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Pricing ESG risk in sovereign credit: an emerging divergence

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In 2019, the international business of Federated Hermes published part one of ‘Pricing ESG risk in sovereign credit’ and uncovered a robust correlation between environmental, social and governance (ESG) factors and sovereign credit spreads.

The study established an inverse relationship between national ESG scores and government-bond credit-default swap (CDS) spreads: on average, the countries with lower ESG scores have the widest CDS spreads, while those with the highest ESG scores have the tightest CDS spreads.

The link between ESG scores and CDS spreads remained even after controlling for risk that should be reflected in credit ratings, which suggests they do not entirely explain CDS spreads. The analysis also found that governance had the strongest, most consistent correlation with sovereign CDS spreads, while spreads do not seem to fully reflect environmental risks.

But the research triggered a range of follow-up queries from readers, particularly on whether our findings would hold up if we examined developed and emerging markets separately.

We applied the analytical techniques from our previous study and split the dataset into developed markets (DM) and emerging markets (EM). We found that:

  • Although the relationship between Beyond Ratings’ ESG scores and CDS spreads is statistically significant for both datasets, it is stronger for developed markets. The research suggests that other more urgent risks – such as economic and financial ones – exert a greater influence on CDS spreads in EM jurisdictions than ESG factors. This could be because some ESG risks are more gradual in nature and simply become dominated by pure credit risk in EMs. Nonetheless, we believe that the relative financial weakness of some EMs leaves them more vulnerable to deteriorating ESG factors, which translates directly into credit risk.
  • Even when comparing a country’s previous ESG performance to its current CDS spreads over several different time horizons, the relationship between CDS spreads and ESG factors is stable, which suggests a steady pricing relationship. The results of the regression analyses show that ESG factors are significant at the 1% level for DM countries but only at 5% for the EM group. On average, ESG factors have a more significant effect on DM sovereign credit spreads than for EM countries, and the highly significant relationship between ESG scores and CDS spreads documented in the original study is clearly driven mainly by DM countries. Yet despite this statistically weaker relationship, ESG scores do have an impact on EM credit spreads. We believe it is useful to include ESG factors in any analysis of EM sovereign risk, as ESG risk in EMs can quickly morph into credit risk that in turn can drive spreads higher as investors become concerned about defaults.
  • The strongest relationship between CDS spreads and ESG scores exists for the social and governance sub samples – particularly for DMs – while a less clear relationship is observed for EMs. As we know from first instalment of this paper, the first relationship between ESG strength and CDS spreads for DM sovereigns cannot be entirely explained by conventional credit risk. This reinforces the need to assess and price the longer-term risks associated with ESG factors before they translate into credit risks, which can be especially painful for countries with less financial resilience. While there is also an observable pattern for EMs, the relationship is nowhere near as stark – which is consistent with our earlier findings. The unconditional results for the E,S and G sub-samples also demonstrate that there is a strong relationship between CDS spreads and social and governance scores. The correlation between environmental scores and CDS spreads for both EMs and DMs is less compelling, which is generally consistent with the results of our original research.

Using the output from our regression analyses, we demonstrated a strong link between sovereign credit risk and ESG scores for DMs. We could not establish a similar meaningful implied CDS curve using selected EM data and there is clearly a divergence between the relative financial strength of DM and EM countries and the way they assess and price ESG risks.

Yet ESG risks can rapidly develop into material financial risks in EM countries. As a result, ESG analysis is increasingly important for investors in both DM and EM sovereign debt – perhaps even more so for EMs, given the risks are not yet priced into CDS spreads.

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