Integrating ESG Factors Into Cost‐Efficiency Frontier: Evidence From the European Listed Banks

Abstract

This paper provides the first in‐depth analysis of the effects of incorporating environmental, social, and governance (ESG) factors into the cost‐efficiency frontier of banks. Drawing on both shareholder and stakeholder theories, the research addresses the increasing regulatory and market pressures for banks to incorporate ESG components into their operational processes. Using data from 42 European listed banks spanning the 2006–2021 period and a stochastic frontier approach (SFA), the study introduces two novel ESG‐related variables in the stochastic frontier function: (i) a variable measuring the contribution of ESG factors to banking output production and (ii) a variable measuring the risks associated with ESG controversies. Additionally, it evaluates the impact of executive remuneration tied to ESG goals on cost efficiency, addressing a critical gap in the literature. The findings reveal that ESG‐related frontier variables significantly influence the banks' cost function. Furthermore, the results show that banks with a stronger commitment to ESG principles achieve higher cost efficiency in the long term, despite short‐term cost increases associated with ESG investments. Moreover, the results highlight that executive compensation linked to ESG targets negatively affects cost efficiency. By filling these gaps, the paper significantly contributes to the literature, offering valuable insights for bank managers tasked with balancing short‐term costs against long‐term efficiency gains through strategic ESG investments.