Empirical studies on environmental, social, and governance (ESG) related topics have focused mainly on equity markets. First published in the Journal of ESG and Impact Investing, Portfolio Management Research, this article focuses on the financial materiality of ESG risk assessment for sovereign debt instruments.
To begin, the authors 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 (CDS) 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. The authors then calculate the implied sovereign five-year CDS spread curves, based on sovereign ESG risk scores, to illustrate those results and examine the more-granular results for specific income groups and index universes.
What does this mean for investors:
- The countries with the lowest ESG risk show tight sovereign five-year CDS spreads, and vice versa
- The correlation of sovereign ESG risk assessments with sovereign credit risk provides insightful information on the financial materiality of sovereign ESG risks
- The financial materiality of sovereign ESG risk assessment is stronger for high-yield emerging markets
- The financial materiality of sovereign ESG risk assessment in emerging markets is generally stronger for aggregated ESG, governance, and social risk assessments
Points of differentiation:
- Detailed discussion on the financial materiality of ESG-related topics on the sovereign fixed income side. This information helps fill a void as existing literature is poor on this asset class, particularly amongst our competitive set
- Utilises our LSEG D&A / FTSE Sustainable Sovereign Risk Methodology (2SRM) data, which responds to increasing market maturity, customers' needs and the World Bank's recommendations
- Illustrates how the sovereign risk (i.e., sovereign 5Y CDS spreads) of constituents of the main FTSE flagship government bond index series behave according to E, S, G and aggregated ESG risks, while controlling for economic and financial factors
