This research paper examines the application of sovereign risk ceilings to non-sovereign debt issuers in emerging markets and developing economies (EMDEs). It questions whether sovereign risk should automatically cap a credit rating once contractual, legal, and structural mitigants are established. The analysis suggests that sovereign ceilings often function as a broad proxy for government interference risk but fail to account for how these risks transmit through specific project structures or currency regimes.

Sovereign ceilings as a methodological construct

The sovereign ceiling practice limits the rating of international debt obligations of non-sovereign borrowers to the highest rating available for their sovereign’s obligations. This constraint materially affects the cost, tenor, and availability of external financing across EMDEs. However, empirical evidence suggests a contradiction: sovereign default does not imply universal corporate default. Moody’s data on EM corporate defaults during sovereign crises show that the majority of rated entities — over three-quarters of all EM corporates and sub-sovereigns, and over 83% of utilities and 94% of banks — did not default during the four-year crisis windows reviewed.

Further evidence from infrastructure debt indicates a gap between ceiling methodology and observed performance. The 20-year cumulative default rate for middle- and low-income country infrastructure debt is approximately 7.0%, which is lower than the corporate benchmark for Ba2 (18.7%) and closer to investment-grade quality (Baa1 at 5.8%). Furthermore, the median recovery rate for private lending in this sector is 91.1%, more than double the EM corporate benchmark of 30–40%.

Sovereign interference risk and disaggregated transmission channels

The report proposes a structured framework to disaggregate sovereign risk into eight explicit transmission channels: 1. Transfer and convertibility (T&C) risk; 2. Payments moratorium; 3. Regulatory and contract interference; 4. Offtaker default; 5. Currency devaluation; 6. Banking system collapse; 7. Expropriation or confiscation; and 8. Macroeconomic contagion. In practice, current ceiling methodologies operate as if all eight channels were jointly and near-deterministically binding, irrespective of the currency regime or project structure.

Regulatory and offtaker risk as binding channels in local currency settings

Two channels are identified as particularly binding for domestic infrastructure: regulatory interference and offtaker default. Regulatory interference is often transmitted through tariff freezes or forced contract renegotiations. A comparison between South Africa and Spain illustrates the limitations of sovereign-level proxies. Between 2010 and 2014, Spain (then rated Baa1 to Baa3) enacted retroactive cuts to solar tariffs, causing approximately 30% of projects to suffer income reductions of around 40%. Conversely, during South Africa’s sub-investment grade period (2015–2019), existing Power Purchase Agreements (PPAs) were honoured despite the suspension of new procurement windows.

Implications for rating methodologies

Current Credit Rating Agency (CRA) methodologies frequently require geographic or revenue diversification outside the domestic jurisdiction to pierce the sovereign ceiling. For domestic-revenue infrastructure projects, these conditions are often logically inapplicable as their assets and customers are inherently in-country. The report recommends a more effective four-step architecture for assessing credit risk:

Step 1: Evaluate standalone creditworthiness based on project fundamentals without reference to the ceiling.

Step 2: Map the eight transmission channels to assess their probability and the credibility of available mitigants.

Step 3: Reposition the sovereign as a contextual factor informing channel activation, rather than an overriding ceiling.

Step 4: Retain a conservative bound only where channels cannot be observed or mitigants remain untested.

Conclusion

The research concludes that methodological reform is necessary to prevent the systematic mispricing of well-structured EMDE infrastructure risk. By shifting to a channel-based assessment, ratings could more accurately reflect the effectiveness of contractual and structural mitigants, potentially improving bankability and lowering the cost of capital for essential services.