The sovereign ESG rating as a tool for identifying insolvency risk

Traditionally, credit risk analysis of sovereign issuers considers macroeconomic and financial variables, such as the state of a country’s finances, the structure of its GDP, its rate of growth, etc. This classic analysis also contains aspects that are indirectly related to the pillar G, for governance, when we consider the rule of law, political stability and the smooth operation of institutions, all of which are significant stakes for the investor. Extensive integration of the ESG criteria will broaden the scope of this analysis and flesh it out by focusing on new risks – those that are extra-financial, in this case. These are the existing, latent or potential environmental, social and governance-related risks to which sovereign issuers are structurally exposed, but also risks relating to the poor political and economic management of States. Such risks have a certain effect on States’ ability to repay their debts, and therefore on their financial rating. Examples, both direct and indirect, of this “link” between solvency and ESG performance are manifold.

The critique of this method lies not in the quality of the data, but in the methodologies used by rating agencies to attain an overall rating. Among other biases on which the critique is based, we find the concept of income bias: when compared with emerging sovereign entities, so-called “developed” States generally receive higher ESG ratings, particularly because they have greater resources at their disposal to develop ambitious policies. This endangers the ability of a State such as Costa Rica, for example (although it is still an environmental leader), to raise funds for its development. Another recent critique, which is also applied to grading companies, focuses on the weighting of the E, S and G aspects by specialist agencies. They will use different weights based on their own methodologies, leading to smaller or larger inconsistencies between ratings, which may result in confusion for investors, who are used to seeing a consensus from credit agencies.

In view of this analysis, it’s the responsibility of the investor to devote the necessary resources to carefully choosing the methodology that best corresponds to their ESG values and beliefs or, ideally, to devise their own ESG ratings for sovereign entities. All of these questions notwithstanding, itis clear that the added value of a sovereign ESG assessment, in addition to credit risk analysis, is something we can now all agree upon.