disclosure scores [Colour figure can be viewed at wileyonlinelibrary.com]

some industries benefit more from high ESG than others do. For
instance, default risk reduction with high ESG disclosure is the highest
in Health and Telecommunication Services (47% each) and is the low-
est in Energy and in Consumer Discretionary (17% each). Overall,
Figure 1 demonstrates that industries with high ESG disclosure have a
lower default risk. Given this evidence, it is important to include this
industry effect in the empirical analysis.
4 | E S G D I S C L O S U R E A N D D E FA U LT R I S K
(H1)
4.1 | Baseline results
Table 3 presents the OLS results of Equation 1 between ESG and
default risk (as measured by DD or CDS). The results for DD and CDS
are reported in Columns 1–3 and 4–6, respectively. Columns 1 and
4 include univariate regression between ESG and default risk; regres-
sions in Columns 2 and 5 include ESG and all control variables;
regressions in Columns 3 and 6 include ESG, all the control variables
and the industry- and year-fixed effects. All of these alternative model
specifications suggest that ESG is positively (negatively) related to DD
(CDS) at the 1% level, which might indicate a lower default risk for
firms that have a greater level of ESG disclosure. Specifically, a
1-point increase in ESG increases DD by 0.025 points (Column 3 of
Table 3). These results also have economic significance. For instance,
one standard deviation increase in ESG raises DD by 5.40%.9 These
findings are consistent with our prediction that ESG disclosure influ-
ences default risk: specifically, we find a significantly positive (nega-
tive) association with DD (CDS). The firm-specific variables are also
important in determining default risk. For instance, larger, more profit-
able and high growth firms all have a lower default risk, while the
8 ATIF AND ALI

TABLE 3 ESG and default risk—baseline results

DD DD DD CDS CDS CDS

(1) (2) (3) (4) (5) (6)

ESG 0.064*** (7.73) 0.041*** (5.13) 0.025*** (3.47) 0.052*** (6.24) 0.038*** (4.23) 0.035*** (4.19)

SIZE 0.316*** (7.11) 0.409*** (9.22) 0.128** (1.98) 0.115* (1.79)

ROA 5.670*** (13.80) 5.262*** (12.10) 2.678*** (6.04) 2.733*** (5.88)

TLTA 4.363*** (13.54) 4.834*** (14.60) 1.825*** (5.01) 2.144*** (6.09)

LIQ 0.004 (0.10) 0.014 (0.36) 0.089** (2.38) 0.094** (2.49)

TANG 0.159 (0.54) 0.082 (0.25) 0.700** (2.00) 0.959** (2.53)

SALES 0.039 (0.38) 0.049 (0.47) 0.256** (2.36) 0.333*** (2.61)

TOBINQ 0.796*** (13.32) 0.706*** (12.15) 0.272*** (5.01) 0.262*** (4.82)

Constant 4.595*** (26.79) 3.307*** (8.30) 3.572*** (6.45) 1.348*** (8.36) 1.020** (2.02) 1.663*** (3.22)

Year effects No No Yes No No Yes

Industry No No Yes No No Yes

effects

SE robust Yes Yes Yes Yes Yes Yes

N 5234 5206 5206 5234 5206 5206

Adj. R2 .065 .355 .513 .087 .188 .249

Note: This table presents the regression results between ESG and default risk using pooled OLS. Dependent variable is distance to default, that is, DD (or credit
default swap spread, i.e., CDS), in Columns 1–3 (Columns 4–6). Figures in parenthesis are the t statistics. See Appendix B for variable definitions.
*Statistical significance at 10% level.
**Statistical significance at 5% level.
***Statistical significance at 1% level.

default risk is higher in firms that have more debt in their capital struc-
ture. Overall, our findings are consistent with prior studies, which
have stated that ESG disclosure decreases firm risk (Sassen
et al., 2016), influences cash flows and cost of capital (Plumlee
et al., 2015) and therefore influences default risk.
4.2 | Endogeneity bias
The relationship between firm default risk and the ESG may possibly
be affected by endogeneity. Two of these possible sources of endo-
geneity (i.e., omitted variable bias and reverse causality) are likely to
bias our main results regarding how ESG influences default risk. First,
omitted variables (e.g., time varying and time unvarying; observable
and unobservable) may simultaneously affect both ESG and default
risk. It is difficult, if not impossible, to capture all the determinants of
default risk in the empirical models, which leads to the omitted vari-
able bias. Second, the direction of causation between ESG disclosure
and default risk is not clear. For instance, Hermalin and
Weisbach (2001) suggest that a firm's governance structure is endog-
enously determined. Bouslah et al. (2013) find a bidirectional causality
between corporate social performance and firm risk. Given this, it is
possible that ESG disclosure and default risk are determined simulta-
neously: that is, not only does ESG disclosure influence firm risk—
firms also adjust ESG disclosure based on the current risk exposure. In
such circumstances, current ESG disclosure is likely to be influenced
by a past realization of default risk (i.e., reverse causality). Hence, as
part of our identification strategy, we address these endogeneity con-
cerns in three ways. First, we employ lagged independent variables to
control for reverse causality. Regressions based on contemporaneous
variables are susceptible to endogeneity bias due to reverse causality,
whereas regressions based on lagged values of independent variables
help to control for reverse causality and thus tend to be less suscepti-
ble to endogeneity effects (Harjoto & Jo, 2015; Luo &
Bhattacharya, 2009). Second, we adopt an instrumental variable
approach, two-stage least squares (2SLS), to address the possible
endogeneity of the ESG disclosure score. Third, we execute PSM,
which can help solve the reverse causality and self-selection bias.
4.2.1 | Lagged variables
To mitigate these reverse causality issues, we estimate alternative
specifications of Equation 1. Specifically, we test the influence of the
ESG score in the previous year on the default risk (DD) in the current
year. We report the results in Columns 1–2 (Lag 1) and Columns 3–4
(Lag 2) of Table 4. As can be seen from these results, ESG is positively
(negatively) related to DD (CDS), suggesting that the prior-year ESG
inversely affects the current year's default risk. These results suggest
that the direction of causation runs from ESG disclosure to default risk
but not vice versa.
4.2.2 | Instrumental variable approach
The instrumental variable approach requires an instrument that is cor-
related with the endogenous variable (i.e., ESG) but that does not have
a direct influence on the dependent variable (i.e., default risk), except
ATIF AND ALI 9

TABLE 4 ESG and default risk—endogeneity bias (lagged independent variables)

Lag 1 Lag 2

DD CDS DD CDS
(1) (2) (3) (4)
ESG 0.022*** (2.97) 0.035*** (4.15) 0.019** (2.34) 0.035*** (4.01)
SIZE 0.419*** (9.18) 0.118* (1.80) 0.452*** (9.18) 0.135** (2.03)
ROA 5.224*** (12.76) 2.562*** (5.51) 5.183*** (11.64) 2.599*** (5.44)
TLTA 4.540*** (12.77) 2.311*** (6.46) 4.331*** (11.05) 2.474*** (6.50)
LIQ 0.022 (0.57) 0.108*** (2.80) 0.038 (0.91) 0.102*** (2.60)
TANG 0.315 (0.86) 0.973** (2.49) 0.516 (1.27) 0.986** (2.52)
SALES 0.092 (0.79) 0.326** (2.50) 0.105 (0.81) 0.304** (2.32)
TOBINQ 0.610*** (11.02) 0.262*** (4.72) 0.562*** (9.01) 0.272*** (4.78)
Constant 4.173*** (8.40) 1.704*** (3.25) 1.242** (2.41) 1.575*** (2.95)
Year effects Yes Yes Yes Yes
Industry effects Yes Yes Yes Yes
SE robust Yes Yes Yes Yes
N 4638 4635 4034 4032
Adj. R2 .471 .250 .400 .257

Note: This table presents the regression results between ESG and default risk using lagged independent variables. Columns 1–2 are based on 1-year lag,
and Columns 3–4 are based on 2-year lag. Figures in parenthesis are the t statistics. See Appendix B for variable definitions.
*Statistical significance at 10% level.
**Statistical significance at 5% level.
***Statistical significance at 1% level.

through the endogenous variable (Kennedy, 2003, p. 159). Specifi-
cally, a valid instrument must satisfy two conditions. First, the rele-
vance condition requires that, after controlling for the set of variables
in our model, the instrument correlates with ESG. Second, the exclu-
sion restriction requires that, conditional to the full set of control vari-
ables, the instrument influences default risk only through its
correlations with ESG.
Our instrument in this study, the industry median ESG, is com-
puted as the average score of ESG of all the firms in a particular year
except firm i's score of ESG in that year.10 The intuition behind using
this instrument is that a firm's ESG might be highly related to the
industry peers due to their similar business mix and investment oppor-
tunities, but such an industry average is unlikely to directly affect a
firm's default risk. Moreover, firm-level default risk may affect firm-
level ESG, whereas it is less likely to affect industry-level ESG. Given
these arguments, the industry median ESG should be a valid instru-
ment, since it is related to firm-level ESG but unrelated to firm-level
default risk.
Column 1 in Table 5 reports the first-stage regression results,
where the dependent variable is the ESG. The explanatory variables
include the instrumental variable and the same control variables as in
Equation 1. The coefficient on ESG (IND) is statistically significant at
the 1% level, suggesting that the instrument is valid because of its rel-
evance and its statistical power to explain ESG. We also check the
validity of the instrument. First, the reported F statistics of the first-
stage regression is very high, which indicates that our instrument is
not weak. Moreover, as the Cragg–Donald's Wald F statistic is greater
than the critical value (at the 10% level) given by Stock and
Yogo (2005), this again rejects the null hypothesis that the instrument
is not weak.
Columns 2 and 3 of Table 5 present the second-stage regression
results in which we regress the ESG (fitted) on default risk while con-
trolling other firm-specific variables. Consistent with our earlier find-
ings, the coefficient on ESG is statistically significant and negative
(positive) for CDS (DD), indicating that a higher ESG disclosure leads
to lower default risk. Therefore, our results are robust to the use of
the 2SLS approach and seem not to be driven by an endogeneity bias.
4.2.3 | PSM estimate
To further eliminate the endogeneity bias, we execute two-step PSM,
in which firm-years with higher ESG are matched with firm-years with
lower ESG, but with no significant differences in terms of all other var-
iables (see, e.g., Atif et al., 2021; Chen et al., 2017). Specifically, in the
first step, we create a dummy variable (high-ESG) that takes the value
‘1’ if ESG score is greater than the sample median and ‘0’ otherwise.
Firms with ESG scores greater than the sample median are considered
in the treatment group whereas firms with ESG scores lower than
sample median are included in the control group. We run the logit
regression for high-ESG with all the explanatory variables specified in
Equation 1. The predicted estimates from the logit regression are used
as the propensity scores for each firm-year observation. The logit
regression results are reported in Column 1, Panel A, Table 6. The
10 ATIF AND ALI

T A B L E 5 ESG and default risk—

First stage Second stage
endogeneity bias (Instrumental variable
ESG DD CDS approach)
(1) (2) (3)
ESG (fitted) 0.338*** (3.63) 0.296*** (3.33)
ESG (IND) 1.013*** (3.76)
SIZE 4.317*** (17.06) 0.950** (2.27) 1.008** (2.55)
ROA 4.016*** (2.81) 6.427*** (9.43) 3.665*** (5.71)
TLTA 5.507*** (3.19) 3.013*** (3.78) 0.602 (0.86)
LIQ 0.171 (1.35) 0.037 (0.65) 0.043 (0.89)
TANG 0.528 (0.32) 0.486 (0.81) 0.986* (1.72)
SALES 0.268 (0.50) 0.123 (0.60) 0.212 (1.26)
TOBINQ 1.054*** (5.32) 0.411*** (3.58) 0.017 (0.17)
Constant 9.358*** (5.70) 3.718** (2.35)
Year effects Yes Yes Yes
Industry effects No No No
F statistics 27.7
Cragg–Donald 14.03
N 5206 5206 5206

Note: This table presents the regression results between ESG and default risk using 2SLS. Column 1
presents the result of first-stage regression, and Columns 2–3 present second-stage regression. Figures
in parenthesis are the t statistics. See Appendix B for variable definitions.
*Statistical significance at 10% level.
**Statistical significance at 5% level.
***Statistical significance at 1% level.

regression results suggest that firms with higher ESG are larger in size
and have lower leverage, more tangibility, more sales and a higher firm
value (TOBINQ). The pseudo-R2 for the regression is high, with a value
of 34.05%.
In the second step, we use the propensity scores to form
one-to-one matched pairs, ensuring that the firms with ESG higher
than the median (treatment group) are sufficiently similar to the firms
with ESG lower than the median (control group). Specifically, each firm
with higher ESG was matched to a firm with lower ESG using the clos-
est propensity score. We employ matching with replacement, requir-
ing that the difference in the propensity scores of the treatment and
the matched firms does not exceed 0.1% in absolute value. With the
application of these criteria, we are able to effectively match 1922
firm-year observations; hence, our treatment and control groups are
nearly identical along all explanatory variables, with one
exception: ESG.
We run two diagnostic tests to verify that the treatment and con-
trol groups are indistinguishable in terms of observable characteristics.
In the first diagnostic test, we re-estimate the logit regression for the
post-match sample. The results are reported in Column 2, Panel A,
Table 6. Most of the regression coefficients are statistically insignificant
and are smaller than those in the column pre-match, suggesting that
both groups are almost similar in terms of observable characteristics.
2
The pseudo-R drops substantially from 34.05% for the pre-match sam-
ple to 0.1% for the post-match sample. This implies that the PSM
removes all observable differences other than the difference in ESG.
In the second diagnostic test, we examine the difference for each
observable characteristic between the treated firms and the control
firms, reporting the results in Panel B, Table 6. Again, we find no sig-
nificant difference in observable characteristics between the two
groups. These results suggest that PSM removes other observable dif-
ferences, increasing the probability that any difference in the default
risk between the treated and control groups can be attributed to dif-
ferences in ESG rather than to differences in other variables.
The PSM estimates and the multivariate results using the matched
sample are reported in Panels C and D, Table 6, respectively. As evident
in Panel C, Table 6, we find significant differences in both default risk
measures between the treatment and control group.11 In particular, we
find that the CDS spread is lower and distance to default is higher in the
firms with higher ESG than in the otherwise indistinguishable firms with
relatively lower ESG. Likewise, the multivariate results reported in
Panel D, Table 6 show that firms with higher ESG have lower default
risk. These results from the propensity match method suggest that the
variation in default risk is attributable to the systematic differences in
ESG. Hence, we infer that greater ESG leads to greater stability in firms.
Natural experiment is one of the state-of-the-art solutions to the
endogeneity problem, as suggested by several empirical studies (see,
e.g., Black et al., 2015; Chen et al., 2015; Gippel et al., 2015). How-
ever, the implementation of such a methodology requires a purely
exogenous natural event, such as mandatory ESG disclosure reforms.
In the context of our study, we are unable to use natural experimenta-
tion because of the absence of any mandatory ESG disclosure reforms
ATIF AND ALI 11

TABLE 6 ESG and default risk—endogeneity bias (propensity score matching)

Panel A: Pre-match regression and post-match diagnostic test

Post-match
Pre-match
High-ESG
High-ESG
(1) (2)
SIZE 0.992*** (31.73) 0.014 (0.22)
ROA 0.539 (1.41) 0.333 (0.60)
TLTA 0.928*** (4.57) 0.123 (0.28)
LIQ 0.013 (0.54) 0.033 (0.70)
TANG 0.882*** (5.47) 0.156 (0.40)
SALES 0.263*** (4.47) 0.030 (0.20)
TOBINQ 0.102*** (3.39) 0.020 (0.34)
Constant 7.945*** (26.21) 0.353 (0.58)
Year effects No No
Industry effects No No
Observations 5212 1922
2
Pseudo-R .3405 .001

Panel B: Mean differences

Treated Control Difference t test

SIZE 7.593 7.594 0.002 0.03
ROA 0.046 0.042 0.004 0.84
TLTA 0.539 0.542 0.003 0.27
LIQ 2.422 2.494 0.072 0.81
TANG 0.280 0.284 0.004 0.38
SALES 1.060 1.059 0.000 0.01
TOBINQ 1.924 1.947 0.023 0.40

Panel C: PSM estimator

Variables Treated Controls Difference t statistics

DD 6.27 5.56 0.71 4.99***
CDS 0.17 0.56 0.39 4.28***

Panel D: Multivariate regression

DD CDS
ESG 0.022*** (3.64) 0.022*** (4.50)
SIZE 0.420*** (9.32) 0.093** (2.51)
ROA 6.841*** (14.42) 3.610*** (9.24)
TLTA 5.123*** (18.00) 1.955*** (8.34)
LIQ 0.050 (1.59) 0.065** (2.51)
TANG 0.200 (0.69) 0.737*** (3.07)
SALES 0.094 (1.19) 0.320*** (4.88)
TOBINQ 0.809*** (18.20) 0.239*** (6.54)
Constant 3.733*** (5.44) 0.008 (0.01)
Year effects Yes Yes
Industry effects Yes Yes
N 1922 1922
Adj. R2 .518 .203
F 80.266 19.846
12 ATIF AND ALI

Note: This table reports the regression results between ESG disclosure and default risk using propensity score matching estimation. Panel A reports the
parameter estimates from the logit model used to estimate the propensity scores. The dependent variable, High-ESG, is an indicator variable set to 1 if ESG
score is greater than median and 0 otherwise. Panel A reports the pre-match propensity score regression (in Column 1) and post-match diagnostic
regression (in Column 2). Panel B reports the univariate comparisons with corresponding t statistics of firm characteristics between firms with high and low
ESG. Panel C reports the average treatment effect on default risk for the matched sample. Panel D reports multivariate results relating to ESG and default
risk for matched sample. The dependent variable is DD in Column 1 and CDS in Column 2. Figures in parenthesis are the t statistics. See Appendix B for
variable definitions.
*Statistical significance at 10% level.
**Statistical significance at 5% level.
***Statistical significance at 1% level.

in the United States during our sample period. Therefore, the disclo-
sure of ESG is still at the discretion of the firm due to the absence of
any credibly exogenous reform. Overall, we acknowledge that it is not
possible to completely eliminate endogeneity. However, our results,
based on lagged independent variables, an instrumental variable and
the PSM technique, provide a certain degree of comfort that even
when considering endogeneity due to omitted variable and reverse
causality, the main findings regarding the relationship of ESG disclo-
sure to default risk do not change.
5 | ROLE OF PROFITABILITY,
PERFORMANCE VARIABILITY AND COST OF
DEBT (H2)
In Section 2, we argue that profitability, performance variability and
cost of debt/capital are the important mechanisms through which
ESG disclosure influences default risk. In this section, we empirically
test these assertions.
First, we investigate the relationship between ESG and default
risk via profitability. We use two common measures of profitability:
(1) return on assets (ROA), measured as net income divided by total
assets, and (2) return on equity (ROE), measured as net income divided
by common shareholder equity. Table 7 presents the interaction
effect of ESG and profitability (using ROA and ROE) on default risk in
Columns 1–2 and 3–4 for DD and CDS, respectively. As expected, we
find that the coefficients on the interaction terms (ESG * ROA and
ESG * ROE) are statistically significant, positive for DD and negative
for CDS. These results suggest that firms with better ESG disclosure
have higher profitability and thus have a lower level of default risk.
Second, we examine the association between ESG and perfor-
mance variability. We measure performance variability using the qua-
ntile regression forecasts of the interquartile range of the distribution
of profitability: that is, ROA (see, Konstantinidi & Pope, 2016). This
approach, which relies only on cross-sectional fundamental character-
istics, requires time series data for computation. We forecast perfor-
mance in different quantiles using the following equation:
 
QUANT q ðROAit  Xit Þ ¼ βq0t þ βq1t ROAit1 þ βq2t LOSSit1 þ βq3t ðLOSSit1  ROAit1 ð2Þ
þβq4t ACCit1 þ βq5t PAYERit1 þ βq6t PAYOUTit1 :
Our model resembles that by Correia et al. (2018), with the
exception that we forecast return on assets (ROA), rather than return
on net operating assets equity (RNOA). LOSS, a dummy variable,
equals 1 if ROA < 0 and 0 otherwise. ACC is the difference between
net income and operating cash flow, scaled by total assets. PAYER, a
dummy variable, equals 1 if PAYOUT > 0 and 0 otherwise. PAYOUT is
the ratio of dividend paid divided by net income.
First, we capture conditional dispersion in the future earnings dis-
tribution using the predicted interquartile range (IQR) = Qi75  Qi25, a
commonly used measure of earning dispersion. The higher the IQR,
the higher is the uncertainty in future earnings. Second, we estimate
conditional skewness in the future earnings distribution as SKEW = [(
Qi75  Qi50)  (Qi50  Qi25)]/IQRi, which captures the balance between
upside risk relative to downside risk in future earnings within the two
middle quartiles. Third, we estimate conditional kurtosis in the future
earnings distribution as KURT = [(Qi87.5  Qi62.5) + (Qi37.5  Qi12.5)]/
IQRi, which measures the density of the distribution close to Q25 and
Q75, relative to the density close to Q50. Finally, we decompose the
numerator of KURT to capture asymmetry in the relative densities of
the distribution surrounding Q25 and Q75 as UPi = [(Qi87.5  Qi62.5)]/
IQRi and DOWNi = [(Qi37.5  Qi12.5)]/IQRi. The higher the SKEW and
KURT, the higher is the uncertainty in the future earnings realization.
Table 8 presents the results between ESG and the five perfor-
mance variability measures, IQR (Column 1), SKEW (Column 2), KURT
(Column 3), UP (Column 4) and DOWN (Column 5). We find that the
coefficients of ESG are negative and significant for all performance
variability proxies expect SKEW. Overall, these results provide empiri-
cal support to our argument that ESG disclosure enhances perfor-
mance or earning stability and thus lowers the level of default risk.
Finally, we test the linkage between ESG and default risk via cost
of debt. On the one hand, the firms experience default if they are
unable to meet contractual debt payment (i.e., principal and interest
or cost of debt). On the other hand, firms with more investment in
ESG activities are considered safer by debtholders, and thus, they
require less risk premium, which reduces the cost of debt (Eliwa
et al., 2019). We tested if this is true for our sample. We obtain the
cost of debt data for our sample firms from the Bloomberg database.
First, we test the effect of cost of debt on default risk, reporting
our results in Table 9, with Column 1 for DD and Column 2 for CDS.
We find a significant negative (positive) coefficient of cost of debt
with DD (CDS), suggesting that firms have higher default risk if the
cost of debt is higher. Second, we test the impact of ESG on cost of
debt and reported the results in Column 3, Table 9. We find a signifi-
cant negative coefficient on ESG with cost of debt, which implies that
firms with higher ESG disclosure have a lower cost of debt. Taken
together, these results indicate that ESG reduces default risk by
reducing the cost of debt.
ATIF AND ALI 13

TABLE 7 ESG and default risk—role of profitability

DD DD CDS CDS
(1) (2) (3) (4)
ESG 0.010 (1.56) 0.017*** (4.90) 0.021** (2.57) 0.030*** (3.51)
ROA 2.359*** (2.61) 0.259 (0.28)
ESG * ROA 0.210*** 0.217***
ROE 0.536*** (5.73) 0.153 (1.28)
ESG * ROE 0.007* (1.67) 0.012*** (2.59)
SIZE 0.416*** (9.48) 0.593*** (24.94) 0.122* (1.91) 0.213*** (3.44)
TLTA 4.780*** (14.55) 6.260*** (35.75) 2.089*** (6.15) 2.890*** (8.54)
LIQ 0.014 (0.34) 0.042** (2.25) 0.094** (2.49) 0.109*** (2.77)
TANG 0.025 (0.08) 0.043 (0.22) 0.900** (2.41) 0.934** (2.42)
SALES 0.050 (0.48) 0.369*** (6.44) 0.332*** (2.62) 0.166 (1.27)
TOBINQ 0.674*** (11.63) 0.619*** (25.97) 0.229*** (4.41) 0.213*** (3.95)
Year effects Yes Yes Yes Yes
Industry effects Yes Yes Yes Yes
Constant 3.563*** (6.43) 1.100 (0.65) 1.674*** (3.28) 2.942*** (5.99)
N 5206 5206 5206 5206
Adj. R2 .519 .468 .261 .227

Note: This table reports the regression results between ESG, profitability and default risk using pooled OLS. Figures in parenthesis are the t statistics. See
Appendix B for variable definitions.
*Statistical significance at 10% level.
**Statistical significance at 5% level.
***Statistical significance at 1% level.

TABLE 8 ESG and default risk—role of performance variability

IQR SKEW KURT UP DOWN

(1) (2) (3) (4) (5)
ESG 0.0000*** (3.02) 0.0002 (1.11) 0.0018*** (6.20) 0.0006** (2.39) 0.0013*** (8.18)
SIZE 0.0015*** (12.40) 0.0051*** (3.71) 0.0015 (0.64) 0.0017 (0.86) 0.0005 (0.39)
ROA 0.2595*** (38.91) 1.9362*** (26.40) 3.9140*** (30.19) 3.3458*** (30.29) 0.5524*** (11.32)
TLTA 0.0063*** (5.51) 0.0265* (1.81) 0.1599*** (7.31) 0.0780*** (4.07) 0.0782*** (7.62)
LIQ 0.0005*** (4.55) 0.0030** (2.39) 0.0000 (0.01) 0.0049*** (2.77) 0.0048*** (3.83)
TANG 0.0058*** (6.12) 0.0851*** (7.15) 0.1441*** (7.73) 0.1953*** (12.01) 0.0557*** (5.88)
SALES 0.0011*** (4.16) 0.0077** (2.41) 0.0229*** (4.50) 0.0072* (1.65) 0.0155*** (5.84)
TOBINQ 0.0005*** (2.72) 0.0025 (1.12) 0.0026 (0.64) 0.0150*** (4.45) 0.0178*** (7.99)
Constant 0.0325*** (17.31) 0.0791*** (4.06) 1.9704*** (60.81) 0.7763*** (28.07) 1.1878*** (68.57)
Year effects Yes Yes Yes Yes Yes
Industry Yes Yes Yes Yes Yes
effects
N 4187 4187 4187 4187 4187
Adj. R2 .697 .565 .624 .628 .226

Note: This table reports the regression results between ESG performance variability using pooled OLS. Figures in parenthesis are the t statistics. See
Appendix B for variable definitions.
*Statistical significance at 10% level.
**Statistical significance at 5% level.
***Statistical significance at 1% level.
14 ATIF AND ALI

T A B L E 9 ESG and default risk—role

DD CDS COD
(1) (2) (3)
of cost of debt (COD)

COD 0.249*** (7.10) 0.170*** (4.79)

ESG 0.008*** (3.57)
SIZE 0.551*** (16.64) 0.273*** (6.36) 0.115*** (5.83)
ROA 3.663*** (10.88) 2.178*** (5.89) 0.614*** (3.24)
TLTA 4.190*** (13.16) 1.896*** (6.28) 2.083*** (13.31)
LIQ 0.020 (0.67) 0.042 (1.30) 0.036** (2.26)
TANG 0.402 (1.25) 0.520 (1.47) 0.301** (2.03)
SALES 0.071 (0.80) 0.225** (2.05) 0.173*** (3.74)
TOBINQ 0.594*** (10.84) 0.293*** (6.61) 0.116*** (5.94)
Constant 6.031*** (2.85) 1.396* (1.67) 3.726*** (16.35)
Year effects Yes Yes Yes
Industry effects Yes Yes Yes
N 7255 7262 5196
Adj. R2 .516 .234 .438

Note: This table reports the pooled OLS regression results between cost of debt and default risk in
Columns 1–2 and between ESG and cost of debt in Column 3. Figures in parenthesis are the t statistics.
See Appendix B for variable definitions.
*Statistical significance at 10% level.
**Statistical significance at 5% level.
***Statistical significance at 1% level.

6 | ADDITIONAL ANALYSES
6.1 | Role of corporate life cycle
In this section, we report our exploration of the effect of ESG disclo-
sure on default risk at various stages of the firm life cycle, as argued in
the introduction. We use three alternative methods to classify firms
into different life cycle stages. First, we adopt the cash flow-based
method developed by Dickinson (2011), who argues that cash flow
captures differences in firm profitability, growth and risk. Thus, one
may use operating (CFO), investing (CFI) and financing (CFF) cash
flows to classify firms into five stages: introduction, growth, mature,
shake-out and decline. The firm is considered in the introduction stage
if CFO < 0, CFI < 0 and CFF > 0; growth, if CFO > 0, CFI < 0 and
CFF > 0; mature, if CFO > 0, CFI < 0 and CFF < 0; and decline, if
CFO < 0, CFI > 0 and CFF ≤ 0 or CFF ≥ 0, with the remaining firm-
years classified under the shake-out stage.12
Second, we follow DeAngelo et al. (2006) and use retained earn-
ings to total assets (RETA) as a proxy for the life cycle. RETA measures
the extent to which a firm is reliant on internal or external financing.
Firms with high RETA are mature or older, with declining investment,
whereas firms with low RETA are in the young and growth stages.
Finally, as life cycle stages naturally relate to firm age, we use firm age
as a simple and natural proxy of life cycle. We measure firm age as a
difference between the current fiscal year and the year of
incorporation.
First, we investigate the direct effect of firm life cycle on default
risk. The results are reported in Panel A, Table 10. All the control
variables are the same as in Equation 1. Column 1 includes the regres-
sion results using the Dickinson (2011) life cycle proxy. Compared to
the shake-out stage, the introduction, growth and decline stages are
significantly negatively associated with DD, while the mature stage of
the life cycle is positively associated with DD (p < .01). Columns 2 and
3 include the regression results using the RETA and AGE life cycle
proxies, respectively. These results suggest that both RETA and AGE
are positively and significantly associated with DD (p < .01). Overall,
these results suggest that mature and older firms have lower default
risk whereas introductory and younger firms have higher default risk.
Second, and more importantly, we investigate the interactive
effect of ESG and firm life cycle on default risk. These results are
reported in Panel B, Table 10. All the control variables are the same as
in Equation 1. Columns 4–6 include the regression results using
Dickinson (2011) life cycle stages, RETA and AGE life cycle proxies,
respectively. The results suggest that the coefficient on ESG and Dick-
inson (2011) life cycle stages with DD is significant and positive only
for the mature stage. Moreover, both the coefficients on the interac-
tion between ESG * RETA and ESG * AGE with DD are positive and sta-
tistically significant. These results imply that firms with higher ESG
disclosure reduce default risk for only those firms that are mature
and older.
Finally, we use a split sample strategy to investigate the effect of
ESG on default risk in different life cycle stages. For a Dickinson (2011)
life cycle proxy, we run separate regressions for firms in introduction,
growth, mature and decline stages. For RETA and AGE life cycle prox-
ies, we split the sample into old firms, with RETA and AGE higher than
the sample median, and as young, with RETA and AGE lower than the
TABLE 10 ESG and default risk—role of corporate life cycle
ATIF AND ALI

Panel A: Life cycle and default risk Panel B: ESG, life cycle and default risk

DD DD DD DD DD DD
(1) (2) (3) (4) (5) (6)
INTRO 0.949*** (5.42) 1.606*** (4.11)
GROWTH 0.335*** (2.58) 0.439* (1.95)
MATURE 0.660*** (5.74) 0.113 (0.54)
DECLINE 0.539*** (2.96) 0.513 (1.09)
RETA 0.705*** (9.69) 0.083 (0.30)
AGE 0.012*** (4.90) 0.003 (0.61)
ESG 0.004 (0.50) 0.006 (0.66) 0.002 (0.17)
ESG * INTRO 0.004 (0.17)
ESG * GROWTH 0.004 (0.39)
ESG * MATURE 0.026*** (2.88)
ESG * DECLINE 0.018 (0.58)
ESG * RETA 0.065*** (3.19)
ESG * AGE 0.000** (1.96)
SIZE 0.480*** (14.52) 0.432*** (13.23) 0.510*** (14.95) 0.374*** (15.72) 0.299*** (6.50) 0.420*** (9.19)
ROA 3.036*** (9.49) 2.083*** (7.05) 3.694*** (10.59) 4.226*** (18.12) 2.876*** (6.55) 5.221*** (11.70)
TLTA 4.530*** (15.12) 4.112*** (14.16) 4.815*** (14.96) 4.526*** (26.39) 3.877*** (11.66) 4.990*** (14.55)
LIQ 0.035 (1.21) 0.020 (0.69) 0.009 (0.30) 0.020 (1.11) 0.018 (0.46) 0.019 (0.50)
TANG 0.192 (0.62) 0.062 (0.20) 0.315 (0.96) 0.190 (1.06) 0.199 (0.64) 0.023 (0.07)
SALES 0.157* (1.79) 0.144* (1.65) 0.075 (0.83) 0.080 (1.42) 0.049 (0.48) 0.035 (0.34)
TOBINQ 0.629*** (11.63) 0.704*** (15.26) 0.624*** (10.80) 0.718*** (31.74) 0.742*** (12.37) 0.708*** (12.33)
Constant 5.934** (2.50) 5.845*** (2.62) 1.960*** (5.49) 4.635*** (2.91) 4.808*** (8.43) 3.756*** (6.63)
Year effects Yes Yes Yes Yes Yes Yes
Industry effects Yes Yes Yes Yes Yes Yes
N 7277 7182 7134 5206 5184 5098
Adj. R2 .528 .533 .517 .538 .553 .524

Note: This table reports the pooled OLS regression results between corporate life cycle and default risk in Columns 1–3 (Panel A) and between ESG, life cycle and default risk in Columns 4–6 (Panel B). Figures in
parenthesis are the t statistics. See Appendix B for variable definitions.
*Statistical significance at 10% level.
**Statistical significance at 5% level.
***Statistical significance at 1% level.
15
16 ATIF AND ALI

sample median. The unreported results indicate that ESG reduces
default risk only during Dickinson's mature stage. ESG disclosure sig-
nificantly reduces default risk for old age firms only and significantly
reduces default risk only for high RETA firms (i.e., mature firms).
6.2 | Components of ESG and default risk
to check if the relationship between ESG disclosure and default risk is
consistent across different periods. Our results reveal that the impact
of ESG on default risk exists for both pre-GFC and post-GFC periods.
Finally, we test the interaction effect of ESG disclosure and GFC on
default risk and find that the interaction term is positive and statisti-
cally significant at the 1% level. These results indicate that firms with
high ESG disclosure had lower default risk during the GFC period.

Table 11 reports the results between the components of ESG disclo-

sure (environmental, social and governance) and default risk. These
analyses are important to rule out the possibility that our results are
driven by one of the components. Columns 1–3 of Table 11 show that
ESG disclosures are positively and significantly associated with DD:
that is, a lower default risk. Overall, these results suggest that all the
components of ESG are important determinant of default risk for US
firms.
6.3 | Excluding GFC
For this section, we exclude the extreme observations during the
global finance crisis (GFC) and then investigate the impact of ESG on
default risk. We consider observations during 2008 and 2009 as GFC.
Our untabulated results suggest that even when we exclude GFC
years, our main inference does not change: that is, ESG disclosure
reduces default risk. We also conduct pre-GFC and post-GFC analyses
6.4 | Alternative measure of ESG
Our analyses so far have been based on the ESG disclosure data
(instead of ESG performance) obtained from the Bloomberg database.
Cho et al. (2015) argue that managers may engage in the deceitful
behaviour of creating organizational facades for signalling purposes.
This practice may result in ESG performance differing from ESG dis-
closure (Tashman et al., 2019). With this in mind, we use an alterna-
tive measure of ESG from the Thomson Reuters Eikon (Asset4)
database which is designed to transparently and objectively measure
a company's relative ESG performance, commitment and effective-
ness, in terms of environmental aspects (i.e., resource use, emissions
and innovation), social aspects (workforce, human rights, community
and product responsibility) and governance aspects (management,
stakeholders and corporate social responsibility strategy). The results
are reported in Table 12. Consistent with our baseline results reported
in Table 3, we find that overall ESG performance and its factors

TABLE 11 ESG components and default risk

DD DD DD CDS CDS CDS

(1) (2) (3) (4) (5) (6)

G factor 0.042*** (3.82) 0.053*** (3.99)

E factor 0.016*** (2.79) 0.020*** (2.61)

S factor 0.015*** (2.62) 0.024*** (3.29)

SIZE 0.437*** (10.71) 0.271*** (3.62) 0.376*** (6.41) 0.169*** (3.05) 0.128 (1.22) 0.094 (1.13)

ROA 5.187*** (11.88) 5.391*** (4.85) 7.112*** (9.77) 2.620*** (5.63) 3.163*** (3.44) 4.378*** (6.33)

TLTA 4.875*** (14.82) 5.044*** (9.49) 4.698*** (10.36) 2.216*** (6.27) 2.310*** (3.01) 2.083*** (4.07)

LIQ 0.016 (0.41) 0.061 (0.76) 0.067 (1.21) 0.097** (2.56) 0.003 (0.04) 0.134** (2.42)

TANG 0.021 (0.06) 0.343 (0.84) 0.211 (0.54) 0.871** (2.29) 1.233** (2.20) 1.376*** (2.82)

SALES 0.050 (0.48) 0.537*** (3.18) 0.150 (1.14) 0.334** (2.57) 0.610** (2.54) 0.494*** (2.68)
TOBINQ 0.711*** (12.19) 1.400*** (9.62) 0.900*** (9.40) 0.273*** (5.00) 0.815*** (5.45) 0.347*** (3.90)

Constant 1.635*** (2.63) 4.409*** (4.31) 4.171*** (4.94) 4.160*** (5.90) 1.159 (0.97) 0.468 (0.60)

Year Yes Yes Yes Yes Yes Yes

effects
Industry Yes Yes Yes Yes Yes Yes
effects

N 5206 2034 3429 5206 2036 3428

Adj. R2 .512 .608 .536 .240 .362 .250

Note: This table reports the pooled OLS regression results between individual components of ESG and default risk. Figures in parenthesis are the t statistics. See
Appendix B for variable definitions.
*Statistical significance at 10% level.
**Statistical significance at 5% level.
***Statistical significance at 1% level.
 ATIF AND ALI

TABLE 12 Alternative measure of ESG—Asset4

DD DD DD DD CDS CDS CDS CDS

(1) (2) (3) (4) (5) (6) (7) (8)

ESG 0.007* (1.82) 0.013*** (3.77)

G factor 0.003* (1.85) 0.006** (1.97)

E factor 0.004*** (2.78) 0.007*** (2.63)

S factor 0.005*** (3.04) 0.011*** (3.26)

SIZE 0.406*** (6.88) 0.443*** (17.80) 0.417*** (15.70) 0.419*** (15.72) 0.233*** (3.59) 0.296*** (4.41) 0.253*** (3.88) 0.244*** (3.77)

ROA 8.208*** (8.52) 8.175*** (16.28) 8.238*** (16.40) 8.339*** (16.43) 5.700*** (6.85) 5.627*** (6.76) 5.754*** (6.85) 5.856*** (6.93)

TLTA 5.799*** (10.91) 5.824*** (28.54) 5.804*** (28.41) 5.799*** (28.35) 3.140*** (6.04) 3.180*** (6.08) 3.148*** (5.99) 3.121*** (5.97)
LIQ 0.052 (0.96) 0.055** (2.05) 0.053** (2.00) 0.052** (1.96) 0.070 (1.30) 0.072 (1.33) 0.070 (1.30) 0.070 (1.30)

TANG 0.376 (0.85) 0.348** (2.07) 0.359** (2.13) 0.354** (2.10) 1.103** (2.39) 1.064** (2.28) 1.075** (2.32) 1.085** (2.35)

SALES 0.274* (1.82) 0.271*** (4.61) 0.266*** (4.52) 0.270*** (4.58) 0.477*** (2.77) 0.474*** (2.70) 0.461*** (2.66) 0.471*** (2.76)

TOBINQ 0.789*** (8.74) 0.802*** (20.08) 0.794*** (19.87) 0.786*** (19.66) 0.385*** (4.15) 0.407*** (4.31) 0.392*** (4.18) 0.376*** (4.06)

Constant 3.409*** (4.51) 3.144*** (9.48) 3.440*** (10.20) 3.377*** (10.13) 2.114*** (2.74) 2.605*** (3.30) 2.052*** (2.66) 2.101*** (2.73)

Year effects Yes Yes Yes Yes Yes Yes Yes Yes

Industry effects Yes Yes Yes Yes Yes Yes Yes Yes

SE robust Yes Yes Yes Yes Yes Yes Yes Yes

N 4714 4714 4714 4712 4725 4725 4725 4723

Adj. R2 .553 .552 .552 .553 .338 .331 .333 .337

Note: This table presents the regression results between ESG and default risk using pooled OLS. ESG and its factors are from Thomson Reuters Eikon (Asset4). Dependent variable is distance to default, that is, DD (or credit
default swap spread, i.e., CDS), in Columns 1–3 (Columns 4–6). Figures in parenthesis are the t statistics. See Appendix B for variable definitions.
*Statistical significance at 10% level.
**Statistical significance at 5% level.
***Statistical significance at 1% level.
17
18
(i.e., E, S and G) are significantly and positively (negatively) associated
with DD (CDS), suggesting that the firms with higher ESG performance
have a lower level of default risk.
7 | C O N CL U S I O N
ESG performance (also termed nonfinancial or extra-financial informa-
tion) has emerged as an important consideration for evaluating invest-
ment decisions. On the other hand, default risk has become an
important yardstick of firms' financial health due to its severe conse-
quences for firms. However, previous literature has not revealed how
ESG disclosure influences default risk and through which mechanisms.
We explore the effect of ESG disclosure on default risk for the non-
financial US firms over the period from 2006 to 2017. Our results sug-
gest that ESG disclosure is positively related to default risk as proxied
by the distance to default (DD) measure and is negatively related to
credit default swap spread (CDS). We also explore various mechanisms
through which ESG disclosure reduces default risk. We find that the
inverse effect ESG disclosure on default risk is through increased prof-
itability and reduced performance variability. We also find that ESG
reduces default risk via cost of debt. We specifically find that firms
with a lower cost of debt have a lower default risk and firms with high
ESG have a lower cost of debt. Finally, we document that the negative
impact of ESG on default risk exists only for mature and older firms.
Our findings are consistent when using alternative variable specifica-
tions and alternative estimation methods, including lagged indepen-
dent variables, an instrumental variable approach and PSM.
Our study contributes to the stream of research that explores the
determinants of firms' default risk. We extend this literature by pro-
viding robust evidence on the role of aggregate ESG disclosure as crit-
ical determinants of default risk for nonfinancial US firms. Moreover,
our study extends the literature on the consequences of ESG by
examining various mechanisms through which ESG disclosure reduces
default risk. Finally, we contribute to the firm life cycle literature by
providing empirical evidence that the corporate life cycle moderates
the effect of ESG disclosure on default risk. Our findings are impor-
tant for the potential of SRI to screen investment and to facilitate
fund availability for firms with a better ESG outlook. Our findings also
provide insights for debtholders to consider a firm's sustainability ini-
tiative before making decisions. Given our findings, policy makers
aiming at sustainability should encourage firms to disclose their sus-
tainability initiatives.
ENDNOTES
1
For instance, investors taking nonfinancial information into consider-
ation before making investment decisions have become essential in the
light of UN Principles for Responsible Investment (Capelle-Blancard &
Monjon, 2014).
2
Default (a) adversely affects productivity through supply chain interrup-
tions and employee attrition, (b) incurs legal and administrative costs,
(c) destroys some or all of the value of investment the shareholders
have made and (d) harms customer retention and employee well-being
(e.g., Brogaard et al., 2017).
ATIF AND ALI
3
Despite the increasing importance of ESG, critics (e.g., Friedman, 1970)
have supported the view that businesses exist to make profit, and thus,
no social responsibility should be assigned to businesses that incur
extra expenses.
4
Prior literature examines default risk from an array of factors: stock
market liquidity (Brogaard et al., 2017), incentive structure (Bennett
et al., 2015), innovation performance (Hsu et al., 2015), debt maturity
choice (Goyal & Wang, 2013), stock market return and volatility
(Giesecke et al., 2011), as well as corporate governance characteristics
such as CEO compensation, board independence and ownership struc-
ture (see, e.g., Acrey et al., 2011; Ali et al., 2018; Chiang et al., 2015;
Chiu & Wagner, 2012; Miglani et al., 2015; Schultz et al., 2017;
Switzer & Wang, 2013; Vallascas & Hagendorff, 2013).
5
A better ESG disclosure also indicates better management quality, sig-
nalling superior management of firm financial risk.
6
The ESG disclosure data from Bloomberg is mainly available from 2006
onward which is the main reason we start our sample period
from 2006.
7
Firms' ESG performance and relevant nonfinancial disclosure have
gained global focus. With this ever-increasing attention, three main
agencies (Bloomberg, MSCI and Thomson Reuters) provide ESG ranking
across different industries and geographic locations. These agencies
implement different scoring frameworks, along with uniform interna-
tional ESG guidelines such as from the GRI and the UN. Bloomberg pro-
vides real-time individual and aggregate ESG disclosure scores ranging
from 0.1 to 100, mainly from 2006, which marks the start of our sample
period. These scores are mainly derived from ESG information publi-
shed by the firms (e.g., annual reports and websites of firms), from
information provided by public sources (e.g., super funds) and
from questionnaires sent to firms in order to get information regarding
ESG concerns.
8
Market-based default risk measures overcome the criticism of
accounting-based models: the forward-looking nature of market data
reflects the expectations of a firm's future cash flows and hence should
be more appropriate for prediction purposes (Beaver et al., 2005).
9
We multiply the standard deviation of ESG, that is, 12.88, with the coef-
ficient on ESG, that is, 0.025, in Column 3 of Table 3 to get 0.322.
Therefore, one standard deviation increase in the ESG increases the
distance to default (DD) by 0.322 points. As the mean distance to
default (DD) is 5.98, an increase by 0.322 denotes a change by 5.40%
of the average default risk.
10
Several governance studies have used this instrument (see, e.g., Ali
et al., 2018; Jiraporn et al., 2011; Liu et al., 2014; Liu et al., 2015;
Yang & Zhao, 2014).
11
The difference in the means between the treatment and control groups
is the PSM of the average treatment effect on the treated (ATT).
12
The life cycles of firms are categorized into five stages: introduction,
growth, mature, shake-out and decline. Five dummy variables are cre-
ated for each of the five stages. However, to avoid the problem of
dummy variable trap multicollinearity in the regression model, one
of the stages is dropped. As the shake-out stage of the life cycle is
ambiguous in theory (Dickinson, 2011), we drop this stage in the
regression model.
DATA AVAILABILITY STAT EMEN T
The default risk data is sourced from publicly available database
whereas ESG data is sourced from privately subscribed database.
OR CID
Searat Ali https://orcid.org/0000-0002-7250-8116
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22 ATIF AND ALI

APPENDIX B : VARIABLE DEF INITIONS

Notation Name Measure Source

Dependent variables
DD Distance to default Annual average of distance to default based on stock RMI-NUS
based on stock price variability
CDS Credit default swap spread Credit derivatives that allow the transfer of the firm's RMI-NUS
default risk between two agents for a predetermined
time period
Key independent variables
ESG Environmental, social and governance ESG is the aggregate environmental, social and Bloomberg
governance performance index.
E factor Environment The environmental factor refers to the firm's use of Bloomberg
energy, water, carbon emissions, pollution and
natural resources conservation. It includes the
appraisal of environmental risks that might affect the
firm's income and how the firm is managing those
potential risks.
S factor Social The social factor, which refers to the firm's relationship Bloomberg
with society, includes employee health, safety and
rights at the workplace, product safety and social
philanthropy.
G factor Governance The governance factor includes board independence, Bloomberg
diversity, shareholder rights and disclosure of
information. It evaluates the information required by
investors and stakeholders on accounting
transparency, conflict of interest and strength of
governance structure.
Control variables
SIZE Firm size Natural logarithm of total assets Bloomberg
ROA Firm profitability1 Net income divided by total assets Bloomberg
TLTA Firm leverage Total liabilities divided by total assets Bloomberg
LIQ Firm liquidity Current assets divided by current liabilities Bloomberg
TANG Asset tangibility Plant property and equipment divided by total assets Bloomberg
SALES Firm sales Total sales divided by total assets Bloomberg
TOBINQ Growth opportunities Fair market value and total liabilities divided by total Bloomberg
assets
Additional variables
ROE Firm profitability2 Net income divided by common shareholder equity Bloomberg
IQR Inter quantile range The 0.5 interquartile range calculated as Qi75  Qi25 Bloomberg
SKEW Skewness Skewness calculated as [(Qi75  Qi50)  (Qi50  Qi25)]/IQRi Bloomberg
KURT Kurtosis Kurtosis calculated as [(Qi87.5  Qi62.5) Bloomberg
+(Qi37.5  Qi12.5)]/IQRi
UP Up The upside component of KURT, calculated as Bloomberg
[(Qi87.5  Qi62.5)]/IQRi
DOWN Down The downside component of KURT, calculated as Bloomberg
[(Qi37.5  Qi12.5)]/IQRi
COD Cost of debt Interest expense divided by average interest-bearing Bloomberg
debt
CLC Corporate life cycle A vector of dummy variables that capture firms' Bloomberg
different stages in the life cycle following the
Dickinson (2011) model
ATIF AND ALI 23

Notation Name Measure Source

RETA Retained earnings Retained earnings divided by total assets. A high RETA Bloomberg
implies that the firm is more mature or old with
declining investment, while the firm with a low RETA
tends to be young and growing (DeAngelo
et al., 2006).
AGE Firm age Natural logarithm of the current year minus the year of Bloomberg
incorporation
ESG (IND) Industry-average ESG The average ESG of all the firms in firm i's industry
excluding firm i's ESG