When ESG meets AAA: The effect of ESG rating changes on stock returns

•ESG rating changes impact on stock returns is studied via calendar-time portfolios.•Upgrades lead to modest positive returns, downgrades depress returns significantly.•ESG leaders outperform laggards, though abnormal returns are relatively small.•ESG rating effects are robust in various specifications and asset-pricing models.•Upgrades boost returns substantially after the start of the COVID-19 pandemic. This study is the first to employ calendar-time portfolio methodology to investigate the impact of 748 ESG rating changes on stock returns of US firms over 2016–2021. While ESG rating upgrades lead to positive yet inconsistently significant abnormal returns of 0.5% per month, downgrades are detrimental to stock performance, leading to statistically significant monthly risk-adjusted returns of -1.2% on average. These findings are more pronounced for ESG leaders than laggards and are robust to various asset-pricing model specifications. The effects of ESG rating levels are modest, with ESG laggards underperforming in risk-adjusted terms.