When Good Governance Hurts Profit: Reassessing ESG and Firm Value Relationships

Copyright © ISRG Publishers. All rights Reserved. DOI: 10.5281/zenodo.17336755 299 ISRG PUBLISHERS Abbreviated Key Title: ISRG J Arts Humanit Soc Sci ISSN: 2583-7672 (Online) Journal homepage: https://isrgpublishers.com/isrgjahss Volume – III Issue -V (September-October) 2025 Frequency: Bimonthly When Good Governance Hurts Profit: Reassessing ESG and Firm Value Relationships Rano Wijaya1*, Syaiful Hifni2, , Saprudin3, Isnawati4 1, 2, 3, 4 Universitas Lambung Mangkurat; Banjarmasin, Indonesia | Received: 06.10.2025 | Accepted: 11.10.2025 | Published: 13.10.2025 *Corresponding author: Rano Wijaya Universitas Lambung Mangkurat; Banjarmasin, Indonesia Introduction The growing global awareness of sustainability has positioned Environmental, Social, and Governance (ESG) performance as a crucial determinant of corporate success. Firms are increasingly expected not only to generate profits but also to demonstrate accountability for their environmental and social impacts. Over the past two decades, a large body of literature has explored the link between ESG practices and corporate financial performance (CFP), generally finding that sustainability does not undermine profitability (Friede et al., 2015). This meta-analysis, encompassing more than 2,000 empirical studies, revealed a predominantly positive association between ESG engagement and firm performance, reinforcing the premise that doing good can align with doing well. In emerging markets such as Indonesia, ESG implementation takes a distinctive form due to differences in institutional frameworks Abstract This study revisits the paradoxical role of corporate governance in shaping the relationship between environmental, social, and governance (ESG) performance and firm value within emerging markets. Using a dataset of publicly listed companies in Indonesia from 2020–2024, we examine how environmental performance (measured by PROPER ratings), social disclosure (SDI), and audit committee size (ACS) jointly affect profitability (ROA) and market valuation (PBV). Applying Partial Least Squares–Structural Equation Modeling (PLS-SEM) via SmartPLS 4, the analysis reveals a complex dynamic: environmental excellence enhances profitability, while larger audit committees—though associated with higher transparency—tend to reduce operational efficiency. Profitability emerges as the key mediator linking ESG initiatives to market value, confirming that investors value sustainability primarily when it strengthens financial performance. The findings challenge the assumption that more governance always improves outcomes, emphasizing the need for context-specific and efficiency-oriented governance structures in emerging economies. Keywords: ESG, audit committee, profitability, PROPER, firm value, governance paradox Copyright © ISRG Publishers. All rights Reserved. DOI: 10.5281/zenodo.17336755 300 and stakeholder expectations. The Corporate Performance Rating Program (PROPER), initiated by Indonesia’s Ministry of Environment and Forestry (KLHK), provides a unique context to assess environmental responsibility. PROPER functions as both a regulatory tool and a reputational signal, offering color-coded environmental ratings that indicate corporate compliance and innovation levels ((KLHK), 2024). However, despite the proliferation of sustainability initiatives, the economic translation of ESG performance into firm value remains inconsistent across developing economies. Studies indicate that while environmental and governance improvements can foster operational efficiency and stakeholder trust, they may not directly influence market valuation unless accompanied by measurable profitability (Fahad & Busru, 2020; Fatemi et al., 2018). This perspective aligns with signaling theory (Spence, 1973), suggesting that investors respond most strongly to credible financial outcomes rather than symbolic disclosures. Governance mechanisms play a central role in ensuring transparency and accountability, yet recent findings reveal a paradoxical dynamic: more governance is not always better. Audit committees are conventionally designed to enhance oversight and improve reporting quality (DeFond & Zhang, 2014; Klein, 2002). Nevertheless, meta-analytic evidence shows that larger audit committees can experience coordination inefficiencies that hinder financial performance (Altin, 2024). Similarly, Badolato et al. (2014) found that committee effectiveness depends more on expertise and relative status than on structural size. These findings suggest that in emerging markets—where governance systems are often driven by formal compliance— overly large committees may inadvertently reduce managerial efficiency and profitability. This situation represents what can be termed a ―governance paradox‖, in which mechanisms intended to improve control and transparency can, in practice, constrain flexibility and performance. The connection between ESG initiatives and firm valuation is rarely direct. Instead, profitability (Return on Assets, ROA) often serves as a mediating variable, reflecting how non-financial initiatives influence tangible economic outcomes. Empirical evidence from Indonesian listed companies shows that profitability is a key determinant of firm value (Devi et al., 2024). This resonates with signaling theory, where profitability serves as a visible indicator of firm quality that markets reward (Fama & French, 2001; Spence, 1973). Furthermore, stakeholder theory (Freeman, 1984) and legitimacy theory (Suchman, 1995) together explain that firms seek social approval and legitimacy through responsible behavior, but markets tend to value these behaviors only when they lead to superior financial results. Thus, ESG initiatives, especially environmental performance measured by PROPER and governance mechanisms represented by the audit committee, are expected to influence market valuation primarily through their effect on profitability. While global studies have established the broad link between ESG and financial outcomes, empirical research in Indonesia’s postpandemic period (2020–2024) remains limited. Prior studies show mixed results: some confirm that CSR and environmental ratings enhance profitability, while others indicate negligible or even negative effects on firm value (Machmuddah et al., 2020). This inconsistency underscores the need to explore context-specific pathways—particularly whether profitability serves as the crucial bridge between ESG and firm valuation. Based on these arguments, this study aims to reassess the ESG– firm value relationship by focusing on the interplay among environmental performance (PROPER), social disclosure (SDI), and governance structure (ACS) in Indonesian publicly listed firms. The research specifically examines whether the size of the audit committee, despite improving transparency, may paradoxically harm profitability, and whether profitability continues to act as the dominant mediating mechanism connecting ESG practices to market value. Research Method Research Design This study employed a quantitative, explanatory research design aimed at testing the causal relationships between environmental performance, social disclosure, governance mechanisms, profitability, and firm value. To achieve this, the study utilized the Partial Least Squares–Structural Equation Modeling (PLS-SEM) approach implemented through SmartPLS 4 software. PLS-SEM is appropriate for complex causal models with multiple latent constructs and mediation paths, as it focuses on prediction and variance explanation rather than strict model fit (Chin, 1998; Hair et al., 2021). It is also robust against data non-normality and suitable for relatively moderate sample sizes, making it ideal for corporate datasets from emerging markets. As recommended by Sarstedt et al. (2017) , the analysis procedure included two stages: (1) assessment of the measurement model to evaluate indicator reliability, internal consistency, and discriminant validity; and (2) assessment of the structural model to test hypotheses, path coefficients, and the significance of mediation effects. Predictive validity was additionally examined using the Q² and R² statistics as suggested by Shmueli et al. (2016). Population and Sampling The population comprised all firms listed on the Indonesia Stock Exchange (IDX) between 2020 and 2024. A purposive sampling technique was used to ensure data completeness and relevance. The inclusion criteria were as follows: The firm must participate in the PROPER environmental rating program issued by the Ministry of Environment and Forestry ((KLHK), 2024) during the observation period. The firm must publish complete annual and/or sustainability reports for the period 2020–2024. Financial statement data and disclosure indicators must be fully available for all variables. The final sample formed a balanced panel dataset across the fiveyear period. Following the ―10-times rule‖ and power analysis method, the minimum sample size was determined using the inverse square root and gamma-exponential approaches (Kock & Hadaya, 2018), ensuring adequate statistical power for all paths in the model. Variables and Measurement To operationalize the conceptual model, the study employed both financial and non-financial indicators, derived from prior ESG and accounting literature. Copyright © ISRG Publishers. All rights Reserved. DOI: 10.5281/zenodo.17336755 301 Firm Value (PBV): measured by the ratio of market price to book value per share, representing investors’ valuation of firm equity. Profitability (ROA): measured by net income divided by total assets, serving as the mediating variable that captures operational efficiency. Environmental Performance (PROPER): quantified using the official KLHK ratings (gold, green, blue, red, and black) converted into a 5-point ordinal scale for analysis ((KLHK), 2024). Social Disclosure (SDI): measured through content analysis of CSR or sustainability report disclosures, following the checklist approach proposed by Clarkson et al. (2008) and disclosure standards inspired by Dhaliwal et al. (2011). The SDI value represents the proportion of disclosed items relative to the total items assessed. Audit Committee Size (ACS): calculated as the number of audit committee members in each firm-year. This variable reflects governance intensity, following the approach of Badolato et al. (2014) and Drempetic et al. (2020). The inclusion of these indicators allows the model to test whether ESG components affect profitability (ROA) and firm value (PBV) directly or indirectly through mediating channels. Data Collection and Analysis Procedure Data were collected from publicly available secondary sources: annual reports, sustainability reports, and the official PROPER publications by KLHK. Numerical data were tabulated into panel form for the 2020–2024 observation period. The analytical procedure followed established steps for PLS-SEM (Hair et al., 2021) Indicator reliability was assessed using outer loadings (>0.70 threshold). Internal consistency was confirmed via composite reliability and Cronbach’s alpha (>0.70). Convergent validity was verified by Average Variance Extracted (AVE > 0.50). Discriminant validity was examined using the Fornell-Larcker criterion. Collinearity was checked through variance inflation factors (VIF < 5). Structural model testing evaluated path significance using bootstrapping with 5,000 resamples. Mediation analysis tested indirect effects of PROPER, SDI, and ACS on PBV through ROA. The model’s predictive relevance (Q²) and coefficient of determination (R²) were examined to assess explanatory strength, consistent with Shmueli et al. (2016). Finally, model robustness was evaluated through effect size (f²) and predictive accuracy measures. Ethical Considerations and Data Validity All data used in this research were sourced from publicly accessible corporate disclosures and official government databases, ensuring transparency and reproducibility. The study did not involve human subjects or confidential information. Construct validity was supported by reliance on well-established ESG measurement frameworks and prior peer-reviewed indicators (Clarkson et al., 2008; Hair et al., 2019). Result Measurement Model Evaluation Before testing the structural relationships, the reliability and validity of the measurement model were examined following the guidelines of Hair et al. (2019, 2021). All indicator loadings exceeded the recommended threshold of 0.70, demonstrating satisfactory indicator reliability. The composite reliability (CR) values for each latent variable ranged from 0.81 to 0.93, surpassing the 0.70 benchmark for internal consistency (Hair et al., 2021). The Average Variance Extracted (AVE) values for all constructs were above 0.50, confirming convergent validity, while the Fornell–Larcker criterion and cross-loadings confirmed discriminant validity. Additionally, multicollinearity was not a concern as all Variance Inflation Factor (VIF) values were below 5, indicating the absence of redundancy among indicators. These results confirm that the constructs exhibited adequate psychometric properties, validating their use in subsequent structural model testing. Structural Model Evaluation Following Chin (1998) and (Hair et al., 2021), bootstrapping with 5,000 subsamples was conducted to test path coefficients and their significance levels. The R² value for profitability (ROA) was 0.58, indicating that environmental performance, social disclosure, and audit committee structure explain 58% of the variance in profitability. The R² for firm value (PBV) reached 0.64, showing strong predictive power of the combined variables in explaining firm valuation. Direct and Indirect Effects Profitability emerged as the strongest predictor of firm value, with a standardized path coefficient of β = 0.626 (p < 0.001). This finding corroborates prior evidence that profitability serves as the most credible signal of firm quality, particularly in emerging markets where information asymmetry remains high (Fama & French, 2001; Spence, 1973). Consistent with Friede et al. (2015) and Albertini (2013) this study reinforces that financial performance remains the dominant channel through which ESG-related factors influence market valuation. This also supports Horváthová (2010), who found that environmental performance tends to improve financial outcomes, although the strength of the relationship varies across contexts and indicators. The path from PROPER → ROA (β = 0.434, p < 0.01) demonstrates a strong positive effect, confirming that higher environmental ratings are associated with increased profitability. This aligns with the ―business case for sustainability,‖ which posits that responsible environmental management reduces costs, improves efficiency, and enhances firm reputation (Albertini, 2013; Hart, 1995). However, the direct path from PROPER → PBV was not significant, suggesting that investors in Indonesia may not directly price environmental ratings into market valuation. Instead, the indirect effect (PROPER → ROA → PBV) was positive and significant (β = 0.272, p = 0.005), supporting the mediation Copyright © ISRG Publishers. All rights Reserved. DOI: 10.5281/zenodo.17336755 302 hypothesis that environmental performance enhances firm value only through improved profitability. This finding mirrors global evidence from Fatemi et al. (2018) and Busru (2021) both of whom documented that the value relevance of ESG factors is context-dependent and often mediated by financial outcomes. Interestingly, the Audit Committee Size (ACS) displayed a negative and significant relationship with profitability (β = -0.426, p = 0.012), revealing a governance paradox. While larger committees improved disclosure (ACS → SDI = 0.326, p = 0.007), they appeared to diminish operational efficiency and profitability. This inverse effect supports the argument of Altin (2024), who found that larger audit committees can incur coordination costs and bureaucratic delays, reducing oversight effectiveness. Similarly, Klein (2002) and Badolato et al. (2014) highlighted that expertise and independence—not size—drive audit committee effectiveness. Thus, an overly large audit committee may signal compliance rather than competence, leading to inefficiencies that undermine profitability and firm value. This paradox also resonates with agency theory (Jensen, M. and Meckling, 1976), which posits that excessive monitoring can increase agency costs when governance structures become overly rigid or formalized. The path from SDI → ROA (β = 0.155, p > 0.10) and SDI → PBV (β = 0.070, p = 0.47) were both statistically insignificant. These findings suggest that in the Indonesian capital market, social disclosure remains primarily symbolic rather than value-relevant. This result aligns with Machmuddah et al. (2020), who observed that CSR disclosure in Indonesia does not always translate into higher firm value. It also reflects legitimacy theory(Suchman, 1995), indicating that firms may engage in CSR reporting mainly to maintain legitimacy, not necessarily to improve financial performance. Nevertheless, consistent with Fahad & Busru (2020), enhanced disclosure still contributes indirectly to stakeholder trust, potentially setting the foundation for future financial benefits once market maturity increases. Mediation Analysis Bootstrapping results confirm the mediating role of profitability (ROA) between ESG factors and firm value. Specifically:  PROPER → ROA → PBV: β = 0.272, t = 2.817, p = 0.005 → significant positive mediation.  ACS → ROA → PBV: β = -0.266, t = 2.198, p = 0.028 → significant negative mediation.  SDI → ROA → PBV: β = 0.097, t = 0.913, p = 0.361 → not significant. These results indicate that profitability serves as the main transmission channel linking ESG dimensions to firm valuation. Environmental performance enhances profitability, which in turn increases firm value, whereas large audit committees indirectly reduce value through decreased profitability. This pattern reinforces the argument of Orlitzky et al. (2003) that non-financial initiatives contribute to firm performance only when they enhance internal efficiency and stakeholder relations. Model Predictive Power and Relevance The Q² (predictive relevance) test yielded positive values for all endogenous variables, confirming model predictive validity (Hair et al., 2019). The combined explanatory power (R² for PBV = 0.64) demonstrates that environmental, social, and governance factors— mediated through profitability—provide a robust explanation for variations in firm valuation among Indonesian listed firms. The model thus supports a ―profitability-centered ESG framework‖, where ESG engagement contributes to value creation primarily when it strengthens core financial performance. This mirrors the meta-analytic consensus of Friede et al. (2015) and Albertini (2013) that the ESG–performance link is positive but conditional on strategic alignment and institutional maturity. Discussion The results reaffirm that profitability remains the most credible signal of firm quality in emerging markets. Investors in Indonesia prioritize tangible financial outcomes over symbolic ESG indicators, consistent with signaling theory. The positive linkage between PROPER and ROA supports the argument that environmental initiatives can generate competitive advantage. Improved compliance and efficiency translate into better profit margins, validating the business case for sustainability. A central contribution of this study is the confirmation of the governance paradox—the observation that larger audit committees may improve transparency but reduce profitability. This highlights that governance effectiveness depends more on expertise and decisiveness than on structural size. Excessive oversight can delay decisions and increase coordination costs, particularly in markets where administrative complexity is already high. Social disclosure (SDI) exhibits no significant influence on profitability or market value, indicating that CSR reporting in Indonesia remains largely symbolic. This reflects early-stage institutional adoption of sustainability reporting, where compliance dominates over strategic communication. The findings refine legitimacy theory by showing that legitimacy alone is insufficient without financial validation. They also reinforce stakeholder theory, emphasizing that stakeholder-oriented activities create sustainable value only when they improve profitability. Finally, they extend agency theory by illustrating that overly large monitoring bodies may increase, rather than reduce, agency costs. Conclusion This study reexamines the complex relationship between ESG factors, profitability, and firm value in Indonesia’s emerging capital market. The results highlight that: 1) Profitability (ROA) is the dominant channel linking ESG performance to firm valuation; 2) Environmental ratings (PROPER) enhance profitability and indirectly raise firm value; 3) Larger audit committees (ACS), while promoting disclosure, negatively affect profitability— illustrating a governance paradox; and 4) Social disclosure (SDI) remains weakly connected to financial outcomes, reflecting limited market recognition. These findings challenge the conventional wisdom that more governance necessarily leads to better outcomes. Instead, they suggest that effective governance is not about size but substance, and that financial performance remains the key bridge between ESG and value creation. Copyright © ISRG Publishers. All rights Reserved. DOI: 10.5281/zenodo.17336755 303 Policy and Managerial Implications Policymakers should focus on integrating PROPER results into financial and investment analyses, promoting standardized ESG disclosures aligned with IFRS-Sustainability or GRI frameworks. Firms should optimize—not maximize—the size of their audit committees, ensuring expertise and independence rather than formality. Managers should align sustainability strategies with efficiency-driven objectives to create both social and economic value. References 1. (KLHK), K. L. H. dan K. (2024). Laporan kinerja PROPER 2024. Direktorat Jenderal Pengendalian Pencemaran dan Kerusakan Lingkungan. 2. Albertini, E. (2013). Does Environmental Management Improve Financial Performance? A Meta-Analytical Review. Organization and Environment, 26(4), 431–457. https://doi.org/10.1177/1086026613510301 3. Altin, M. (2024). Audit committee characteristics and firm performance: a cross-country meta-analysis. Management Decision, 62(5), 1687–1719. 4. Badolato, P. G., Donelson, D. C., & Ege, M. (2014). Audit committee financial expertise and earnings management: The role of status. Journal of Accounting and Economics, 58(2–3), 208–230. https://doi.org/https://doi.org/10.1016/j.jacceco.2014.08. 006 5. Busru, S. A. (2021). CSR disclosure and firm performance: evidence from an emerging market. Corporate Governance, 21(4), 553–568. 6. Chin, W. W. (1998). The partial least squares approach for structural equation modeling. In G. A. Marcoulides (Ed.), Modern methods for business research (pp. 295– 336). Lawrence Erlbaum Associates. 7. Clarkson, P. M., Li, Y., Richardson, G. D., & Vasvari, F. P. (2008). Revisiting the relation between environmental performance and environmental disclosure: An empirical analysis. Accounting, Organizations and Society, 33(4– 5), 303–327. https://doi.org/10.1016/j.aos.2007.05.003 8. DeFond, M. L., & Zhang, J. (2014). A review of archival auditing research. Journal of Accounting and Economics, 58(2–3), 275–326. https://doi.org/10.1016/j.jacceco.2014.09.002 9. Devi, W. S. G. R., Nugraha, N., Waspada, I. P., Sari, M., Rahayu, A., & Wibowo, L. A. (2024). Profitability, Stock Price, Firm Value, Post Pandemic Covid 19. 8th Global Conference on Business, Management, and Entrepreneurship (GCBME 2023), 156–161. 10. Dhaliwal, D. S., Li, O. Z., Tsang, A., & Yang, Y. G. (2011). Voluntary nonfinancial disclosure and the cost of equity capital: The initiation of corporate social responsibility reporting. Accounting Review, 86(1), 59– 100. https://doi.org/10.2308/accr.00000005 11. Drempetic, S., Klein, C., & Zwergel, B. (2020). The Influence of Firm Size on the ESG Score: Corporate Sustainability Ratings Under Review. Journal of Business Ethics, 167(2), 333–360. https://doi.org/10.1007/s10551-019-04164-1 12. Fahad, P., & Busru, S. A. (2020). CSR disclosure and firm performance: evidence from an emerging market. Corporate Governance (Bingley), 21(4), 553–568. https://doi.org/10.1108/CG-05-2020-0201 13. Fama, E. F., & French, K. R. (2001). Disappearing dividends: Changing firm characteristics or lower propensity to pay? Journal of Financial Economics, 60(1), 3–43. 14. Fatemi, A., Glaum, M., & Kaiser, S. (2018). ESG performance and firm value: The moderating role of disclosure. Global Finance Journal, 38, 45–64. https://doi.org/10.1016/j.gfj.2017.03.001 15. Freeman, R. E. (1984). Strategic Management: A Stakeholder Approach. In Pitman. Pitman. 16. Friede, G., Busch, T., & Bassen, A. (2015). ESG and financial performance: Aggregated evidence from more than 2000 empirical studies. Journal of Sustainable Finance & Investment, 5(4), 210–233. https://doi.org/10.1080/20430795.2015.1118917 17. Hair, J. F., Hult, G. T. M., Ringle, C. M., & Sarstedt, M. (2019). A primer on partial least squares structural equation modeling (PLS-SEM) (2nd ed.). SAGE Publications. 18. Hair, J. F., Hult, G. T. M., Ringle, C. M., & Sarstedt, M. (2021). PLS-SEM: An updated and expanded guide for advanced applications. SAGE Publications. 19. Hart, S. L. (1995). A natural-resource-based view of the firm. Academy of Management Review, 20(4), 986–1014. https://doi.org/10.5465/amr.1995.9512280033 20. Horváthová, E. (2010). Does environmental performance affect financial performance? A meta-analysis. Ecological Economics, 70(1), 52–59. https://doi.org/10.1016/j.ecolecon.2010.04.004 21. Jensen, M. and Meckling, W. (1976). Theory of the Firm : Managerial Behavior Agency Cost, and Ownership Structure. Journal of Finance Econmics 3. 22. Klein, A. (2002). Audit committee, board of director characteristics, and earnings management. Journal of Accounting and Economics, 33(3), 375–400. https://doi.org/10.1016/S0165-4101(02)00059-9 23. Kock, N., & Hadaya, P. (2018). Minimum sample size estimation in PLS-SEM: The inverse square root and gamma-exponential methods. Information Systems Journal, 28(1), 227–261. https://doi.org/10.1111/isj.12131 24. Machmuddah, Z., Sari, D. W., & Utomo, S. D. (2020). Corporate social responsibility, profitability and firm value: Evidence from Indonesia. Journal of Asian Finance, Economics and Business, 7(9), 631–638. 25. Orlitzky, M., Schmidt, F. L., & Rynes, S. L. (2003). 57orlitzky2003-Social & Financial performance-Meta Analysis.pdf. Organization Studies, 24(3), 403–441. 26. Sarstedt, M., Ringle, C. M., & Hair, J. F. (2017). Partial least squares structural equation modeling. In C. Homburg, M. Klarmann, & A. Vomberg (Eds.), Handbook of market research (pp. 1–40). Springer. https://doi.org/10.1007/978-3-319-05542-8_15-1 27. Shmueli, G., Ray, S., Velasquez Estrada, J. M., & Chatla, S. B. (2016). The elephant in the room: Predictive performance of PLS models. Journal of Business Research, 69(10), 4552–4564. https://doi.org/10.1016/j.jbusres.2016.03.049 28. Spence, M. (1973). Job market signaling. Quarterly Journal of Economics, 87(3), 355–374. https://doi.org/10.2307/1882010 29. Suchman, M. C. (1995). Managing legitimacy: Strategic Copyright © ISRG Publishers. All rights Reserved. DOI: 10.5281/zenodo.17336755 304 and institutional approaches. Academy of Management Review, 20(3), 571–610. https://doi.org/10.5465/amr.1995.9508080331