As the usefulness of ESG analytics is increasingly being focused upon across a vast array of financial markets, it’s useful to be aware how ESG performance data correlates with and influences international credit ratings. By way of introduction, the chart below compares the ESG performance of a range of countries with their sovereign credit ratings.

One thing is clear in this chart— the explanatory power of the line of best fit is on the low side which means the relationship between sovereign credit ratings and ESG performance data is far from clear. For example, Iceland and Saudi Arabia have comparable sovereign credit ratings and GDP, but Iceland has an ESG performance score roughly 150% higher than Saudi Arabia. As the chart above shows, these two countries are towards the best and worst in the analysis sample respectively in terms of ESG performance. The fact that these two very different countries have comparable sovereign credit ratings shows that ESG performance doesn’t strongly correlate with sovereign credit ratings, which is contrary to the lay of the land in the corporate world.

As the chart below shows, there’s only a 26% correlation between sovereign credit spreads and ESG performance:

Source: Data from Newton, Bloomberg, UN, WB, World Economic Forum, University of Notre Dame and Transparency International, June 2019

So the question is why is this the case? Surely environmental, social and governance factors are key inputs when assessing sovereign credit risk as they are in the corporate world?

Well, yes, but there’s more to it than that.

The answer lies in the importance of each of the environmental (E), social (S) and governance (G) factors when assessing a country’s ability to repay its short and mid-term debt, which is at the heart of assessing an international credit rating. Whilst they are generally considered in amalgamation, E, S and G issues are quite distinct from one another. For example, in terms of E factors, climate change presents varying degrees of hurricane risk for different regions, whilst countries which are heavily dependent upon agriculture are also heavily exposed to the changing climate. On the S side, education and income levels are key inputs, whilst in terms of G factors, respect for the rule of law is one of the main inputs. If you consider this short list of ESG input examples, the issues involved range from climate change, agriculture, education, and income to the rule of law — these are clearly distinct issues, albeit with some common drivers and connections. The key point to note here is that E, S and G inputs each create a world of useful analytic data in their own right which can be used to measure and mitigate against risk.

So coming back to sovereign risk, the next question to ask is how E, S and G inputs affect credit risk at a country level? Upon deeper analysis of these 3 types of data, it’s clear that social and governance performance data is far more financially relevant for credit markets than environmental data in the short and mid-term. For example, the S factors of income level and equality are often directly connected with the underlying economic strength of a country’s economy, so credit markets are right to focus on S issues. This explains why some Latin American countries such as Costa Rica, and African countries such as Ghana have weak ESG scores but strong credit ratings.

For example, the S factors of income level and equality are often directly connected with the underlying economic strength of a country’s economy, so credit markets are right to focus on S issues. This explains why some Latin American countries such as Costa Rica, and African countries such as Ghana have weak ESG scores but strong credit ratings.

And what about the environmental factors I hear the environmentally minded readers ask? Whilst environmental performance data on issues such as biodiversity and energy mix may not currently be focused upon by international credit markets given it’s not a good proxy for short term financial stability, it does serve a useful purpose when assessing how prepared each country is in the face of potential longer term challenges. For example, climate change is arguably the biggest long term environmental risk the world is currently facing, and it is likely to affect each country very differently depending upon how prepared they are for it. So focusing on E factors such as climate change exposure and preparation remains a highly relevant strategy for international credit investors even if they are not as directly connected with short term credit ratings.

Tying these findings together, in order for credit investors to gain a fully informed short, medium and long term picture of a country’s credit worthiness when investing in sovereign and sub-sovereign debt, the complementary use of credit ratings and ESG performance data is recommended. High quality ESG data adds significantly to the quality of the analysis.