Do ESG Practices Improve Firm Investment Efficiency in China? Evidence from Overinvestment and Underinvestment

HRMARS - Against the backdrop of the global sustainability transition, ESG performance has become a critical factor shaping firms’ resource allocation efficiency and long-term value creation. Although a growing body of literature has examined the economic consequences of ESG, existing evidence on its effect on investment efficiency remains limited, particularly in emerging markets. Using panel data on 4,047 Chinese A-share listed firms from the Shanghai and Shenzhen stock exchanges over the period 2014–2024, this study employs a two-way fixed effects model to systematically examine the impact of the performance of ESG and its pillars on firm investment efficiency. To provide a more detailed understanding, this study further distinguishes between two forms of investment inefficiency, namely overinvestment and underinvestment. The empirical results show that ESG performance significantly improves firm investment efficiency, and that the environmental, social, and governance pillars all exert significant positive effects. Further analysis indicates that the effect of ESG performance on overinvestment is not significant, and only the environmental pillar shows a significant negative effect. This suggests that ESG performance may be less effective in constraining overinvestment driven by managerial opportunism or the misuse of free cash flow. In contrast, ESG performance plays a more significant and robust role in alleviating underinvestment, with all three pillars significantly reducing the level of underinvestment. These findings enrich the literature on the economic consequences of ESG from the perspective of investment efficiency and provide new empirical evidence on how ESG performance improves firms’ resource allocation efficiency in emerging markets. The study also provides practical implications for firms, policymakers, and financial institutions seeking to promote more efficient investment decisions through ESG practices.