Key findings

Countries with lower environmental, social and governance (ESG) risks show tighter five-year sovereign credit default swap (CDS) spreads, while higher ESG risks correspond to wider spreads. Sovereign ESG risk assessments are correlated with sovereign credit risk, with stronger effects observed in high-yield and emerging markets. Aggregated ESG, governance and social risks are generally more financially material than environmental risks.

Abstract

The study investigates the financial materiality of ESG risk assessment for sovereign debt. Using FTSE Russell/Beyond Ratings sovereign ESG risk scores as a proxy for ESG risks, and five-year CDS spreads as a proxy for sovereign credit risk, the analysis covers 70 sovereign issuers from 2010–2022. After controlling for economic factors, ESG risk scores are shown to provide additional information on sovereign creditworthiness, particularly in emerging markets. Implied CDS spread curves based on ESG risk scores illustrate these findings.

What are the transmission channels between ESG and sovereign risks?

Environmental risks are typically long-term, with research linking higher CO₂ emissions and fossil fuel dependency to greater sovereign borrowing costs. Climate change and biodiversity loss can drive credit rating downgrades, while the natural resource curse highlights the risks of mismanaged natural capital.

Social risks operate on a medium-term horizon. Inequalities, weak healthcare systems and unemployment can increase sovereign risks. The COVID-19 pandemic exposed vulnerabilities in health systems, showing their importance in resilience. Human rights protections are also key for stability and international credibility.

Governance risks are short-term factors with immediate effects on sovereign creditworthiness. Political stability, transparency, corruption control and institutional effectiveness strongly influence borrowing costs. Failures in governance, or exposure to terrorism and violent conflict, raise sovereign risks significantly.

Econometric framework, data, and hypotheses

The study applies a panel fixed-effects regression on up to 70 economies between Q1 2010 and Q4 2022. Sovereign CDS spreads proxy credit risk, while ESG risk scores proxy sovereign ESG risks. Control variables include real GDP growth and CPI inflation. Results show negative correlations between aggregated ESG and CDS spreads, particularly in emerging and high-yield economies. Hypotheses expect better ESG performance to reduce credit risk, though inertia in advanced economies reduces observed significance.

Financial materiality of sovereign ESG risk: the results

Analysis finds that aggregated ESG and social risk scores significantly explain CDS spreads, with governance also material. Environmental risk scores are less robust. For countries with ESG scores above 60, CDS spreads remain low, while below 60 spreads increase sharply, especially for social and governance risks.

The results are stronger in emerging and developing economies (EMDEs), where ESG-related coefficients are larger. For advanced economies, ESG risk materiality is weaker and less consistent, with only environmental risks occasionally significant. Among EMDEs, social and governance risks show the greatest financial relevance.

By credit quality, investment-grade economies show limited significance, while high-yield economies show strong ESG–CDS relationships, especially for governance. Similarly, FTSE Emerging Markets Government Bond Index samples confirm ESG’s explanatory power, with frontier markets showing even larger coefficients.

Conclusion

Sovereign ESG risk scores correlate with sovereign credit risk, evidencing financial materiality. The relationship is strongest in EMDEs and high-yield markets, with social and governance dimensions more influential than environmental factors. For advanced economies and investment-grade issuers, results are less clear, reflecting that many ESG factors may already be priced in. These findings suggest that ESG risk assessments can provide investors with valuable inputs for sovereign debt investment decisions.