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ESG Ratings and Their Disagreements

ESG Momentum Scores: Investing in ESG Improvers

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What Is ESG Momentum and Why Does It Matter for Investors?

ESG momentum refers to the rate of change in a company's ESG scores over time — whether a company is improving or deteriorating in its ESG management relative to prior periods or relative to peers. Unlike static ESG levels (which measure current ESG quality), ESG momentum captures ESG trajectory. The investment case for ESG momentum is that markets may undervalue companies that are improving their ESG profile, particularly when the improvement signals operational quality improvements that will eventually translate to better financial performance. ESG momentum also avoids the best-in-class problem of always owning already-highly-rated companies that may have less room for further improvement.

Quick definition: ESG momentum is the change in a company's ESG score or ESG quality over a defined lookback period (typically 1–3 years). Positive ESG momentum (improving scores) is used by some investors as a positive investment signal; negative ESG momentum (deteriorating scores) as a negative signal. ESG momentum is distinct from ESG level — a company can have high ESG momentum from a low starting point.

Key takeaways​

  • ESG momentum investing selects or tilts toward companies with improving ESG profiles rather than (or in addition to) companies with the currently highest ESG scores.
  • The investment thesis for ESG momentum is based on both a fundamental argument (improving ESG signals operational quality improvement) and a market dynamics argument (ESG improvers are repriced upward as their improvement is recognized by more investors).
  • Academic evidence for ESG momentum as a standalone return factor is mixed; the signal is more robust in specific markets and time periods than universally.
  • ESG momentum strategies face the gaming problem: companies that know their scores are measured annually may improve questionnaire responses or adopt policies specifically to generate positive momentum, without underlying operational improvement.
  • Truvalue Labs (now part of FactSet) pioneered ESG momentum scoring using NLP-based continuous assessment; MSCI and other providers have developed their own ESG trajectory signals.

The ESG Momentum Investment Thesis​

The case for using ESG momentum as an investment signal rests on several arguments:

Operational quality signal: Companies that consistently improve their ESG practices — reducing accident rates, improving supply chain standards, strengthening governance — are typically organizations with improving management quality and operational execution. ESG improvement may proxy for management quality improvement that is difficult to directly observe in financial metrics.

Repricing opportunity: If markets tend to recognize ESG quality with a lag — pricing in ESG improvements only after they become clearly visible in formal ESG scores — then companies with recent ESG improvement may be underpriced relative to their improving quality. This is the same logic as financial quality momentum factors.

Transition investing: Companies in the process of transitioning from high-ESG-risk profiles (high-carbon, governance-challenged, labor-practice-weak) to improved ESG profiles may offer the best risk-adjusted returns, since their current prices may reflect their current (weak) ESG quality rather than their improving trajectory.

Avoidance of fully-priced ESG leaders: Companies with the highest static ESG scores may already have their ESG quality priced in — with lower expected returns from further ESG improvement. ESG improvers may offer better marginal return to ESG quality improvement.

ESG Momentum Signal Construction​

Several approaches to constructing ESG momentum signals:

Annual score change: The simplest approach — the change in aggregate ESG score from one year to the next. Positive change = positive momentum; negative change = negative momentum. Limitations: annual scores are updated infrequently; measurement volatility can produce spurious signals; score changes can reflect methodology changes rather than company behavior changes.

Multi-year trend: Using a 2–3 year trend in ESG scores smooths annual noise and captures more persistent improvement. A company whose ESG score has increased by 10% per year for 3 consecutive years has stronger momentum signal than one that improved by 30% in year 1 and then was flat.

NLP-based continuous momentum: Truvalue Labs' approach (now FactSet Truvalue Labs) uses NLP to assess ESG-relevant news and data points on a continuous basis, producing signals that update more frequently than annual ESG scores. This continuous assessment captures ESG trajectory between annual disclosure cycles.

Controversy-adjusted momentum: Calculating ESG momentum from controversy-adjusted scores (ESGC in Refinitiv's framework) rather than base scores ensures that apparent improvement is not masked by deteriorating controversy records.

ESG momentum signal types​

Academic Evidence on ESG Momentum​

The academic evidence on ESG momentum as an investment factor is more equivocal than for static ESG factors:

Positive findings: Several studies (including Borgers et al., 2015; Lins et al., 2017) have found that ESG improving companies generate positive abnormal returns, particularly in the 1–3 year horizon following score improvements. The repricing mechanism — markets updating valuations as ESG improvement is recognized — has been documented in some market environments.

Mixed findings: The signal is not consistent across markets, time periods, or ESG providers. The 2020–2022 period saw high-ESG-momentum clean energy companies significantly outperform followed by sharp correction — suggesting that ESG momentum exposure can create valuation risk as much as return opportunity.

Gaming concerns: If companies that are improving their questionnaire responses (without underlying operational improvement) show "positive ESG momentum," the signal may not predict financial outperformance associated with genuine operational improvement. Distinguishing real improvement from questionnaire optimization in momentum signals is difficult.

ESG Momentum vs. ESG Level in Portfolio Construction​

These two signals can be combined or used independently:

Level only: Hold companies with highest current ESG scores. Risk: fully priced-in ESG quality; no upside from improvement.

Momentum only: Hold companies with fastest ESG score improvement. Risk: may hold companies with improving questionnaire performance but still-poor actual ESG quality.

Level + momentum: Require minimum ESG quality level (filtering out genuinely poor ESG performers) plus positive momentum (tilting toward the improvers within the qualifying universe). This combination captures quality floor with improvement signal.

Transition focus: Specifically seek companies transitioning from poor to adequate ESG quality — potentially offering the most repricing upside but requiring comfort with currently low absolute ESG scores.

Real-world examples​

ESG integration of ESG improvers at major asset managers: Several large active ESG managers, including Impax and Nordea Asset Management, have described incorporating ESG trajectory alongside ESG level in their stock selection — giving credit to companies demonstrating genuine improvement in sustainability management alongside absolute score assessments.

FactSet Truvalue Labs ESG Pulse: The Truvalue Labs ESG Pulse signal, based on continuous NLP assessment, has been used by asset managers to build ESG momentum factors in quantitative equity strategies. Studies of the signal's performance have generally found positive but period-dependent return predictability.

Climate transition ESG momentum: The energy transition created a specific ESG momentum opportunity in 2020–2021 as traditional energy companies announced net-zero commitments and transition strategies — generating positive ESG momentum signals and positive financial performance simultaneously. The subsequent commodity price cycle (2022) partially reversed these gains, demonstrating the interaction between ESG momentum and sector-level commodity dynamics.

Common mistakes​

Confusing ESG momentum with financial momentum: Financial price momentum (buying securities with recent strong price appreciation) is a well-documented factor in equity markets. ESG momentum (buying securities with improving ESG scores) is different — it is based on improving fundamental quality signals, not price signals. The two strategies are not equivalent and should not be conflated.

Ignoring the lag between ESG improvement and financial market recognition: The repricing mechanism for ESG improvement may take 2–3 years to materialize. Short-horizon strategies (1-year holding periods) may miss the repricing window; long-horizon strategies (3–5 years) may capture more of it.

Over-relying on annual score change as momentum: Annual ESG score changes are noisy. A company that improved its score by 5 points from year 1 to year 2 due to a methodology change by the rating agency has not demonstrated genuine ESG momentum. Cleaning ESG momentum signals for methodology-driven score changes is important for signal validity.

FAQ​

Is ESG momentum a separate factor from traditional financial factors?​

ESG momentum has some correlation with traditional quality momentum factors — companies with improving fundamentals often show both financial and ESG improvement. The pure ESG-specific component of ESG momentum (beyond what is explained by financial factors) is smaller than the gross ESG momentum signal. Disentangling the two requires factor attribution analysis.

Do ESG momentum funds have different characteristics from ESG level funds?​

Yes — ESG momentum funds tend to have higher active share, more frequent turnover (as momentum signals are more dynamic than level scores), more exposure to transitioning companies with currently imperfect ESG scores, and potentially more exposure to sectors where ESG improvement is most active (energy transition, supply chain improvement in consumer goods). They may be less "pure" ESG in a values sense — holding companies with improving but still-imperfect ESG profiles.

How does the gaming problem affect ESG momentum strategies?​

ESG momentum strategies are more vulnerable to questionnaire gaming than ESG level strategies. A company that improves its CSA questionnaire responses without operational improvement creates a positive momentum signal that is not backed by genuine improvement. Combining ESG momentum signals with controversy monitoring (looking for positive score movement without controversy deterioration) is one mitigation approach.

Are there index products tracking ESG momentum?​

Several index providers have developed ESG momentum variants — including MSCI ESG Momentum Tilt indices and similar products from other providers. These indices tilt portfolio weights toward holdings with improving ESG scores, combining ESG momentum signal with broad market exposure. AUM in ESG momentum products is smaller than in ESG level products.

How should investors balance ESG level and ESG momentum in portfolio construction?​

The appropriate balance depends on investment objectives. For values-aligned investors who want to hold only companies currently meeting ESG standards, ESG level is the primary criterion. For impact-oriented investors who want to accelerate ESG improvement, ESG momentum (investing in companies undergoing genuine ESG improvement) may be more directly aligned with impact objectives. For pure return-seeking ESG integration, combining level (quality floor) with momentum (improvement signal) within a financially-motivated framework may produce the best risk-adjusted outcomes.

Summary​

ESG momentum — the change in a company's ESG score over time — is used by some investors as a signal that companies are improving their ESG management quality, with expected repricing as the improvement is recognized by more investors. The investment thesis rests on both operational quality (ESG improvement proxies for management quality improvement) and market dynamics (improving companies are underpriced relative to their improving trajectory) arguments. Academic evidence for ESG momentum as a return predictor is positive but period-dependent and market-specific. Key risks include gaming of annual score updates, signal noise from methodology changes, and the valuation risk that ESG momentum exposure created during 2020–2021 for clean energy. Combining ESG level (quality floor) with ESG momentum (improvement signal) is more robust than either signal alone.

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