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Laxman Pai, Opalesque Asia: Environmental, social and governance (ESG) factors have a more significant effect on sovereign credit spreads in developed markets than emerging ones, says a study.
A research by Federated Hermes said there is a significant correlation and a "meaningful" relationship exists between ESG factors and sovereign default swaps in both.
The Federated Hermes study conducted with Beyond Ratings, 'Pricing ESG risk in sovereign credit, part II', analyses five-year credit default swap (CDS) spreads and ESG scores from 28 developed markets (DM) countries and 31 emerging market (EM) countries during 2009-2018.
In 2019, Federated Hermes and Beyond Ratings published the first part of this study which assessed the correlation between ESG factors and sovereign credit spreads.
The results established an inverse relationship: 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. This research has progressed further to investigate which countries in the dataset are driving this relationship. That is why the second part of the study has been conducted, to show whether the relationship is principally driven by DMs or EMs.
The first stage of the new study looked at the relationship between ESG and CDS spreads unconditionally, without controlling for any effects that might influence the relationship.
The unconditional average CDS spread was assessed per quintile - data split into five equal groupings based on a country's ESG score. Apart from a small anomaly in the fourth quintile, the results show a clear observable relationship between ESG strength and CDS spreads for DM sovereigns.
Dr. Michael Viehs, Head of ESG Integration, at the international business of Federated Hermes, commented: "With this study, we have provided yet another piece of evidence that ESG factors can be considered as a risk management tool. Several key learnings also have important implications for other debt instruments, such as money market securities. It is nowadays imperative to also consider ESG factors in the investment process."
"ESG risks are at the heart of sovereign credit risk, and the finance industry is developing its understanding of how both developed and emerging markets are exposed to these risks," said Julien Moussavi, Ph.D., Head of Sustainable Investment Sovereign Research, Beyond Ratings.
Julien added: "By using Beyond Ratings' ESG scores and historical CRAs' credit ratings, our model captures the financial materiality of these risks more acutely in the case of developed markets and it unveils that ESG risks are increasingly relevant for emerging markets, although they are yet to be accurately and coincidentally priced. Additional tests using a range of country classifications and explanatory variables at different levels aim to ensure that our main results are robust."
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