Evidencing Financial Materiality of Sovereign ESG Risk

Abstract

Empirical studies on ESG-related topics have focused mainly on equity markets. This article focuses on the financial materiality of ESG risk assessment for sovereign debt instruments. The authors first review the existing literature on sovereign ESG and transmission channels to sovereign risk. Using an econometric framework, they then examine the empirical correlation between ESG risk and credit risk for 70 sovereign issuers. They use sovereign ESG risk scores from FTSE Russell/Beyond Ratings as a proxy for ESG risk, and five-year credit default swap spreads as a proxy for sovereign credit risk. By controlling for economic factors, the authors find that sovereign ESG risk assessments are correlated with sovereign credit risk, providing information on the financial materiality of sovereign ESG risks, especially for high-yield emerging markets. They then calculate the implied sovereign five-year CDS spread curves, based on sovereign ESG risk scores, to illustrate those results. The authors also examine more-granular results for specific income groups and index universes.