ESG and Firm Performance: Non-linear Dynamics and Bidirectional Causality in Pharmaceutical Industry

This study examines the bidirectional relationship between environmental, social and governance (ESG) performance and firm performance in the global pharmaceutical sector, employing a cross-lagged panel model for 255 firms from 2016 to 2022. Using Bloomberg ESG scores and three performance metrics, namely return on assets (RoA), return on invested capital (RoIC) and Tobin’s Q, we uncover nuanced, non-linear relationships. Results indicate that lagged ESG performance positively influences accounting-based measures (RoA and RoIC), supporting the notion that sustainability investments yield operational efficiencies over time. However, market-based valuation (Tobin’s Q) exhibits a U-shaped relationship, suggesting initial investor scepticism followed by long-term rewards for persistent ESG commitment. On the other hand, financial performance does not consistently drive subsequent ESG improvements, rejecting reverse causality. The inverted U-shaped relationship for RoIC aligns with the environmental Kuznets curve (EKC), revealing diminishing returns to ESG investments beyond a threshold. These findings contribute to stakeholder and signalling theories, demonstrating that ESG integration enhances financial resilience while highlighting market inefficiencies in pricing sustainability. The study advances the ESG–performance literature by providing sector-specific insights, emphasizing the strategic value of ESG in pharmaceuticals, where regulatory and reputational stakes are high. Policymakers and managers can leverage these insights to optimize ESG resource allocation and improve disclosure frameworks.