ESG performance and investment efficiency in Asian firms: Mediating roles of agency costs and financial constraints

Abstract

The focus of this study is the relationship between Environmental, Social, and Governance (ESG) performance and investment inefficiency in Asian firms. Focusing on non-financial industry firms among 17 Asian countries from 2015 to 2024, we observe that higher ESG performance is related to lower investment inefficiency, chiefly attributed to reduced overinvestment, while the relationship with underinvestment is statistically insignificant. This asymmetric pattern is aligned with agency theory, which states that overinvestment reflects managerial empire-building and inefficient use of free cash flow, both of which are constrained by stronger ESG governance. In contrast, underinvestment is more closely related to financing constraints, which are less effectively addressed by ESG. Mediation analysis shows that both agency costs and financing constraints act as channels through which ESG affects investment efficiency. Using managerial compensation as a proxy for agency costs, our results identify governance channels through which ESG adoption influences corporate investment decisions, with agency costs exhibiting a stronger mediating effect than financing constraints. Although ESG engagement is associated with higher managerial compensation, it is also associated with lower overinvestment, which suggests that compensation serves as an incentive-alignment mechanism that reduces managerial empire-building and enhances capital-allocation efficiency. Findings are robust to lagged ESG specifications, alternative inefficiency measures, and country-level regressions. These findings suggest that ESG mandates focused on governance may be more effective at improving capital-allocation efficiency across various institutional environments in Asia than mandates focused on disclosure.