The Direct and Indirect Impacts of <scp>ESG</scp> Controversies on Sustainability Performance: A Longitudinal Study

ABSTRACT Firms attempt to recover from the damage caused by ESG controversies by improving their sustainability efforts to enhance post‐controversy performance. We argue that a firm's ability to recover from such damage is influenced by decreased financial performance resulting from the controversies. Furthermore, we investigate whether this financial decline acts as a complementary mediator, whereby both the mediated and direct effects of controversies on sustainability performance operate in the same direction. Using 37,291 longitudinal observations from 2007 to 2023 across 35 countries in America, Asia, Europe, and Oceania, we employ instrumental variable approaches for the generalized method of moments (GMM IV) and structural equation modeling (SEM IV). The main results reveal that the decrease in accounting, market, and growth‐based financial performance has complementary mediating effects on the relationship between controversies and sustainability performance. Moreover, earnings acceleration emerges as a robust indicator of growth‐based financial performance, significantly influencing sustainability performance. These findings advance stakeholder and legitimacy theory perspectives by highlighting decreased financial performance as a key driver of recovery mechanisms following ESG controversies.