The Effect of ESG performance on the stock market during the COVID-19 Pandemic – Evidence from Japan

Abstract

Environmental, social, and governance (ESG) practices can play a crucial role in promoting green recovery by fostering sustainable and responsible economic growth. Based on a novel dataset of Japanese listed companies from January 2016 to December 2021, this study examines the effect of corporate (ESG) performance on the Japanese stock market during the COVID-19 pandemic. We contribute additional evidence to the literature by exploring the unique role of ESG factors that affect stock markets during economic downturns. The results of the study show a positive association between corporate ESG performance and stock returns during the COVID-19 period. Furthermore, we demonstrate that strong ESG performance contributed to enhanced stock market stability and increased market liquidity in Japan during the COVID-19 pandemic. These results provide a rationale for implementing supportive measures and regulations that encourage companies to adopt and disclose robust ESG practices. By doing so, they can contribute to the stability and liquidity of the stock market and fostering sustainable economic growth.

1. Introduction

Environmental, social, and governance (ESG) practices in Japan have gained significant attention and adoption in recent years. Corporates, investors and policy-makers are recognizing the importance of integrating ESG factors into investment decision-making processes, corporate strategies, and regulatory frameworks. According to the findings from Nomura Securities’ 2021 Individual Investor Survey, retail investors in Japan are increasingly interested in ESG investments after the coronavirus pandemic drew attention to environmental issues and human rights matters. Along with the growing number of market participants and policy-makers who recognize the importance of ESG practice, sustainable assets under management in Japan increased sixfold from 2016 to 2020 to a total of $2.8 trillion, ranking third globally.

With the global economic recovery from the COVID-19 pandemic gaining momentum, the notion of a “green recovery” is gaining prominence (Gusheva and de Gooyert, 2021). Instead of placing economic policies above environmental and social concerns, this concept focuses on leveraging the current opportunity to advance climate action, establish a circular economy, and transition towards resilient social and economic models capable of withstanding disasters and infectious diseases (Taghizadeh-Hesary and Rasoulinezhad, 2023). Given this prevailing global trend, it is evident that the ESG perspective will continue to attract significant attention in the financial markets.

The novel coronavirus disease (COVID-19) has spread rapidly worldwide and has caused a global pandemic, affecting the global financial market through supply reductions, demand reductions, and economic instability. As the most advanced stock market in Asia, the Japanese stock market experienced significant volatility and fluctuations during the COVID-19 crisis. In particular, this market, represented by indices such as the Nikkei 225 and the TOPIX, declined steeply in early 2020, mirroring global market sentiments. Throughout the pandemic, the Japanese stock market exhibited volatility, with fluctuations in response to global market trends, news related to COVID-19 cases, and economic indicators. However, there were periods of recovery as well, driven by factors such as progress in vaccine development, easing of restrictions, fiscal and monetary policies to boost the economy, and improving the economic outlook.

The exceptional circumstance of the COVID-19 pandemic provides us with a unique opportunity to test theories of ESG policies: can ESG engagement make the stock market immune to sudden economic downturns, such as the COVID-19 shock? Given a commitment to sustainable development and responsible business conduct, Japanese companies have been increasingly focusing on integrating ESG factors into their operations. But the specific impact of corporate ESG performance on stock market performance during the COVID-19 period remains relatively unexplored.

Understanding the relationship between corporate ESG performance and stock market performance during the COVID-19 period holds several important implications. First, the research provides investors with valuable information to guide their investment decisions in turbulent times. By evaluating the influence of ESG factors on stock market performance, investors can assess the resilience and stability of companies with strong ESG performance, ultimately informing their investment strategies. In addition, by focusing on the Japanese stock market, which has its own distinct characteristics and regulatory framework, we contribute to a more comprehensive understanding of the global landscape of ESG development and its implications for financial markets. Third, in Japan, achieving sustainability in various economic sectors is a significant objective, and the government is actively trying to pursue a green economic recovery in the post-COVID era (Farhad Taghizadeh-Hesary et. al 2023). This research may have important policy implications for the policy-makers in Japan.

ESG engagement is widely believed to make corporate stocks more immune to adverse shocks (Bouslah et al., 2018, Albuquerque et al., 2020, Broadstock et al., 2021, Ding et al., 2021). ESG engagements help build public trust in a firm, offering the prospect of significant downside protection in a crisis period. Lins et al. (2017) argued that ESG benefits are not constant over time but are related to the overall level of trust in corporations and financial markets and that such benefits tend to be greatest when trust is at its lowest. In addition, firms that have better corporate social performance are more likely to have better management, which is critical during crisis periods (Alexander and Buchholz, 1978). An alternative explanation for this view is that stocks with better ESG performance appeal to investors who have ethical and social goals. Those ESG investors tend to be more loyal and sell less during a crisis (Heal, 2005, Siddiq and Javed, 2014). Several empirical studies related to the 2008 global financial crisis period (Lins et al., 2017, Bouslah et al., 2018) have suggested that corporations with better ESG performance have higher stock returns, and their stock prices are less volatile during crises.

In light of previous literature, our study examines the relationship between corporate ESG and stock market performance during the COVID-19 pandemic with a focus on Japan. Our results show a positive association between corporate ESG performance and stock returns during the COVID-19 period. Furthermore, the results demonstrate that strong ESG performance contributes to enhanced stock market stability and increased market liquidity in Japan during the COVID-19 pandemic. These results provide a rationale for policy-makers to implement supportive measures and regulations that encourage companies to adopt and disclose robust ESG practices. Corporate managers should prioritize ESG practices, which can enhance their long-term financial performance, attract socially responsible investors, and contribute to a more resilient and stable stock market.

The contribution of this study is twofold. First, by examining the specific impact of ESG performance during the COVID-19 pandemic, we fill a crucial gap in the literature by offering insights into the unique dynamics of the stock market and its response to ESG considerations during a global crisis. Previous literature has rarely explored the specific role of corporate ESG engagement during crises when public confidence in corporations and capital markets declines unexpectedly. Limited insights have been gleaned from the 2008 global financial crisis and the COVID-19 pandemic (Lins et al., 2017, Albuquerque et al., 2020, Bouslah et al., 2018, Engelhardt et al., 2021). We add to the existing body of knowledge on the role of ESG factors in shaping financial outcomes during periods of economic distress. Second, the majority of research examining the impact of ESG performance on stock markets has primarily focused on the United States and Europe, where the concept of ESG originated (Lins et al., 2017, Demers et al., 2021, Engelhardt et al., 2021). However, the research on the Japanese market is rare. Consequently, it remains uncertain whether previous studies’ findings apply to Japan, where the popularity of the ESG concept has grown in recent years.

Third, compared with the literature, we provide a more comprehensive perspective on the importance of ESG performance in the stock market. Most of the literature has primarily focused on stock returns to investigate the impact of ESG performance on the stock market (Ding et al., 2021). In contrast, we assess stock market performance across three dimensions: stock market returns, volatility, and liquidity. This multidimensional approach provides a more holistic and comprehensive understanding of stock market performance beyond solely examining stock returns. In addition, we have further contributed by examining the specific impact of ESG performance during the COVID-19 pandemic by using two different ESG scorings. There is divergence among ESG scores due to different ESG calculation methodologies (Dorfleitner et al., 2015). The results become more convincing by considering two ESG scores instead of relying on just one ESG Score.

The remainder of this paper proceeds as follows. Section 2 discusses the theoretical background and outlines the relevant literature and hypotheses. Section 3 explains the data and methodology employed in this study. Section 4 presents the empirical results. Finally, Section 5 concludes with a discussion of the policy implications.

2. Theoretical background and related literature

The notion that ESG activities help immunize stock prices against economic downturns is premised on the belief that ESG engagement enables firms to improve their social image, establishing investors’ reliance and trust in a firm (Benson and Humphrey, 2008, Lins et al., 2017). Public trust is vital for well-functioning markets and financial stability, especially during economic downturns when public confidence in corporations and capital markets declines unexpectedly (Guiso et al., 2004, Ashwin Kumar et al., 2016). As a result of broad public trust and the current sustainability trend, investors may have higher demand for stocks with high ESG scores in times of crisis, leading to higher stock prices and turnover rates.

In addition, outside shareholders are likely to be concerned that the financial information they previously relied on to guide investment decisions may not be credible during the crisis. As such, they may seek nonfinancial information, such as ESG ratings, that reflect a firm’s values and integrity and place a valuation premium on firms believed to be more trustworthy (Lins et al., 2017).

An alternative rationale supporting the notion that ESG performance impacts corporate financial performance is rooted in the idea that stocks exhibiting stronger ESG performance are attractive to investors with ethical and social objectives. ESG investments are attractive to investors seeking to attain those objectives without compromising or even sacrificing their financial returns (Renneboog et al., 2008, Crifo et al., 2017, Hartzmark and Sussman, 2019). In recent years, an increasing number of investors have actively responded to sustainability development, directing money away from funds with low portfolio ESG scores to those with high scores. Those ESG investors tend to be more loyal and sell less during a crisis (Heal, 2005, Siddiq and Javed, 2014). Several studies related to the 2008 global financial crisis period (Lins et al., 2017, Bouslah et al., 2018) and early studies on the COVID-19 pandemic period (Albuquerque et al., 2020, Broadstock et al., 2021, Ding et al., 2021) have suggested that corporations with better ESG performance indeed have higher stock returns, and their stock prices are less volatile in times of crisis.

There is a growing body of empirical studies examining the relationship between ESG factors and stock market returns. While some studies suggest a positive relationship between ESG performance and stock returns, others find it negative or insignificant (Lins et al., 2017, Bae et al., 2021, Demers et al., 2021, Albuquerque et al., 2020, Ramelli and Wagner, 2020). Demers et al. (2021) explained the negative relationship between ESG factors and stock market returns from an agency theory perspective. Management may achieve its ESG goals at the expense of shareholder value. For example, amid the COVID-19 crisis, society started to focus more on the health and safety of employees, such as securing employment and responding to customers’ needs, which led to higher costs for companies. From this perspective, ESG investments are wasteful and potentially harmful to shareholders.

Previous research has explored the relationship between ESG factors and stock returns in the Japanese stock market. Studies by Yamaguchi et al. 2019 and Murata and Hamori (2020) found evidence of a positive association between ESG performance and stock returns. These findings suggest that companies with strong ESG practices tend to generate higher financial returns for investors. However, previous literature has rarely explored the specific role of corporate ESG engagement during crises in Japan. Limited insights have been gleaned from the 2008 global financial crisis and the COVID-19 pandemic (Lins et al., 2017, Albuquerque et al., 2020, Bouslah et al., 2018, Engelhardt et al., 2021). In addition, most of the research on this issue has been mainly in the context of the United States and Europe, where the concept of ESG was initially developed (Lins et al., 2017, Demers et al., 2021, Engelhardt et al., 2021). Thus, it is unclear whether the results of previous studies apply to Japan, where the ESG concept has gained popularity in recent years.

Takahashi and Yamada (2021) investigated the factors affecting the Japanese stock market during the COVID-19 pandemic period. Using Japanese listing companies as the sample, they did not find evidence that higher corporate ESG scores led to higher stock returns during the COVID-19 crisis and explained that the ESG concept is still in its infancy in Asia, and sudden adverse market shocks may lead investors to sell the stocks of companies with high ESG scores, which are preferred by investors and considered to have higher stock prices before market downturns. Moreover, the ESG issue is associated with long-term value creation. Thus, better returns may not be observed in the short term but may be significant in the long run.

Against the theoretical background and literature, we develop two hypotheses as follows:

H1

Better corporate ESG performance is positively associated with stock returns and market liquidity in Japan.

H2

Companies with high ESG scores have lower volatility during the COVID-19 pandemic.

3. Data and empirical methodology

3.1. Data

Using monthly frequency data, we employ a firm fixed effects panel model over a sample dataset of more than 300 listing firms in Japan. Due to data availability, the sample dataset covers the period from January 2016 to December 2021. The ESG concept has increased in popularity in recent years and has begun to gain ground, particularly since the adoption of the United Nations Sustainable Development Goals (SDGs) in 2015. Thus, we assume that 2016–2021 is an ideal sample period.

We examine stock market performance from three angles: stock market return, volatility, and liquidity. In line with the literature (Schwert, 2002, Erdem, 2020), stock returns are measured by monthly stock log returns, as shown in Eq. (1), where i and t denote the firms and time indices, respectively. ${\mathit{Price}}_{i,t}$ represents the stock price of firm i at time t.

$${\mathit{Return}}_{i,t}=Ln\left(\frac{{\mathit{Price}}_{i,t}}{{\mathit{Price}}_{i,t-1}}\right)$$ (1)

We use the annualized standard deviation of daily returns of stocks for the past 30 days as a proxy measure of stock market volatility, which is most commonly used in the literature to quantify market volatility. The standard deviation of stock returns captures the dispersion or variability in stock returns around their average values. Higher standard deviations indicate greater volatility, implying higher risk. We assume that there are 252 trading days in a year and calculate the market volatility as shown in Formula (2). $STD\left(\mathit{Return}\right)$ represents the standard deviation of daily returns.

$${\mathit{V\; olatility}}_t=STD\left(\mathit{Return}\right)\ast \sqrt{252}$$ (2)

The stock turnover rate is used to reflect stock market liquidity, which equals the monthly average trading volume relative to the shares outstanding. This rate provides insights into trading activity and the ease with which stocks can be bought or sold in the market. Higher turnover rates are associated with more liquid and efficient markets, implying that investors can easily buy or sell shares without significantly impacting the stock’s price.

To test the robustness of the results, we utilize corporate ESG scores from both FTSE Russel and S&P, incorporating their distinct methodologies. Despite the differences in their approaches, this complementary use of scores offers a more comprehensive and well-rounded assessment of companies’ ESG performance. Both ESG scores provide investors and stakeholders with valuable insights into companies’ sustainability practices and risk profiles. All 17 SDGs are reflected in the 14 themes under the FTSE ESG rating framework.

The FTSE Corporate ESG Score was developed by FTSE Russell, a leading provider of global index and data solutions. FTSE ESG scores offer a comprehensive assessment by providing not only aggregate ESG scores for companies but also individual scores for each dimension – environmental (E), social (S), and governance (G). The ESG scores are derived from a calculation that incorporates 14 thematic scores encompassing various aspects related to sustainability and responsible business practices, as shown in Table 1. FTSE ESG scores typically range from 0 to 5, where a higher score indicates better ESG performance. A score of 0 suggests poor ESG performance, while a score of 5 indicates excellent ESG performance within the given industry context.

Table 1.

FTSE ESG rating methodology.

ESG	Environmental	Biodiversity
		Climate Change
		Pollution & Resources
		Water Security
	Social	Customer Responsibility
		Health & Safety
		Human Right & Community
		Labor Standard
	Governance	Anti-corruption
		Corporate Governance
		Risk Management
		Tax Transparency

FTSE Russell, ESG Ratings and data model.

The S&P ESG Scores evaluate companies based on their performance across a range of ESG factors, including climate change mitigation, environmental impact, social policies, labor standards, corporate governance, and more. The scores are designed to capture the risks and opportunities associated with ESG considerations, allowing investors to make more informed decisions and allocate capital to companies that align with their sustainability goals.

The methodology behind the S&P ESG Scores incorporates a robust framework that relies on a combination of quantitative and qualitative data. The scores consider company-reported data, news and controversies, industry-specific issues, and third-party sources to provide a comprehensive evaluation of each company’s ESG performance. S&P ESG scores range from 0 to 5. Similar to FTSE ESG scores, a higher score indicates better ESG performance.

3.2. Methodology

We derive the following firm fixed effects panel model to estimate the impact of ESG performance on stock market performance (return, volatility, and liquidity) through the stock market as the baseline equation.

$${\mathit{Return}}_{i,t}={\alpha }_0+{\alpha }_1{\mathit{Covid}}_{e,t}+{\alpha }_2{\mathit{FTSEESG}}_{i,t}+{\alpha }_3{\mathit{FTSEESG}}_{i,t}\ast {\mathit{Covid}}_{e,t}+{\alpha }_4{X}_{i,t}+{\delta }_i+{\mu }_{i,t}$$ (3)

$$VO{L}_{i,t}={\alpha }_0+{\alpha }_1{\mathit{Covid}}_{e,t}+{\alpha }_2{\mathit{FTSEESG}}_{i,t}+{\alpha }_3{\mathit{FTSEESG}}_{i,t}\ast {\mathit{Covid}}_{e,t}+{\alpha }_4{X}_{i,t}+{\delta }_i+{\mu }_{i,t}$$ (4)

$${\mathit{Liquidity}}_{i,t}={\alpha }_0+{\alpha }_1{\mathit{Covid}}_{e,t}+{\alpha }_{2}FTSEES{G}_{i,t}+{\alpha }_3{\mathit{FTSEESG}}_{i,t}\ast {\mathit{Covid}}_{e,t}+{\alpha }_4{X}_{i,t}+{\delta }_i+{\mu }_{i,t}$$ (5)

where i, c, and t denote firms, economies, and time indices, respectively. $R_{i,t}$ represents the stock monthly log return. $VO{L}_{i,t}$ represents stock price volatility calculated as the annualized standard deviation of daily log returns of stocks for the past 30 days. ${\mathit{Liquidity}}_{i,t}$ represents the monthly stock trade turnover rate. ${\mathit{FTSEESG}}_{i,t}$ represents the FTSE aggregate ESG scores. In the regression analysis, the S&P aggregate ESG scores and the E, S, and G scores from both FTSE Russell and S&P are added sequentially to replace FTSE aggregate ESG scores. ${\mathit{Industry}}_t$ represents the industry dummy. ${\delta }_i$ represents firm fixed effects, and ${\mu }_{i,t}$ is the error term. A key input into our set of explanatory variables is the interaction term (${\mathit{FTSEESG}}_{i,t}\ast {\mathit{Covid}}_{c,t}$), which captures the causal effect of corporate ESG performance on stock price, volatility, and market liquidity during the COVID-19 crisis.

We use the Oxford Stringency Index as a proxy for COVID-19 exposure, which is a composite measure that quantifies the strictness of government responses to the pandemic, including measures, such as school closures, travel restrictions, and lockdown policies. COVID-19 fear could significantly decrease stock market volatility and liquidity (Li et al., 2022).

Traditional financial indicators, such as profitability, liquidity, or financial leverage, are demonstrated as the key determinants of a stock’s resilience during severe economic downturns (Albuquerque et al., 2020, Ramelli and Wagner, 2020). $X_{i,t}$ is a vector of corporate-specific control variables, including market size, profitability, financial leverage, revenue growth, and book-to-market ratio – widely used in the literature to capture firm-specific characteristics (Waddock and Graves, 1997, Van Beurden and Gössling, 2008, Cho and Tsang, 2020). Firm size is measured by the natural logarithm of total assets and is widely recognized as an essential factor affecting corporate financial performance because larger firms have greater bargaining power over suppliers and buyers and, thus, could positively affect corporate value. Therefore, we expect a positive relationship between firm size and stock returns and liquidity and a negative relationship between firm size and stock market volatility.

Financial leverage, as measured by the debt/equity ratio, is one of the tools a company can use to make the best financing and investment decisions. A stable and optimal capital structure contributes to better corporate financial performance. We use return on assets (ROA) to reflect firms’ profitability. Another corporate-specific control variable is the revenue growth rate, which represents a firm’s growth potential. We expect a positive relationship between stock return and liquidity and a negative relationship with stock market volatility.

To control for investment and growth opportunities, we include the book-to-market ratio as the control variable. The book-to-market ratio reflects the market value of a company relative to its actual worth. Low book-to-market stocks are undervalued, while high book-to-market stocks are overvalued, and this ratio has been widely proven in the literature to have a significant effect on stock returns (Bae et al., 2021, Bouslah et al., 2018).

Moreover, apart from corporate-specific factors, stocks’ volatility and returns are affected by the level of trading activity ((Jun et al., 2003); (Mortazian, 2022). When market liquidity is high, there are sufficient buyers and sellers, allowing for smoother trading and minimizing the impact of large trades on stock prices. As a result, higher liquidity generally leads to a lower price impact, meaning that executing a trade does not cause significant price movements. To control for the effect of stock market liquidity on stock returns and price volatility, we include the stock turnover ratio in the regressions of stock return and volatility. The variables included in the analysis are provided in Appendix Table A.1, with details on variable symbols, descriptions, and data sources.

Descriptive statistics for our sample firms are provided in Table 2. Due to the distinct calculation methodologies employed by the FTSE and S&P, there is a divergence in ESG scores for Japanese firms. According to FTSE’s analysis, Japanese firms exhibit better governance practices relative to the environmental and social dimensions. Conversely, S&P’s ESG ratings indicate that Japanese firms excel in the environmental domain, with higher environmental scores than social and governance scores.

Table 2.

Descriptive statistics of all variables.

Variable	Obs	Mean	Std. dev.	Min	Max
ROA	27,657	0.041	0.042	−0.631	0.473
Return	28,020	0.006	0.085	−0.630	0.449
Volatility	28,020	0.288	0.121	0.022	1.283
Liquidity	28,034	0.005	0.010	0.000	0.460
FTSEE	28,002	2.438	1.282	0.000	5.000
FTSES	28,002	2.097	1.168	0.000	5.000
FTSEG	28,002	2.729	0.889	0.000	5.000
FTSEESG	28,017	2.414	0.959	0.167	4.700
SPE	25,212	39.718	28.929	0.000	99.000
SPS	25,212	29.549	24.281	0.000	94.000
SPG	25,212	31.622	23.020	0.000	86.000
SPESG	25,212	33.207	24.086	0.000	89.000
Asset	27,900	9.129	1.178	5.739	13.331
Growth	27,504	0.029	0.254	−0.949	14.589
Debt	25,521	0.309	0.224	0.000	1.739
BM	27,858	1.029	0.974	−0.879	16.149
Covid	28,152	13.805	20.534	0.000	53.240

Author’s calculation.

In addition, prior to conducting the regression analysis, examining the Pearson correlations among the selected regression variables is valuable, as presented in Appendix Table A.2. These simple pairwise correlations confirm our expectations that firms with better ESG performance enjoy higher stock returns. The relationship among stock market volatility, liquidity and corporate ESG evaluation is found to be mixed. Finally, the correlations between the independent variables are quite low, suggesting that our estimates do not suffer from multicollinearity issues.

4. Empirical results and discussion

Before the regression, we first use the Levin–Lin–Chu (LLC) test and Fisher augmented Dickey–Fuller test (Fisher ADF) to assess the stationarity of the variables. The results reject the null hypothesis of unit roots for each variable, indicating that the variables are stationary in levels. Hence, all variables appear in the econometric model in levels.

To investigate how corporate ESG performance shapes stock market reactions to COVID-19, we begin our econometric investigation by estimating the baseline equations on stock market returns and corporate ESG scores. As the effects of ESG practices necessitate a substantial timeframe for observation, we employ a lag of one year for ESG scores. The other control variables are lagged by one month to mitigate endogeneity concerns.

The estimation results are provided in Table 3. In Columns 1 to 4, the regressions utilize the FTSE ESG scores, whereas in Columns 5 to 8, the S&P ESG scores are employed. Surprisingly, the regression analysis reveals a negative relationship between corporate social scores and stock returns during the “normal” time, suggesting that companies with better corporate social performance tend to exhibit lower stock returns. The reason behind this result may be that companies focusing more on social responsibility and sustainable practices may incur higher costs or investments that temporarily impact their profitability. In addition, the coefficient estimates on the governance scores are negative and significant, indicating that better governance performance is associated with lower stock returns throughout “normal” times in Japan. Several explanations could account for this finding. One possibility is that companies with strong governance practices may prioritize long-term stability and risk management over short-term profitability, leading to conservative decision making that may limit potential gains. Another factor could be increased scrutiny and regulation associated with strong corporate governance, which may introduce additional costs or restrictions that impact profitability.

Table 3.

Regression results for stock market return.

VARIABLES	(1)	(2)	(3)	(4)		(5)	(6)	(7)	(8)
	Return					Return
L12. FTSEE	−0.0006
	(0.00126)
L12. FTSES		−0.0024⁎
		(0.00125)
L12. FTSEG			−0.0026⁎⁎
			(0.00117)
L12. FTSEESG				−0.00258⁎
				(0.0012)
L12. FTSEE*Covid	0.00023⁎⁎⁎
	(1.82e−05)
L12. FTSES*Covid		0.00026⁎⁎⁎
		(2.09e−05)
L12. FTSEG*Covid			0.00026⁎⁎⁎
			(1.86e−05)
L12. FTSEESG*Covid				0.00027⁎⁎⁎
				(2.00e−05)
L12.SPE						−2.06e−05
						(6.47e−05)
L12.SPS							−0.0003⁎⁎⁎
							(6.81e−05)
L12.SPG								−0.00028⁎⁎⁎
								(6.75e−05)
L12. SPESG									−0.00023⁎⁎⁎
									(7.56e−05)
L12.SPE*Covid						0.00023⁎⁎⁎
						(1.86e−05)
L12.SPS*Covid							0.00026⁎⁎⁎
							(2.13e−05)
L12.SPG*Covid								0.00025⁎⁎⁎
								(1.90e−05)
L12. SPESG*Covid									0.00027⁎⁎⁎
									(2.03e−05)
L.ROA	0.145⁎⁎⁎	0.145⁎⁎⁎	0.146⁎⁎⁎	0.144⁎⁎⁎		0.148⁎⁎⁎	0.151⁎⁎⁎	0.153⁎⁎⁎	0.148⁎⁎⁎
	(0.0235)	(0.0235)	(0.0235)	(0.0235)		(0.0249)	(0.0249)	(0.0249)	(0.0249)
L. Asset	−0.0402⁎⁎⁎	−0.0405⁎⁎⁎	−0.0382⁎⁎⁎	−0.0395⁎⁎⁎		−0.0365⁎⁎⁎	−0.0384⁎⁎⁎	−0.0393⁎⁎⁎	−0.0376⁎⁎⁎
	(0.00620)	(0.00622)	(0.00624)	(0.00625)		(0.00694)	(0.00690)	(0.00693)	(0.00689)
L.Debt	0.0810⁎⁎⁎	0.0789⁎⁎⁎	0.0815⁎⁎⁎	0.0819⁎⁎⁎		0.0803⁎⁎⁎	0.0815⁎⁎⁎	0.0849⁎⁎⁎	0.0841⁎⁎⁎
	(0.0118)	(0.0118)	(0.0118)	(0.0118)		(0.0126)	(0.0126)	(0.0126)	(0.0126)
L.BM	0.00710⁎⁎⁎	0.00690⁎⁎⁎	0.00650⁎⁎⁎	0.00664⁎⁎⁎		0.00671⁎⁎⁎	0.00636⁎⁎⁎	0.00580⁎⁎⁎	0.00607⁎⁎⁎
	(0.000835)	(0.000841)	(0.000842)	(0.000841)		(0.000881)	(0.000888)	(0.000892)	(0.000889)
L. Growth	0.00564⁎⁎	0.00549⁎⁎	0.00485⁎⁎	0.00494⁎⁎		0.00510⁎⁎	0.00545⁎⁎	0.00533⁎⁎	0.00490⁎⁎
	(0.00223)	(0.00223)	(0.00223)	(0.00223)		(0.00227)	(0.00227)	(0.00228)	(0.00227)
L. Lquidity	−0.656⁎⁎⁎	−0.646⁎⁎⁎	−0.628⁎⁎⁎	−0.647⁎⁎⁎		−0.569⁎⁎⁎	−0.556⁎⁎⁎	−0.542⁎⁎⁎	−0.559⁎⁎⁎
	(0.0999)	(0.0999)	(0.0998)	(0.0998)		(0.103)	(0.103)	(0.103)	(0.103)
Covid	0.00013⁎⁎⁎	0.00016⁎⁎⁎	8.80e−05⁎⁎	0.000107⁎⁎		0.00014⁎⁎⁎	0.0001⁎⁎⁎	5.50e−05	8.82e−05⁎⁎
	(4.06e−05)	(4.08e−05)	(4.21e−05)	(4.21e−05)		(4.32e−05)	(4.31e−05)	(4.46e−05)	(4.39e−05)
Constant	0.338⁎⁎⁎	0.344⁎⁎⁎	0.324⁎⁎⁎	0.335⁎⁎⁎		0.305⁎⁎⁎	0.330⁎⁎⁎	0.339⁎⁎⁎	0.322⁎⁎⁎
	(0.0562)	(0.0563)	(0.0564)	(0.0564)		(0.0636)	(0.0634)	(0.0640)	(0.0635)
Industry effect	Yes	Yes	Yes	Yes		Yes	Yes	Yes	Yes
Observations	20,662	20,662	20,662	20,662		18,521	18,521	18,521	18,521
R-squared	0.037	0.037	0.039	0.038		0.038	0.038	0.040	0.039
Number of firms	376	376	376	376		362	362	362	362

Note: Standard errors in parentheses.

^*Indicate significance at the 10% levels.

^**Indicate significance at the 5% levels.

^***Indicate significance at the 1% levels.

Authors based on estimation of Eqs. (3).

To understand the impact of ESG factors on stock market returns during COVID-19 shocks, we include an interaction term composed of COVID-19 exposure and ESG scores, and the coefficient estimates on the interaction terms (FTSEE*Covid, FTSES*Covid, FTSEG*Covid, and FTSEESG*Covid) indicate a positive and statistically significant relationship. These findings suggest that stocks with higher social, governance and ESG scores tend to exhibit higher returns. The regression results remain consistent regardless of whether we employ FTSE or S&P ESG data. The results provide empirical evidence for the viewpoint of Ashwin Kumar et al. (2016) and Albuquerque et al. (2020) that good ESG engagement enables firms to improve their social image and public trust, which is vital for financial stability, especially during economic downturns when public confidence in corporations and capital markets declines unexpectedly.

We then run the regression on market volatility to understand the impact of ESG performance on stock market volatility. Table 4 presents the estimation results for stock market volatility, where Columns 1 to 4 present the regression results using FTSE ESG scores, while Columns 5 to 8 utilize S&P ESG scores. The regression results for stock market volatility and corporate governance scores are robust, suggesting that companies with better corporate governance tend to experience lower stock market volatility regardless of whether it is during the “normal” time and economic downturn period. In addition, the combined effect of ESG factors and the pandemic leads to a greater change in liquidity levels compared to the effect of ESG factors alone. Strong corporate governance practices often entail effective risk management strategies, greater transparency, and improved accountability, which can help mitigate uncertainties and reduce market volatility. Additionally, robust governance frameworks can enhance investor confidence and attract long-term investors who value stability, thereby contributing to smoother stock market performance.

Table 4.

Regression results for stock market volatility.

VARIABLES	(1)	(2)	(3)	(4)		(5)	(6)	(7)	(8)
	VOL					VOL
L12. FTSEE	0.0047⁎⁎⁎
	(0.00145)
L12. FTSES		0.00186
		(0.00144)
L12. FTSEG			−0.0007⁎⁎⁎
			(2.3e−05)
L12. FTSEESG				0.00390⁎⁎
				(0.00183)
L12. FTSEE*Covid	−0.00071⁎⁎⁎
	(2.10e−05)
L12. FTSES*Covid		−0.00083⁎⁎⁎
		(2.41e−05)
L12. FTSEG*Covid			−0.0008⁎⁎⁎
			(2.13e−05)
L12. FTSEESG*Covid				−0.0009⁎⁎⁎
				(2.29e−05)
L12.SPE						9.20e−05
						(7.45e−05)
L12.SPS							−9.53e−05
							(7.83e−05)
L12.SPG								−0.0002⁎⁎⁎
								(7.71e−05)
L12. SPESG									−0.00011
									(8.66e−05)
L12.SPE*Covid						−0.0007⁎⁎⁎
						(2.14e−05)
L12.SPS*Covid							−0.0008⁎⁎⁎
							(2.45e−05)
L12.SPG*Covid								−0.0008⁎⁎⁎
								(2.17e−05)
L12. SPESG*Covid									−0.0008⁎⁎⁎
									(2.33e−05)
L.ROA	−0.175⁎⁎⁎	−0.167⁎⁎⁎	−0.173⁎⁎⁎	−0.167⁎⁎⁎		−0.204⁎⁎⁎	−0.198⁎⁎⁎	−0.200⁎⁎⁎	−0.196⁎⁎⁎
	(0.0271)	(0.0271)	(0.0269)	(0.0270)		(0.0287)	(0.0287)	(0.0285)	(0.0285)
L. Asset	−0.0142⁎⁎	−0.00815	−0.0167⁎⁎	−0.0127⁎		−0.0329⁎⁎⁎	−0.0261⁎⁎⁎	−0.0368⁎⁎⁎	−0.0305⁎⁎⁎
	(0.00714)	(0.00715)	(0.00714)	(0.00717)		(0.00799)	(0.00793)	(0.00792)	(0.00789)
L.Debt	0.129⁎⁎⁎	0.134⁎⁎⁎	0.126⁎⁎⁎	0.126⁎⁎⁎		0.127⁎⁎⁎	0.133⁎⁎⁎	0.127⁎⁎⁎	0.124⁎⁎⁎
	(0.0136)	(0.0135)	(0.0135)	(0.0135)		(0.0146)	(0.0145)	(0.0144)	(0.0145)
L.BM	0.00119	0.00242⁎⁎	0.00352⁎⁎⁎	0.00302⁎⁎⁎		0.000796	0.00167	0.00264⁎⁎⁎	0.00242⁎⁎
	(0.000962)	(0.000967)	(0.000963)	(0.000965)		(0.00102)	(0.00102)	(0.00102)	(0.00102)
L. Growth	−0.00839⁎⁎⁎	−0.00767⁎⁎⁎	−0.00584⁎⁎	−0.00618⁎⁎		−0.0085⁎⁎⁎	−0.0074⁎⁎⁎	−0.00545⁎⁎	−0.00606⁎⁎
	(0.00256)	(0.00256)	(0.00255)	(0.00255)		(0.00261)	(0.00261)	(0.00260)	(0.00260)
L. Lquidity	1.352⁎⁎⁎	1.321⁎⁎⁎	1.274⁎⁎⁎	1.331⁎⁎⁎		1.264⁎⁎⁎	1.232⁎⁎⁎	1.198⁎⁎⁎	1.246⁎⁎⁎
	(0.115)	(0.115)	(0.114)	(0.114)		(0.119)	(0.118)	(0.117)	(0.118)
Covid	0.00259⁎⁎⁎	0.00260⁎⁎⁎	0.00279⁎⁎⁎	0.00273⁎⁎⁎		0.00269⁎⁎⁎	0.00269⁎⁎⁎	0.00288⁎⁎⁎	0.00284⁎⁎⁎
	(4.68e−05)	(4.69e−05)	(4.82e−05)	(4.83e−05)		(4.97e−05)	(4.95e−05)	(5.10e−05)	(5.02e−05)
Constant	0.324⁎⁎⁎	0.274⁎⁎⁎	0.344⁎⁎⁎	0.312⁎⁎⁎		0.508⁎⁎⁎	0.449⁎⁎⁎	0.554⁎⁎⁎	0.492⁎⁎⁎
	(0.0647)	(0.0648)	(0.0645)	(0.0647)		(0.0732)	(0.0729)	(0.0731)	(0.0727)
Industry effect	Yes	Yes	Yes	Yes		Yes	Yes	Yes	Yes
Observations	20,662	20,662	20,662	20,662		18,521	18,521	18,521	18,521
R-squared	0.195	0.197	0.209	0.204		0.197	0.201	0.212	0.207
Number of firms	376	376	376	376		362	362	362	362

Note: Standard errors in parentheses.

^*Indicate significance at the 10% levels.

^**Indicate significance at the 5% levels.

^***Indicate significance at the 1% levels.

Authors based on estimation of Eqs. (4).

The coefficient estimates on the environmental scores are positive and significant, indicating that better environmental performance is associated with higher stock market volatility throughout “normal” times in Japan. However, as suggested by the significant and negative coefficient estimates on the FTSEE*Covid, better corporate environmental performance could enhance stock market stability in Japan. We may explain this result from the perspective of investor behavior. During normal times, companies with strong environmental performance may attract increased attention from socially responsible investors. These investors may be more sensitive to environmental risks and uncertainties, leading to higher trading activity and potentially greater stock price fluctuations, thus increasing market volatility. However, during the COVID-19 pandemic, investors’ focus may shift more towards financial stability and resilience. Companies with robust environmental practices may be perceived as better equipped to navigate the crisis, leading to reduced market volatility for these firms.

Turning to other control variables, as expected, COVID-19 exposure and financial leverage have a significantly positive impact on stock market volatility. Market perceptions and investor sentiment can also contribute to the observed relationship, as higher exposure to COVID-19 may be seen as a risk factor, leading to increased selling pressure and higher volatility. Companies with higher financial leverage typically have higher debt obligations and may be more vulnerable to economic downturns or market fluctuations. This can increase the perceived riskiness of their stocks, leading to higher volatility.

The regression analysis reveals that corporate ROA, revenue growth, and total assets are negatively associated with stock market volatility. Higher total assets and ROA indicate better financial performance and profitability, which can inspire investor confidence and contribute to reduced market volatility. Similarly, companies with robust revenue growth may be perceived as resilient and well positioned to navigate market uncertainties, resulting in lower stock market volatility.

Finally, we perform a regression analysis on market liquidity to examine the influence of ESG performance on stock market liquidity. Table 5 presents the estimation results for stock market liquidity, where Columns 1 to 4 present the regression results using FTSE ESG scores, while Columns 5 to 8 utilize S&P ESG scores. Our findings indicate no significant relationship between corporate ESG performance and stock market liquidity during “normal” times. However, the significant coefficient of the interaction terms (FTSEE*Covid, FTSES*Covid, FTSEG*Covid, and FTSEESG*Covid) implies that the combined effect of ESG factors and the pandemic has a statistically significant influence on stock market liquidity.

The impact of ESG factors on stock market liquidity is amplified during the COVID-19 pandemic. Better ESG performance enhances stock market liquidity during the COVID-19 pandemic. This can be explained by broad public trust in corporations with good ESG performance and the current sustainability trend. Investors may have a higher demand for stocks with high ESG scores in times of crisis.

Table 5.

Regression results for stock market liquidity.

VARIABLES	(1)	(2)	(3)	(4)		(5)	(6)	(7)	(8)
	Liquidity					Liquidity
L12. FTSEE	6.29e−05
	(8.88e−05)
L12. FTSES		−0.00012
		(8.85e−05)
L12. FTSEG			0.00012
			(8.27e−05)
L12. FTSEESG				1.11e−05
				(0.000113)
L12. FTSEE*Covid	7.70e−06⁎⁎⁎
	(1.28e−06)
L12. FTSES*Covid		7.33e−06⁎⁎⁎
		(1.47e−06)
L12. FTSEG*Covid			3.36e−06⁎⁎
			(1.32e−06)
L12. FTSEESG*Covid				6.53e−06⁎⁎⁎
				(1.41e−06)
L12.SPE						1.00e−06
						(4.93e−06)
L12.SPS							1.01e−06
							(4.92e−06)
L12.SPG								5.78e−06
								(4.89e−06)
L12. SPESG									6.01e−06
									(5.47e−06)
L12.SPE*Covid						7.07e−06⁎⁎⁎
						(1.34e−06)
L12.SPS*Covid							6.21e−06⁎⁎⁎
							(1.54e−06)
L12.SPG*Covid								3.25e−06⁎⁎
								(1.37e−06)
L12. SPESG*Covid									5.95e−06⁎⁎⁎
									(1.47e−06)
L.ROA	−0.00115	−0.000872	−0.000701	−0.000960		−0.00283	−0.00276	−0.00259	−0.00279
	(0.00166)	(0.00166)	(0.00166)	(0.00166)		(0.00180)	(0.00180)	(0.00180)	(0.00180)
L. Asset	−0.00418⁎⁎⁎	−0.00405⁎⁎⁎	−0.00424⁎⁎⁎	−0.00416⁎⁎⁎		−0.00399⁎⁎⁎	−0.00391⁎⁎⁎	−0.00377⁎⁎⁎	−0.00386⁎⁎⁎
	(0.000436)	(0.000437)	(0.000439)	(0.000440)		(0.000500)	(0.000498)	(0.000501)	(0.000498)
L.Debt	0.00428⁎⁎⁎	0.00412⁎⁎⁎	0.00401⁎⁎⁎	0.00417⁎⁎⁎		0.00316⁎⁎⁎	0.00306⁎⁎⁎	0.00283⁎⁎⁎	0.00304⁎⁎⁎
	(0.000830)	(0.000829)	(0.000830)	(0.000830)		(0.000913)	(0.000913)	(0.000914)	(0.000914)
L.BM	−0.00025⁎⁎⁎	−0.00024⁎⁎⁎	−0.00022⁎⁎⁎	−0.00024⁎⁎⁎		−0.00024⁎⁎⁎	−0.00023⁎⁎⁎	−0.00019⁎⁎⁎	−0.00023⁎⁎⁎
	(5.87e−05)	(5.91e−05)	(5.93e−05)	(5.92e−05)		(6.35e−05)	(6.40e−05)	(6.44e−05)	(6.41e−05)
L. Growth	0.000172	0.000189	0.000262⁎	0.000198		0.000122	0.000152	0.000180	0.000139
	(0.000157)	(0.000157)	(0.000157)	(0.000157)		(0.000164)	(0.000164)	(0.000165)	(0.000165)
Covid	−1.4e−05⁎⁎⁎	−1.0e−05⁎⁎⁎	−1.0e−05⁎⁎⁎	−1.3e−05⁎⁎⁎		−1.4e−05⁎⁎⁎	−1.0e−05⁎⁎⁎	−7.7e−06⁎⁎	−1.1e−05⁎⁎⁎
	(2.85e−06)	(2.87e−06)	(2.97e−06)	(2.97e−06)		(3.12e−06)	(3.11e−06)	(3.23e−06)	(3.17e−06)
Constant	0.0413⁎⁎⁎	0.0407⁎⁎⁎	0.0417⁎⁎⁎	0.0413⁎⁎⁎		0.0401⁎⁎⁎	0.0396⁎⁎⁎	0.0383⁎⁎⁎	0.0391⁎⁎⁎
	(0.00395)	(0.00396)	(0.00397)	(0.00397)		(0.00458)	(0.00458)	(0.00463)	(0.00458)
Industry effect	Yes	Yes	Yes	Yes		Yes	Yes	Yes	Yes
Observations	20,678	20,678	20,678	20,678		18,531	18,531	18,531	18,531
R-squared	0.010	0.010	0.009	0.009		0.008	0.007	0.006	0.007
Number of firms	376	376	376	376		362	362	362	362

Note: Standard errors in parentheses.

^*Indicate significance at the 10% levels.

^**Indicate significance at the 5% levels.

^***Indicate significance at the 1% levels.

Authors based on estimation of Eqs. (5).

5. Conclusion and policy recommendations

Does ESG engagement make the stock market more resilient to sudden economic downturns, such as the COVID-19 pandemic? To shed empirical light on this question, we examine the correlations between stock market performance (stock return, stock price volatility, market liquidity) and corporate ESG performance using a novel dataset of more than 300 listing Japanese firms. Firm fixed-effect models are applied in the analysis. We contribute to the extensive literature by adding new evidence on the unique role of ESG factors affecting stock markets during the COVID-19 crisis in Japan.

Controlling for a number of corporate-specific factors and COVID-19 exposure, our analysis suggests that corporate ESG performance has had a substantial effect on the stock market during the COVID-19 pandemic in Japan. In detail, the stock prices of companies with better ESG performance embrace higher returns during the COVID-19 pandemic. Moreover, better ESG performance could reduce stock market volatility and enhance market liquidity during the COVID-19 period. These results are consistent with the view that ESG engagement enables firms to improve their social image and public trust, which is vital for financial stability, especially during economic downturns when public confidence in corporations and capital markets declines unexpectedly. Given their high public trust, investors may have a higher demand for stocks with high ESG scores in times of crisis.

The observed contribution of strong ESG performance to enhanced stock market stability and increased market liquidity in Japan during the COVID-19 pandemic further underscores the importance of ESG considerations for investors, corporate managers, and policy-makers. These findings suggest that promoting and incentivizing ESG practices can be an effective policy approach to building resilience in the stock market and fostering market liquidity during periods of economic stress.

For policy-makers, these results provide a rationale for implementing supportive measures and regulations that encourage companies to adopt and disclose robust ESG practices. First, Japanese authority may encourage ESG reporting standards. Implementing standardized frameworks and guidelines for ESG reporting could enhance transparency and comparability among companies, which in turn provides investors with reliable information on companies’ environmental and social performance, facilitating better decision-making and reducing market volatility. Second, Exchanges could strengthen ESG Disclosure Requirements. Enhanced disclosure requirements will enable investors to make informed decisions and reduce market uncertainty. Third, the financial authority may engage with financial institutions, such as banks and asset managers, to encourage the integration of ESG considerations into their investment and lending practices. This collaboration can lead to the development of green financial products and services that support sustainable initiatives and drive green recovery. By doing so, they can contribute to the stability and liquidity of the stock market, potentially attracting more investors and fostering sustainable economic growth.

For corporate managers and investors, the findings emphasize the value of integrating ESG considerations into their decision-making processes. By prioritizing ESG factors, companies can enhance their long-term financial performance, attract socially responsible investors, and contribute to a more resilient and stable stock market.

Finally, we address the limitations of the research. Due to the lack of ESG evaluation data in the previous period, it is difficult to capture the long-term impact that could arise from better engagement in ESG factors. The extension of the observation period is another agenda for research.

Uncited References

Duuren et al. (2016), Fama et al. (1969), Global Sustainable Investment Alliance (GSIA) (2020), Taghizadeh-Hesary et al. (2023), Zhao et al. (2022)

Appendix.

See Table A.1, Table A.2

Table A.1.

Overview of variables used in the analysis.

Variable	Definition	Data source
Return	Stock monthly log normal return	Author’s calculation based on data from S&P Capital IQ
VOL	Standard deviation of 3-month daily return	Author’s calculation based on data from S&P Capital IQ
Liquidity	Stock turnover rate	Author’s calculation based on data from S&P Capital IQ
Stringency	Oxford stringency index	Hale, T., Angrist, N., Goldszmidt, R. et al. (2021)
FTSEESG	Corporate ESG score	FTSE Russel
FTSEE	Corporate environmental score	FTSE Russel
FTSES	Corporate social score	FTSE Russel
FTSEG	Corporate governance score	FTSE Russel
SPESG	Corporate ESG score	S&P Capital IQ
SPE	Corporate environmental score	S&P Capital IQ
SPS	Corporate social score	S&P Capital IQ
SPG	Corporate governance score	S&P Capital IQ
Asset	The natural logarithm of total asset	S&P Capital IQ
Debt	Total debt as a percentage of shareholder’s equity	S&P Capital IQ
Growth	Revenue growth rate	S&P Capital IQ
BM	Book-to-market ratio	S&P Capital IQ

Compiled by authors.

Table A.2.

Correlation matrix of all variables.

	ROA	Return	Volatility	Liquidity	FTSEE	FTSES	FTSEG	FTSEESG	SPE	SPS	SPG	SPESG	Asset	Growth	Debt	BM	Stringency
ROA	1
Return	0.029	1
Volatility	−0.065	−0.077	1
Liquidity	0.379	0.005	0.172	1
FTSEE	−0.086	0.019	0.012	−0.099	1
FTSES	−0.036	0.057	0.014	−0.034	0.765	1
FTSEG	0.007	0.071	−0.018	0.019	0.405	0.587	1
FTSEESG	−0.048	0.053	0.006	−0.050	0.881	0.928	0.720	1
SPE	−0.058	0.021	0.011	−0.061	0.736	0.698	0.391	0.736	1
SPS	−0.055	0.016	−0.014	−0.044	0.611	0.617	0.359	0.637	0.877	1
SPG	−0.031	0.015	−0.016	−0.042	0.559	0.570	0.314	0.582	0.839	0.941	1
SPESG	−0.049	0.018	−0.006	−0.051	0.657	0.649	0.366	0.673	0.938	0.976	0.965	1
Asset	−0.282	−0.004	−0.069	−0.264	0.428	0.381	0.161	0.399	0.456	0.461	0.431	0.464	1
Growth	0.159	0.025	−0.091	0.045	0.003	0.041	0.036	0.023	0.002	0.016	0.008	0.010	0.029	1
Debt	−0.395	0.004	0.038	−0.162	0.040	0.036	0.062	0.053	0.028	0.090	0.067	0.067	0.437	−0.017	1
BM	−0.270	0.078	0.082	−0.169	0.025	0.071	0.088	0.063	−0.004	−0.011	−0.058	−0.023	0.145	−0.005	0.228	1
Covid	−0.076	0.120	0.214	−0.023	0.063	0.222	0.299	0.197	0.068	−0.027	−0.080	−0.017	0.000	0.018	0.031	0.353	1

Author’s calculation.