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Article

The ESG Paradox: Risk, Sustainability, and the Smokescreen Effect

by
Manpreet Kaur Makkar
1,*,
Basit Ali Bhat
2,
Mohsin Showkat
3 and
Fatma Mabrouk
4
1
Apeejay Institute of Management and Engineering Technical Campus, Jalandhar, Punjab 144007, India
2
Mittal School of Business, Lovely Professional University, Phagwara, Punjab 1444111, India
3
School of Commerce, Presidency University, Rajanakunte, Bangalore 560064, India
4
Department of Economics, College of Business Administration, Princess Nourah bint Abdulrahman University, P.O. Box 84428, Riyadh 11671, Saudi Arabia
*
Author to whom correspondence should be addressed.
Sustainability 2025, 17(16), 7539; https://doi.org/10.3390/su17167539
Submission received: 4 July 2025 / Revised: 5 August 2025 / Accepted: 8 August 2025 / Published: 21 August 2025
(This article belongs to the Special Issue ESG Management, Performance, and Corporate Sustainability: Insights and Innovations)
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Abstract

Despite numerous global initiatives, such as the Sustainable Development Goals (SDGs) and the implementation of environmental, social, and governance (ESG) metrics aimed at mitigating climate change, promoting social welfare, and addressing a variety of other causes, progress has been significantly slower than expected, particularly in developing economies. Thus, we attempted to link corporate ESG to sustainable development. It was also investigated whether ESG contributes to a reduction in corporate risk. Using panel data and the Generalized Method of Moments (GMM) technique, we examine the relationship between ESG scores and important financial risk indicators such as systematic risk (beta), stock price volatility, unsystematic risk, and the cost of capital (WACC). The findings show that corporations place a disproportionate emphasis on governance (G) rather than environmental (E) and social (S) characteristics. ESG and G governance were also found to be statistically significant predictors of financial risk. This disparity shows that companies may be using high governance scores to conceal underperformance in environmental and social issues, raising worries about greenwashing and superficial compliance. As a result, their contributions to SDGs such as affordable and clean energy (SDG 7), climate action (SDG 13), and reduced inequalities (SDG 10) are minimal. The findings highlight the need for a more open, balanced, and integrated ESG approach, one that not only promotes sustainable development but also improves long-term financial resilience.

Graphical Abstract

1. Introduction

The rapid rise in globalization and intensifying competition has allowed companies to thrive by exploiting more opportunities to boost their revenues [1]. This spurt in sales is impacting the environment with the rise in carbon emissions, excess consumption of resources, and waste generation. Studies have reported that a 100% rise in sales leads to a 50% rise in CO2 emissions and a 60% rise in waste generation. The fact that significant environmental thresholds have been crossed has increased the seriousness of the impending threat of climate change and its potential cascading effects on ecosystems and people worldwide, presenting a risky mix of opportunities and threats to businesses worldwide [2,3].
Therefore, the UN intervened and forced corporations to improve adherence to sustainability goals, resulting in increased adoption of the Sustainable Development Goals (SDGs) that come both from genuine commitments as well as pressure from external sources to appease investors, governments, and society [4,5,6]. Sustainability has become a buzzword among corporations to ensure that their businesses do not face any hurdles in growth, expansion, and diversification. Yet this line between authentic accountability and strategic posturing blurs all too easily and creates serious questions about corporate intent [7], as the holistic development of society is nearly impossible to achieve without intent [8] and just on the basis of pressure from external factors.
All this has given rise to environmental, social, and governance (ESG) metrics, lauded as a progressive way to incorporate sustainability into corporate DNA [9,10]. However, this paper claims that, like The Truman Show, a carefully curated world, ESG is used as an illusion of progress, covering up underlying structural problems by corporations, especially related to emerging nations. Instead of genuinely contributing towards the sustainable development of nations and the world, ESG scores have become a tool for greenwashing for some businesses [11], especially with limited consumer choices or necessity products [12,13]. Also, businesses with major social and environmental impact show this phenomenon when public doubt and investor scrutiny coincide with important issues [11,12,13,14,15]. Non-renewable energy companies represent a crucial sector that serves as the backbone for the growth of emerging nations [16,17], and simultaneously, they are a major contributor to carbon emissions.
The above discussion highlights a significant research gap, as this sector has the highest ESG score compared to other sectors, and claims alignment with ESG principles, yet it remains unclear whether these efforts genuinely advance the global sustainability agenda or merely serve as strategic maneuvers to maintain relevance amid growing scrutiny. Furthermore, misaligned ESG performance with sustainable development can give stakeholders a false sense of security by portraying companies as sustainable without reflecting their actual environmental or social impact. This misrepresentation can result in poor long-term risk management, as firms may underestimate vulnerabilities such as climate change or labor issues. Under pressure from regulatory scrutiny and reputational risks, companies often remain underprepared for real-world challenges.
As a result, their subpar performance in ESG variables may adversely affect their risk profile, rendering them more susceptible to regulatory scrutiny and reputational harm, which may result in changing investor perspectives [18,19]. Although extensive research has explored the integration of ESG factors into risk and financial performance, there remains a lack of consensus on how sustainability representation influences market and corporate risk profiles [20]. Although the quantity of evidence is growing, it is still less robust than in developed markets, with numerous studies revealing only modest or context-dependent relationships [21]. The existing literature contains mixed conclusions about the statistical relevance of ESG-related influences on risk indicators in emerging nations. While some studies show a positive association between ESG performance and financial outcomes, including risk mitigation, others suggest that the relationship is weak or insignificant, particularly in regions where ESG disclosure practices are underdeveloped or poorly enforced [22,23,24]. Despite the growing emphasis on ESG integration in corporate strategy, there remains a significant disconnect between ESG performance metrics and actual contributions to sustainable development. This misalignment is particularly pronounced in developing economies [25], where ESG disclosures are often inconsistent, unaudited, and underregulated. As a result, stakeholders may develop a false sense of security, misjudging corporate resilience and risk exposure. The ambiguity surrounding the impact of sustainability representation on market and corporate risk raises critical concerns about the reliability of ESG as a tool for risk assessment and sustainable investment.
After taking a deep dive into the sustainability indicators of the energy sector, the results show that such a composite measure is misleading for measuring sustainable development, though the ESG performance is relatively good, with a mean combined score of 41.81 in emerging nations. Yet, the disaggregation of these scores reveals an even more troubling reality [26]. The implication is that although firms may stick to the governance rules, they neglect environmental and social imperatives at the same time. Even being a major contributor to escalating climate change and social justice challenges, their G scores are significantly higher than their E and S scores. They are trying to contribute to environmental and social welfare, but their actions are not justifying their impact. This can be one reason that risk factors have an insignificant relationship with environmental and social factors while showing a significant and negative relationship with the governance factor.

2. Literature Review and Theoretical Background

2.1. Theoretical Background

2.1.1. Agency Theory

Two opposing schools of thought exist regarding the purpose of businesses: one asserts that businesses are solely meant to serve the interests of shareholders, and profit maximization is their primary objective [27]. According to ref [28] the only social responsibility of a business is to increase its profits, within the bounds of fair competition and without deception or fraud. He argues against corporate philanthropy, stating that managers, as agents of shareholders, do not have the right to utilize the company’s capital for philanthropic purposes. This perspective is aligned with Agency Theory, which posits that managers are agents of shareholders, and their decision making should revolve around wealth maximization.
However, despite this profit-centric view, it is essential to acknowledge that businesses’ operations can have far-reaching impacts, and ethical considerations demand responsible corporate behavior [29]. Infamous incidents like the Bhopal Gas tragedy and the Exxon Valdez oil spill serve as reminders of the lasting consequences of unethical behavior. From an ethical standpoint, there is an expectation for businesses to act ethically, avoid causing harm, and abide by the law [30].

2.1.2. Legitimacy Theory

Legitimacy theory posits that organizations strive to align their operations with societal norms and expectations to maintain public approval—or “legitimacy” [31]. This alignment has become increasingly significant with the rise of ESG initiatives and corporate responsibility efforts.
Responsible corporate behavior—such as fostering workplace diversity, minimizing environmental impact, and ensuring transparent governance—serves to meet stakeholder expectations [32]. These actions not only reinforce legitimacy but also contribute to long-term value creation. Moreover, legitimacy theory highlights the risks of greenwashing, where companies exaggerate or misrepresent their ESG commitments. Superficial or misleading efforts can erode legitimacy, damage reputations, and diminish stakeholder trust. Genuine legitimacy arises from authentic and effective ESG practices, not from strategic public relations. Ultimately, legitimacy theory underscores that a company’s license to operate is granted by society. Sustained public and stakeholder approval depends on meaningful ESG engagement and responsible corporate conduct.

2.2. Literature Review

Sustainability is a complex concept that has been articulated in numerous ways within scholarly discussions [33,34]. A well-established framework for sustainable development is the three-pillar theory, highlighting the interrelation of society, economy, and environment. This method is widely cited in sustainability studies [35], emphasizing that enduring sustainability can only be realized through a balanced integration of these three pillars [36,37]. Certain interpretations of the three-pillar theory suggest that sustainability is not just about balancing the economy, society, and environment [35]. Instead, it emphasizes that economic sustainability should be from the synergy of social dimensions, while operating within the limits imposed by environmental constraints. The 17 Sustainable Development Goals (SDGs) set forth by the United Nations illustrate this interconnected balance, offering a thorough framework for global sustainability initiatives.
Similarly, from a corporate viewpoint, it is critical to incorporate all three pillars in order to align actions with sustainability [35,38]. According to a study [39], this contributes to the achievement of economic stability, environmental and social responsibility, transparency, and ethical principles that support the company’s and its stakeholders’ holistic and sustainable development. However, the effectiveness of ESG indicators varies significantly across countries, regions, and industries, influencing their relationship with financial performance and investment attractiveness [24,40,41]. For instance, in developed economies, ESG practices are often associated with enhanced market value, whereas in developing regions, they are more closely linked to cost efficiency and competitive advantage.
In the EU, ESG compliance reflects a dynamic regulatory landscape that demands increasing corporate accountability. Firms that fail to meet these evolving sustainability standards face heightened legal, financial, and reputational risks [42,43]. ESG integration has been shown to reduce financial volatility and improve adherence to reporting frameworks [44,45]. Superior environmental performance in the EU correlates with lower idiosyncratic risk [46], while environmentally sensitive industries benefit from reduced reputational exposure and greater market stability. Interestingly, governance scores appear to have a limited impact on overall risk levels in developed markets [47]. However, in developing countries, governance factors tend to exert a more direct and measurable influence on firm value, particularly where institutional frameworks are weaker and regulatory enforcement is inconsistent [48,49]. This contrast highlights the contextual nature of ESG effectiveness, where the relative importance of each pillar varies by region and institutional maturity [21].
Hence, this ESG integration depicts clear benefits—such as reduced financial volatility, improved reporting adherence, and lower idiosyncratic risk and cost of capital [45]. But its effectiveness is increasingly challenged by inconsistencies in ESG scoring methodologies. Despite regulatory advancements, a critical issue persists: ESG scores do not often reflect a firm’s true sustainability performance. Ref. [50] highlights that among S&P 500 firms, ESG ratings are not reliable predictors of financial resilience or risk mitigation, thus challenging economic sustainability. This disconnect is largely driven by fragmented rating methodologies and a lack of standardization, which can mislead investors and contribute to market instability [51]. Moreover, superficial disclosures and selective data reporting—commonly referred to as greenwashing—can exacerbate systemic risk, especially when there is a perceived disconnect between reported ESG scores and actual impact. This undermines the credibility of ESG assessments, eroding investor trust and potentially offsetting the regulatory gains [52].
Based on the given research, this study recognizes that the consequences of ESG vary by sector and location [21]. Consequently, our attention is directed toward the sector with the highest carbon emissions to analyze the relationship between ESG scores and sustainable development. This study seeks to assess the true sustainability performance of the sector and examine its relationships with economic risk factors, thereby deepening the comprehension of ESG risk dynamics within the framework of sustainable development. Therefore, based on the literature review, the following research questions and hypotheses are formed:
  • Do the energy sector firms’ composite ESG scores reflect sustainable development, or do trade-offs exist among these dimensions?
  • To what extent does governance-biased ESG performance reduce corporate risk, including systematic risk, stock volatility, and cost of capital?
To answer these questions, we developed different hypotheses.
  • Hypothesis Development
The integration of ESG principles into corporate strategy has been widely promoted to enhance long-term sustainability and reduce firm-level risk. However, the extent to which composite ESG scores truly reflect a firm’s sustainability performance and how each dimension (environmental, social, and governance) contributes to risk mitigation remains contested, especially in high-emission industries such as the energy sector.
Hypothesis 1 (H1):
The composite ESG scores of firms do not equally reflect all three dimensions (environmental, social, and governance), indicating the presence of trade-offs or weighting imbalances across pillars.
While ESG ratings are designed to provide a holistic view of corporate sustainability, they often obscure the trade-offs or biases that may exist among their components. Firms may score well overall despite underperforming in one or more dimensions. This is particularly relevant in the energy sector, where high environmental externalities may be offset in scoring models by stronger governance or social initiatives. That result in the development of above hypothesis
This hypothesis is grounded in the critique that many ESG ratings lack transparency and are constructed using arbitrary weights, which can result in distorted reflections of true sustainability performance.
Hypothesis 2 (H2):
Governance-biased ESG performance is associated with firm-level risk.
Governance represents a critical pillar within ESG, particularly in contexts where regulatory frameworks are weak or inconsistently enforced. Strong corporate governance can enhance risk management practices, ensure compliance, and foster investor confidence. Thus, even when environmental and social scores are moderate, high governance performance may independently mitigate several types of financial risk.
  • Impact on systematic risk (Beta).
Systematic risk refers to the market-related risk that cannot be diversified away. Firms with better governance structures are more likely to implement sound strategic decisions, maintain regulatory compliance, and reduce exposure to market shocks.
H2a: 
Governance-biased ESG performance is negatively associated with systematic risk (beta), indicating that firms with stronger governance are less sensitive to market-wide fluctuations.
This relationship is especially relevant in the energy sector, where geopolitical factors and regulatory transitions toward clean energy influence market volatility.
  • Impact on stock price volatility (firm-specific risk).
Effective governance enhances operational transparency, reduces information asymmetry, and improves investor perception. This tends to lower speculative trading and firm-specific uncertainties.
H2b: 
Governance-biased ESG performance is negatively associated with stock price volatility, suggesting that firms with stronger governance exhibit more stable stock performance.
Lower volatility reflects the market’s perception of such firms as being less prone to internal disruptions and adverse news.
  • Impact on unsystematic risk (variance).
Unsystematic risk captures firm-specific fluctuations unrelated to broader market movements. These risks are typically driven by management practices, internal controls, and ethical standards, all of which are governance-related factors.
H2c: 
Governance-biased ESG performance is negatively associated with unsystematic risk (as measured by variance), indicating that robust governance reduces idiosyncratic risk exposure.
This implies that well-governed firms in high-risk sectors may still maintain operational resilience even in volatile environments.
  • Impact on cost of capital (WACC).
Investors often demand higher returns to compensate for risk. Firms that demonstrate strong governance may be perceived as more trustworthy and less exposed to scandals or financial mismanagement, thereby lowering the cost of both equity and debt financing.
H2d: 
Governance-biased ESG performance is negatively associated with the cost of capital (WACC), reflecting investor perceptions of reduced overall risk and improved financial integrity.
Lower WACC enhances firm valuation and capital access, reinforcing the economic case for prioritizing governance in ESG strategies.
All the above given literature and hypothesis are consolidated in the following Table 1 and Figure 1. It outlines the key construct of the research, theoretical rationale supporting each hypothesis, and expected relationship based on the literature.

3. Research Methodology

The evaluation of ESG scores represents a critical aspect of sustainable performance. To evaluate the companies’ contribution to sustainable development, ESG data were obtained from the Refinitiv database spanning the years 2012 to 2023, as during this time frame, comprehensive ESG data are available for Indian firms due to mandated CSR policies. Market risk data were gathered from CMIE Prowess IQ.
India, the world’s third-biggest electricity generator and the largest in South Asia, exemplifies the vast energy potential of developing countries [54]. At the same time, Southeast Asia has experienced tremendous expansion, accounting for 11% of global energy demand since 2010, with forecasts suggesting it will account for more than 25% by 2035 [55]. These patterns make India’s energy sector a good sample to study emerging economy energy systems, especially those balancing growth and sustainability. Thus, this study chose the energy sector of India, comprising 33 firms in the power and mining sectors. To ensure data integrity, firms with missing ESG data for two consecutive years were systematically excluded from the analysis, resulting in a final sample size of 28 firms. Subsequently, statistical analysis was conducted utilizing the Kruskal–Wallis test and the Dynamic System GMM Model. The Kruskal–Wallis test, as a non-parametric test, is suitable for comparing multiple groups with violated assumptions of normality to ascertain whether significant differences exist in ESG scores among the sampled energy sector firms. In the event of statistically significant results from the Kruskal–Wallis test, Tukey’s post hoc test was employed to identify specific pairwise differences in ESG scores, thereby providing deeper insights into the nuances of ESG performance within the energy sector. The dynamic System GMM model was utilized due to the dynamic nature of regulatory changes and market risk. Further, this model also reduces the impact of endogeneity.
The study uses four key dependent variables to capture different dimensions of firm-level risk: Beta (systematic market risk), stock volatility (idiosyncratic risk), variance (unsystematic risk), and WACC (weighted average cost of capital, reflecting the firm’s overall cost of financing). Description of these variables is given in the Table 2. The independent variables include the composite ESG score and its three disaggregated components: environmental (E), social (S), and governance (G) scores, sourced from the Refinitiv ESG database. To control for firm characteristics, we include market capitalization (firm size) and leverage ratio (financial risk). Additionally, lagged values of each dependent variable are incorporated into the GMM model to account for dynamic effects and persistence over time.

4. Results

The results given in Table 3 highlight significant disparities in the ESG scores of firms within the energy sector. The mean combined score of 41.81 reflects a low level of performance as it is even below the 50% of scores, hence questioning their sustainable performance. While examining the individual components of the ESG score, it becomes apparent that governance practices receive considerably higher ratings compared to environmental and social initiatives. The mean governance score of 73.267 suggests that these firms have relatively robust governance structures and practices in place. However, the mean environmental score of 25.146 and the mean social score of 24.655 are substantially lower, indicating shortcomings in addressing environmental and social issues.
The Tukey post hoc test results provide insight into the disparities between the environmental (E) and social (S) scores within the energy sector firms, reinforcing the ideology that environmental and social scores are lower than governance scores, thus indicating an imbalance in defining sustainability. The test reveals significant differences between each pair of variables, i.e., G vs E scores (p = 0.0012), and G vs S scores (p = 0.0430). Mean differences in scores highlight substantial gaps between the governance and environmental (53.696) and governance and social (49.137) aspects. The wide confidence intervals further emphasize the magnitude of these differences, calling for a more balanced approach to sustainability.
As indicated in Table 3 and Table 4, the elevated governance scores are due to the rigorous regulatory framework of governance in Indian corporations, especially following numerous corporate scandals, which has inherently elevated governance standards across multiple sectors. The Listing Agreement and the Companies Act of 2013 enforce strict regulations on governance structure and practices, enhancing the governance scores. Some part of the E and S scores can be justified by the mandatory 2% contribution towards the socially responsible activities under the Companies Act of 2013.
The governance regulation standards in India tend to inflate the governance indexes owing to compliance as shown in Table 5, resulting in appearance of superior ESG compliance. However, this results in either accidental or purposeful greenwashing, where higher governance scores hide insufficient environmental and social factors. These firms use these inflated scores to brand themselves as committed to ESG internationally while obscuring endemic failures in addressing India’s climate and social challenges. This imbalance elevates governance measures over actual initiatives in “E” and “S”, which compromise the multifaceted value of the ESG framework. Sustainability, therefore, requires that structure to be equally placed in the environmental and social context and in a country that is struggling to deal with these problems.
Table 6 reveals a troubling inconsistency in how ESG components influence risk parameters. When ESG is considered as a composite variable, it exhibits a significant relationship with risk indicators such as beta (p = 0.007), stock volatility (p = 0.051), and WACC (p = 0.000); our results corroborate those of [44], showing that the higher the ESG score, the lesser the market risk. However, when analyzed individually, the environmental, social, and governance (E, S, and G) components fail to show consistent significance, with p-values far exceeding standard thresholds (e.g., environment: p = 0.675 for beta; governance: p = 0.622 for volatility).
The results indicate a statistically insignificant relationship between the environmental and social factors of ESG and key financial risk indicators. Beta (systematic risk), volatility (stock price swings), and variance (unsystematic risk) failed to show statistically significant associations with environmental and social scores. This indicates that companies may not be adequately mitigating these risk factors. Moreover, the weighted average cost of capital (WACC) had no substantial relationship with environmental and social measures, suggesting that investors may not be sufficiently integrating these risks into their pricing frameworks. This disconnect highlights the potential for underperformance in environmental and social areas to remain obscured, particularly when strong governance scores dominate ESG assessments. Such an imbalance may lead to misinformed investment decisions and heightened financial vulnerability over the long term.

5. Discussion

This study develops the core concept of sustainability in ESG performance by dissecting and studying the interaction of ESG, sustainable performance, and market risk, providing insights for investors and companies into their socio-environmental priorities. It methodically studies the apparent gaps in ESG scoring and delivers a potent critique of how, despite widespread adoption, bundled ESG metrics can fail to capture the nuances that are essential [60] and can simultaneously serve as a driver of the fashionable but unfair concept of greenwashing.
Combined ESG scores have also been taken up as a shorthand for assessing a company’s overall sustainability performance. Yet, the results of this study show that such a composite measure is misleading for measuring sustainable development [9]. The energy sector’s ESG performance is relatively good, with a mean combined score of 41.81 in emerging nations [12]. But the disaggregation of these scores reveals an even more troubling reality. The implication is that although firms may stick to the governance rules, they neglect environmental and social imperatives at the same time (Table 3), or that these companies work only if things are mandated for them. The kind of governance practices might be largely strong, but what comes under its roof is not. The ESG smokescreen hides all these deficiencies. In addition, this masking effect not only misrepresents how firms are truly doing on sustainability [11] but also propagates a sense of progress in achieving the Sustainable Development Goals (SDGs) that is not true.
The study rightly acknowledges the source of the elevated governance scores as India’s strict regulatory framework, which has turned into an emblem of corporate compliance after corporate scandals. Initiatives such as the Listing Agreement Clause 49 and the Companies Act 2013 have consequently brought about severity through board independence, openness regarding remuneration, and improved shareholder rights. These regulations have no doubt improved governance standards, but at the same time, have inadvertently exacerbated the “default elevation” phenomenon of hiding the intentions of corporates. A conservative default elevation of the governance component of ESG scores inflates the governance part of the ESG scores, making it appear more complete based on apparent and incomplete environmental and social domains. It is here that the responsible actions become stark: Is this intentional, or is it a tradeoff of regulatory asymmetry where firms are leveraging governance compliance to paint an ESG-friendly image? Ultimately, both are bad, as they weaken the perceived trustworthiness of ESG as a metric and prolong systemically inefficient means of resolving India’s critical environmental and social problems.
Adding another aspect of sustainability is economic stability; the study considers the relationship between sustainable performance with market risk. This initial result suggests a significant relationship between combined ESG and G scores with risk indicators, including beta, stock volatility, and weighted average cost of capital (WACC) [11,48], lending support to the proposition that ESG performance is positively related to financial stability [18,19]. However, the disaggregated analysis dismantles this narrative. Combined ESG scores test statistically significant, but many E and S components do not drive systematic market risk. This inconsistency exposes a troubling reality: as governance scores skew the combined ESG metric higher than it really should, this causes a firm to appear more stable than it should.
A biased ESG score can lead investors to underestimate the true risk profile of the firm, leading to inefficient resource allocation or over-investing in risky companies [33]. Also, companies that inadequately handle environmental and social risks, despite robust governance or elevated aggregated ESG scores, may incur significant long-term risks, including regulatory penalties, reputational harm, or operational issues. When these risks come to fruition, they have the potential to drive up the cost of capital as lenders and investors seek greater returns to offset the uncertainty. Over time, this misallocation can contribute to greater financial volatility, as markets react to unexpected issues that were not apparent from the aggregated score [19]. Therefore, it is crucial for investors and analysts to look beyond the overall ESG rating and assess each component individually to make informed decisions.
In the South African context, Ref. [61] found that high ESG portfolios outperform low ESG portfolios, particularly during market downturns. They noted that governance has a disproportionately larger impact on performance and risk reduction. This supports the observation that governance-biased ESG scores may create a smokescreen effect, attracting investors by reducing perceived risk while failing to adequately reflect environmental or social vulnerabilities. Also, globally, regulatory frameworks like the EU Sustainable Finance Disclosure Regulation (SFDR) seek to rectify these disparities by mandating transparency and standardization in ESG reporting. However, as indicated by [52], discrepancies in reporting harmonization and resource imbalances between large and small enterprises persistently skew ESG evaluations.
This can also be supported by the 2015 Volkswagen emissions scandal. The company portrayed itself as a leader in environmental innovation while secretly installing software in diesel vehicles to manipulate emissions data. This misrepresentation elevated its ESG ratings, misleading investors and ultimately resulting in significant reputational and financial damage [62]. This case underscores the importance of evaluating each ESG component individually, as overreliance on aggregated scores can obscure underperformance in other areas.
Hence, the study discusses a challenge to the very thing that defines sustainability philosophically. On one side, the vision of sustainability in global frameworks, such as the SDGs, is inherently multidimensional and equally relies on each domain of ESG. Hence, to validate the relevance of ESG scores to sustainability, it should be customized according to the nature of the business and its impact on the environment and society [25,63] so the reductionist approach of governance over environmental and social efforts can be avoided, as it does not lead to any relevant impact. Instead, it poses a moral quandary: how can it be said that a firm is truly sustainable when its governance exceeds indicators but does nothing about the existential threats of climate change and social inequality? The energy sector has an extra responsibility to correct this imbalance because of its significant impact on both the environment and society. Nevertheless, the findings of this study suggest that ESG scores fall short in maintaining a narrative of sustainability and mitigating corporate risks. Additionally, responsible investors ought to take into account the individual scores when evaluating companies, regardless of their overall combined scores.

6. Conclusions and Implications

This research’s findings call for a fundamental shift in how sustainability is conceptualized, measured, and operationalized—particularly within the energy sector. True sustainability must transcend mere compliance with governance frameworks and instead reflect a deeper commitment to environmental stewardship and social equity. The empirical analysis revealed a disproportionate emphasis on governance (G) over environmental (E) and social (S) dimensions in ESG scoring. Governance scores showed a statistically significant association with reduced financial risk—specifically, systematic risk, stock volatility, and cost of capital, whereas environmental and social scores did not reveal significant relationships with these metrics.
This disparity indicates that companies might be deliberately utilizing strong governance indicators to convey a façade of sustainability, possibly concealing deficiencies in environmental and social performance. Such techniques raise concerns about greenwashing and superficial compliance, particularly in areas essential to climate change and equitable societies. Consequently, contributions to essential Sustainable Development Goals (SDGs), such as Affordable and Clean Energy (SDG 7), Climate Action (SDG 13), and Reduced Inequalities (SDG 10), are constrained.

6.1. Theoretical Implications

6.1.1. Agency Theory

The theoretical contribution of our study is inspired by the study of Mao et al. [64], as in their study, they applied fractal theory; similarly, through our study, we tried to contribute to the theoretical development of Agency Theory by extending its traditional focus on shareholder wealth maximization to include broader stakeholder concerns through the lens of ESG practices, whereas classical Agency Theory considers that managers, as agents of shareholders, should not allocate company resources for philanthropic or non-financial purposes. Also, modern corporate realities reveal that managers also act as agents of stakeholders, including employees, communities, and regulators. This dual agency role introduces potential conflicts of interest, especially when stakeholder expectations diverge from short-term profit goals [65].
This study supports the broadened perspective of agency theory by integrating broader stakeholder interests such as investments in sustainable technologies, ethical labor practices, and strong governance structures, which—though potentially costly in the short term—can lead to long-term value creation and risk mitigation for both managers and shareholders. This theoretical extension suggests that aligning shareholders’ value creation and risk mitigation with ESG outcomes can mitigate agency conflicts and promote responsible corporate behavior. Thus, Agency Theory can be reinterpreted to support sustainability-oriented mechanisms, reinforcing the importance of ethical leadership and accountability in achieving holistic outcomes.

6.1.2. Legitimacy Theory

This study advances Legitimacy Theory by demonstrating how firms may strategically leverage governance compliance to maintain external legitimacy while concealing shortcomings (environmental and social performance). Legitimacy Theory suggests that organizations seek to align their operations with societal norms and expectations to secure ongoing support and acceptance [31]. The findings reveal that companies, particularly in emerging economies, may create a “smokescreen effect” through what can be described as a default elevation of governance scores—driven by regulatory mandates—which inflates overall ESG ratings and presents a misleading image of sustainability.
This symbolic compliance undermines both the credibility of ESG metrics and the foundational assumptions of Legitimacy Theory, as it displays an appearance of compliance with societal standards rather than a genuine commitment to sustainable development. The study suggests that firms may be exploiting governance frameworks not to drive genuine ESG integration, but to legitimize themselves by constructing a façade of responsibility. Theoretical insight advances this study by highlighting the risk of uneven regulations, where firms are satisfying formal legitimacy criteria by adhering to the underlying principles. Hence, this research underscores the need for more balanced, transparent, and integrated ESG assessment frameworks that reflect authentic organizational accountability and commitment to long-term sustainability.

6.2. Practical Implications

The findings of this study carry important implications for various stakeholders, such as policymakers and regulators, who must prioritize strengthening ESG reporting frameworks by enforcing standardized disclosures and mandating independent third-party audits, especially in sectors like non-renewable energy, where the risk of greenwashing is high. Investors, too, need to adopt a more critical lens—moving beyond accumulated ESG ratings to assess the actual environmental and social impact of corporate practices. This is crucial for identifying transition risks and safeguarding long-term returns. Corporations must shift from symbolic sustainability gestures to embedding ESG principles into their strategic and operational core. A balanced focus on environmental, social, and governance dimensions not only helps mitigate reputational and regulatory risks but also builds trust with stakeholders and contributes meaningfully to global sustainability goals.
At the same time, academia and researchers are encouraged to delve deeper into the authenticity and effectiveness of ESG practices, particularly in emerging markets where the gap between an ESG-created responsible image and reality may be different. This opens up new avenues for comparative studies and sector-specific analyses. Finally, society and consumers play a pivotal role in driving corporate accountability. As public awareness grows, so does the power of consumer choice and scrutiny—especially in essential sectors where alternatives may be limited. By demanding transparency and ethical conduct, consumers can influence companies to adopt more responsible and sustainable practices. In essence, sustainability must evolve from a compliance-driven exercise to a shared ethical commitment—one that is measurable, credible, and capable of shaping a resilient and equitable future.

Author Contributions

M.K.M.: Formal analysis, Writing—original draft; B.A.B.: Methodology, Writing—review and editing; M.S.: Data curation, Resources; F.M.: Supervision and revision. All authors have read and agreed to the published version of the manuscript.

Funding

This research was funded by Princess Nourah bint Abdulrahman University Researchers Supporting Project number (PNURSP2025R260), Princess Nourah bint Abdulrahman University, Riyadh, Saudi Arabia.

Institutional Review Board Statement

Not applicable.

Informed Consent Statement

Not applicable.

Data Availability Statement

Data are contained within the article.

Acknowledgments

This research was funded by Princess Nourah bint Abdulrahman University Researchers Supporting Project number (PNURSP2025R260), Princess Nourah bint Abdulrahman University, Riyadh, Saudi Arabia.

Conflicts of Interest

The authors declare no conflict of interest.

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Sustainability 17 07539 g001
Figure 1. Research framework. Source: Authors. Note: The analysis begins with the composite ESG score, which is disaggregated into its environmental, social, and governance pillars to test for disproportionate representation (H1). The results indicating a governance bias form the basis for subsequent hypotheses (H2a–H2d), linking governance-driven ESG performance to reductions in systematic and unsystematic risk, stock price volatility, and the cost of capital.
Figure 1. Research framework. Source: Authors. Note: The analysis begins with the composite ESG score, which is disaggregated into its environmental, social, and governance pillars to test for disproportionate representation (H1). The results indicating a governance bias form the basis for subsequent hypotheses (H2a–H2d), linking governance-driven ESG performance to reductions in systematic and unsystematic risk, stock price volatility, and the cost of capital.
Sustainability 17 07539 g001
Table 1. Hypothesis and research rationale.
Table 1. Hypothesis and research rationale.
HypothesisConstructsExpected RelationshipRationale
H1Composite ESG Score vs. ESG Dimensions (E, S, G)Unequal representation/trade-offs among dimensionsESG ratings often use arbitrary weights; high scores may mask underperformance in one or more pillars, especially in emission-heavy sectors like energy [41,49].
H2aGovernance-biased ESG Performance vs. Systematic Risk (Beta)Negative associationStrong governance improves strategic decisions and compliance, reducing firms’ exposure to broad market shocks [53].
H2bGovernance-biased ESG Performance vs. Stock Price VolatilityNegative associationEnhanced transparency and ethical management lower firm-specific uncertainties, leading to more stable stock behavior [42].
H2cGovernance-biased ESG Performance vs. Unsystematic Risk (Variance)Negative associationGood governance reduces operational and managerial risks, resulting in more predictable firm-specific outcomes [48].
H2dGovernance-biased ESG Performance vs. Cost of Capital (WACC)Negative associationInvestors perceive well-governed firms as lower risk and reduce required returns on capital [48,53].
Source: Authors.
Table 2. Description of variables.
Table 2. Description of variables.
CategoryVariable NameLabel in ResultDescription
Dependent Variables (Risk Indicators)BetaBETA,Measures systematic risk (market risk). Calculated using regression of stock returns on market returns. Beta-1 is the lagged beta in the dynamic GMM model.
Stock VolatilityVolatilityStandard deviation of daily stock returns. Proxy for idiosyncratic (firm-specific) risk. Volatility-1 is the lagged volatility.
VarianceVarUnsystematic risk derived from return residuals (total risk–market risk). Var-1 is the lagged variance.
Cost of CapitalWACCWeighted average cost of capital (WACC), representing the overall risk premium required by debt and equity investors. WACC-1 is the lagged value.
Source: Authors.
Table 3. Descriptive statistics.
Table 3. Descriptive statistics.
VariablesObs.MeanMedianStd.Rank Sum
ESG combined28041.8154541.4423213.7666
Env scores28025.14620.77929.3453159,643
Socio scores28024.65514.765112.868203,102
Gov scores28073.26613.445613.243431,685
Chi-squares 768.120
Chi-squared with ties768.632
Probability0.0001
Source: Authors.
Table 4. Tukey test (post hoc test).
Table 4. Tukey test (post hoc test).
Tukey95%
VariablesContrastStd. ErtpConfidence Interval
S vs. E scores4.55831.15553.940.00011.846767
G vs. E scores53.69551.15546.470.001250.98396
G vs. S scores49.1371.155542.520.043046.42561
Source: Authors’.
Table 5. Mandated regulatory framework and default scores.
Table 5. Mandated regulatory framework and default scores.
CategoryAspects of GovernanceRegulationDescription of Regulatory RequirementFollowing CompliancesImplication on Refinitiv Governance Score
Board CompositionBoard IndependenceClause 49 Listing AgreementMinimum 50% independent directors are requiredThere are 51.47% independent directors at 50 companies as per Institutional Advisory Services Report 2023 [56]Higher independence on board leads to higher governance score
Risk Management Board Disclosure SEBI (LODR) RegulationsProper framework for risk management and disclosure to board of directors 9% companies are following risk requirements up to global standards, 49% are at global standards, 31% are up to satisfactory level [57]Organizations with robust risk management framework and disclosure have higher governance scores
Remuneration CommitteeExecutive-Remuneration Clause 49 Listing AgreementA remuneration committee, comprising at least three non-executive directors and chaired by an independent director, is crucial for setting fair and transparent executive pay. Requires percentage of remuneration from profitAs profitability of the company increases, remuneration of directors also grows [58]Fair and transparent remuneration enhances governance score
Shareholders rights Voting Rights Companies Act 2013Every shareholder possesses voting rights by all means, including e-voting and voting by poll In light of Companies Act 2013, shareholder activism has increased in India [59]Improvement in shareholder rights leads to better governance score
Audit Practices Audit Committee CompositionClause 49 Listing AgreementNon-executive chairman of audit committee and 50% independent directors Structured audit committee and transparency in financial reports enhance governance score
Source: Authors.
Table 6. ESG performance and risk.
Table 6. ESG performance and risk.
Dependent VariableIndependent VariableCoefficientStandard Errorp Value
BETABeta-11.00460.05520.011
ESG−1.04100.18960.007
Environment−0.74830.76860.675
Social−1.64960.08230.081
Governance−1.15920.79350.043
Market CAP6.76650.02930.000
Leverage−0.11460.97790.004
Constant1.23011.77860.976
No. of Obs.280
F-statistics0.755
Groups /instruments28/252
AR(2)0.658
Hansen statistics0.703
Stock VolatilityVolatility-11.55560.0001300.933
ESG−1.5900091.9254120.051
Environment−0.9712062.7936100.332
Social−1.3122112.5780090.092
Governance−1.4143061.3500140.022
Market CAP−0.6543531.4876090.062
Leverage 2.7656430.1565080.004
Constant1.0061662.0076540.542
No. of Obs.280
F-Statistics0.962
Groups/Instruments28/252
AR(2)0.596
Hansen Statistics0.768
VarVar-10.231430.4532130.066
ESG−0.07177681.0045740.021
Environment−6.3123060.7763420.132
Social−1.0000030.0123470.233
Governance−0.04151090.4456320.045
Market CAP−0.01075841.0046730.977
Leverage4.150092.9754330.802
Constant−0.00216192.9554470.099
No. of Obs.280
F-Statistics0.601
Groups/Instruments28/252
AR(2)0.661
Hansen Statistics0.825
Cost of capital (WACC)WACC-11.003424 0.021
ESG−1.0000031.1206010.000
Environment−6.3123061.1006320.672
Social0.00177681.1212430.066
Governance0.00175914.9608330.007
Market CAP−1.5201096.6209200.909
Leverage−1.0611063.2109240.801
Constant0.00456432.0026240.699
No. of Obs.280
F-Statistics0.597
Groups/Instruments28/252
AR(2)0.696
Hansen Statistics0.988
Source: Authors.
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Makkar, M.K.; Bhat, B.A.; Showkat, M.; Mabrouk, F. The ESG Paradox: Risk, Sustainability, and the Smokescreen Effect. Sustainability 2025, 17, 7539. https://doi.org/10.3390/su17167539

AMA Style

Makkar MK, Bhat BA, Showkat M, Mabrouk F. The ESG Paradox: Risk, Sustainability, and the Smokescreen Effect. Sustainability. 2025; 17(16):7539. https://doi.org/10.3390/su17167539

Chicago/Turabian Style

Makkar, Manpreet Kaur, Basit Ali Bhat, Mohsin Showkat, and Fatma Mabrouk. 2025. "The ESG Paradox: Risk, Sustainability, and the Smokescreen Effect" Sustainability 17, no. 16: 7539. https://doi.org/10.3390/su17167539

APA Style

Makkar, M. K., Bhat, B. A., Showkat, M., & Mabrouk, F. (2025). The ESG Paradox: Risk, Sustainability, and the Smokescreen Effect. Sustainability, 17(16), 7539. https://doi.org/10.3390/su17167539

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