Sustainable Empowerment: Digital Transformation and Carbon Emissions as a Catalyst for Enterprise ESG Performance

The global corporate environment has changed significantly in the current Industry 4.0 era due to digital transformation towards sustainability and social responsibility. Digital transformation, which includes the use of technologies such as software, internet, big data, Internet of Things (IoT), and artificial intelligence (AI), has the potential to change the way businesses handle day-to-day operations, maximize cash flow, reduce energy consumption [1, 2], and can provide effective technical means to enhance a company's ESG capabilities [3]. Digital transformation not only revolutionizes the way companies operate but also paves the way for companies to take a more sustainable approach [4].

Indonesia is confronting difficulties in national growth, such as the COVID-19 pandemic and Megatrend 2045. This crisis has created motivation for Indonesia to acknowledge the importance of digital technology adoption in improving global competitiveness. This led to the Indonesian Digital Vision (hereafter-IDV) 2045 program, which intends to facilitate the development of Indonesia's national digital transformation to be implemented throughout 38 provinces, through the National Long Term Development Plan (NLTDP) 2025-2045 and National Medium Term Development Plan (NMTDP) 2025-2029 to assure competitiveness and national economic resilience [5]. Figure 1 depicts the results of the DT index test and shows a strong index (category B) in terms of understanding and utilizing digital in everyday life and the workplace. This indicates that Indonesian people are already quite aware of the development of digital transformation.

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Figure 1. Indonesia digital transformation index [5]

The investigation on relationship between digital investment and ESG performance reveals that digital transformation can improve its ESG performance [5]. The inclusion of digital technology into the economy may cut costs, enhance operational efficiency, and strengthen the company's image as a leader in sustainability-oriented innovation [6]. A study discovered that integrating smart manufacturing technology can cut energy usage in large-scale manufacturing facilities by up to 15% through enhanced resource management and predictive maintenance processes [7].

The long-term (10-year) global risk rating by the World Economic Forum, such as cybersecurity and negative outcomes from AI technology indicates that digital transformation has significant effects on environmental, social, and governance (ESG) risks [8]. The existence of this data serves as a reference for identifying the potential of technology growth and focusing on how to utilize it rather than the drawbacks. Organizations can use digital transformation to meet sustainability goals such as lowering carbon emissions, boosting openness and trust through auditable data and expanding social access. Furthermore, digital transformation may aid in resource management by delivering data-driven solutions such as real-time emissions monitoring and supply chain optimization [9, 10].

The main environmental issue faced by many companies today is to meet carbon emissions reduction targets, especially in the heavy industry sector [11, 12]. World economic forum global risks perception survey shows 66% of survey participants focused on extreme weather as one of the major threats in 2024 [8]. Environmental problems, specifically carbon emissions, is blamed as one of the primary causes of climate change and contribute to extreme weather. Extreme weather may be resulting big impact on ESG achievement [9, 12]. As a result, businesses must control their carbon emissions released. Companies that successfully lowered environmental hazards, and manage carbon emissions efficiently can enhance ESG value, which can attract investor and creditor attention and improve the company's standing [12]. This issue forced all businesses in all countries worldwide to participate in carbon emissions mitigation [9]. Since Indonesia is one of the Kyoto Protocol signatories of the Framework Convention on Climate Change (UNFCCC), Indonesia Government has introduced the Minister of Environment and Forestry Regulation No. P.15/Menlhk/Setjen/Kum.1/4/2019 and Presidential Regulation (PP) No. 98 of 2021 on carbon reduction target [13].

Disclosure of carbon emissions positively affects firm value by promoting financial and operational sustainability [9], adds value for investors, since it shows the environmentally friendly business operation and sustainable [14, 15], and improve the company's ESG performance [3].

Companies with better ESG performance tend to have more efficient organizational procedures, fewer reputation-damaging incidents, and greater appeal to institutional investors [16]. Good ESG and corporate financial performance, may indicate that tend to be more financially successful [17] since it can balance environmental protection, responsibility fulfilment, and corporate governance, toward good sustainable corporate development [18]. Some prior studies have examined the relationship between digital transformation and investment in carbon reduction [3, 19, 20] green company and green innovation is measured by carbon intensity [21] and ESG score [22, 23] in China. However, no studies investigate digital transformation, carbon emissions, and ESG performance. ESG Performance in this study is measured by ESG Rating which is represented by A+ to D- grade and numerical score (0-100). ESG Rating Data was droned from Refinitiv database in Indonesia context. Studies in this area are conducted in Indonesia is lack of attention [24, 25]. Using data of manufacturing companies listed on the Indonesia Stock Exchange between 2019 and 2023, this study examines the impact of digital transformation and carbon emissions on ESG Performance using two-way GMM statistical analysis this approach differs from previous studies. In addition, since scope 1 carbon emissions are generated directly by companies, our studies use this scope to analyze how companies are responsible for carbon emissions and how the level of carbon emissions generated by companies directly impacts ESG performance.

This study provides a significant contribution that falls into four aspects. First, this research enriches the ESG and sustainability literature in relation to digital transformation to carbon emissions abatement. Digital transformation implemented by companies by adopting green technologies, such as, Internet of Thing (IoT) and blockchain, to monitor, manage and mitigated carbon emissions released from business operation. The use of cloud computing has replaced physical server that consumed much energy in its operation. The use of IoT may optimize the energy consumption in the manufacturing plant. Those green technologies contribute to good ESG score. Second, this study uses two-way Generalized Method of Moments (GMM) model in the analysis. This GMM model is claimed as a robust and bias-free model, in addressing endogeneity issues. This model has great ability to handle both measurement errors and simultaneity biases. Third, this study offers valuable data for policymakers to understand the interplay between technology adoption, emissions reduction, and ESG performance. Therefore, policymakers can design incentives for green technologies and regulations encouraging digital innovation that supports ESG targets.

Next section will explain the literature review on the context of digital transformation and carbon emissions on ESG performance. It will be followed by hypotheses development and the theories justification. Section 4 presents the research methodology and followed by the analysis results and discussion. Last section will explain conclusions and implications.

3.2 Variables

The operational variables in this study consist of independent, dependent, and control variables as presented in Table 1.

Table 1. Variable definitions and measures

(1) Dependent variables: ESG performance. Some studies published in China utilize the Sino-Securities ESG Index [24, 26]. This research focuses on Indonesia context and uses data drawn from Refinitiv database to assess the ESG performance of listed manufacturing companies. ESG performance is measured by examining the A+ to D- grades in accordance with LSEG, however the ESG Performance grades we utilize for processing are numerical score (0-100) generated from data in Refinitiv’s database.

(2) The Explanatory variables include Digital Transformation and Carbon emissions. We collect data related to digital transformation following methods [24, 28, 35]. Data DT collected from annual reports with textual analysis and word frequency to construct digital transformation indicators to samples data. The measurement method is as follows [24]: first, we utilize Python on the Google Collab website to extract the full-text content of each company's annual report. Second, using the DT world map [24], the frequency of keywords found (refer to Table 2) in each yearly report was used to extract, filter, and analyze text from annual reports. The keywords we chose as reference appeared 10 times or more in each company's annual report from 2019-2023. Third, we continue to count and match the keywords from the Python run results, and the collected word frequencies serve as an indicator system for the company's digital transformation. Table 2 shows the specific keyword map.

The next explanatory variable is carbon emissions, which is measured by scope 1 carbon emissions in tons CO2-e divided by total sales. However, some annual reports and sustainability reports do not include carbon emissions number, researchers collected carbon emissions data from Refinitiv database.

(3) Control variables. To help increase the validity of the relationship between the independent variable and the dependent variable, we consider a series of control variables in the analysis. The control variables studied include debt-to-assets ratio (DR), sales growth rate (S_GrowthR), total sales (Sales), profitability, and year. Table 1 provides the definitions and measures of these variables.

Table 2. Digital transformation keywords

3.3 Model design

Figure 2 presents the research framework used in this research.

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Figure 2. Research Framework

This study utilizes a regression model to analyze the impact digital transformation (DT) and carbon emissions on ESG performance, as follows:

$\begin{gathered}E S G_{i t}=\beta_0+\beta_1 D T_{i t}+\beta_2 C E_{i t}+\beta_3 D R_{i t}+\beta_4 S_{-} \text {Growth }_{i t} \\ +\beta_5 \text { Sales }_{i t}+\beta_6 \text { Profitability }_{i t}+\epsilon_{i t}\end{gathered}$

Information:

• ESG_it = Economy, Sustainability, Governance
• DT_it = Digital Transformation
• CE_it  = Carbon emissions
• DR_it  = Debt Ratio
• S_GrowthR_it  = Sales Growth Rate
• Sales_it  = Sales
• Profitability_it  = Profitability
• Β₀ = Constant
• β₁, β₂, ... β₆, = Regression Coefficient
• $\varepsilon$ = Error
• $i$ = Company
• $t$ = Year

Two-step Generalized Method of Moments (GMM) models are claimed to be robust and bias-free models, overcoming endogeneity issues [41]. In this study, we use a two-way GMM analysis model using lag independent variables as instruments. This model is used to look at the impact of digital transformation and carbon emissions on ESG performance in manufacturing companies in 2019-2023.

This study aims to identify the role digital transformation developments and carbon emissions management become the main drivers in improving the ESG performance. The results are as follows. First, this study shows that digital transformation positively correlated with ESG performance. Digital transformation may help in energy efficiency, environmentally friendly supply chain tracking, customer engagement improvement, transparency and accountability accelerated to support data-based decision-making process. Therefore, the use of some technologies such as IoT, data analytics, blockchain, cloud computing, may strengthening the positive impact on ESG. This result is consistent with previous studies from China [24, 35, 36] which find that digital transformation significantly improves ESG performance, and it plays an important role in sustainable development by leveraging digital technologies to optimize resource management in the three key aspects of corporate ESG performance. For the environmental side, digital transformation can increase transparency and accountability for corporate sustainability reporting using the Internet of Things (IoT) and big data analytics [28]. For the social side, digital transformation supports the use of a more efficient company work system, such as the implementation of remote working systems and indirect digital collaboration [24]. For the governance side, digital transformation increases the accountability of company reports through the use of enterprise resource systems that ensure that data recording is done more accurately [4].

Digital transformation may reduce information asymmetry, improve both operational and managerial efficiency, and serves as a strategic enabler to optimize business processes, specifically in enhancing energy efficiency and operational effectiveness. Aligned with the RBV theory, this digital transformation represents valuable, rare, inimitable, and non-substitutable (VRIN) resources that can provide a competitive advantage and strengthen a company's ESG performance [31].

Second, this study found that carbon emissions scope 1 relative to total sales had a significantly negative impact on company's ESG performance. This indicates that ESG performance is negatively affected by scope 1 carbon emissions, measured scope 1 in tons CO2-e divided by total sales. These emissions include direct sources such as fuel combustion from company-owned vehicles or industrial machinery, chemical processes in production, industrial boilers, and manufacturing processes. Since scope 1 carbon emissions released by companies has become one of the items measured in the ESG performance calculation, high scope 1 carbon emissions released may be seen as high-risk business and deteriorate its competitiveness, impacting the ESG performance negatively. The negative impact of carbon emissions on the company's ESG performance is also influenced by several factors, including the level of supervision from regulators on the company's carbon emissions. The study [10] explains that regulators play an essential role in the disclosure of carbon emissions, indicating that companies under close supervision tend to be more transparent in reporting their carbon emissions. In Indonesia, oversight related to carbon emissions is further strengthened by the implementation of a carbon tax, which has been regulated in the Harmonization of Tax Regulations (HPP Law) No. 7 of 2021, which explains that there is an application of carbon tax for companies that produce emissions exceeding the predetermined limit. This regulation, will certainly encourage companies to carry out carbon emission reduction strategies which will ultimately have a significant impact on the ESG performance.

These findings are also consistent with previous studies on LQ45-listed companies indicate that carbon emission reduction enhances firm value when backed by financial stability [42], regional carbon reduction also improve ESG performance by increasing access to green credits and investor scrutiny [40], and effective carbon disclosure in UK can strengthens market valuation. This explains that higher levels of carbon emissions are associated with weaker ESG performance which can make it more challenging for companies to meet environmental regulations, maintain company’s image, and stakeholders’ expectations. To overcome carbon emissions issue, companies are expected to implement some carbon mitigation strategies for enhancing sustainability and improving ESG performance [12, 14]. This perspective aligns with the RBV theory, which posits that a company can achieve a competitive advantage by effectively utilizing their unique resources [14]. Efficient management of carbon emissions is one approach for companies to emphasize strategic value, which ultimately leads to long-term sustainability and aligns with the improvement of the company’s ESG performance [32].