The Impact of ESG On Sovereign Rating

The credit rating process has evolved over the years, as external lenders intend to reduce the risk of default by borrowing countries. The credit rating methodology by credit agencies such as Fitch, Moody’s, and Standard and Poor’s (S&P’s) uses financial, economic, legal, and empirical evidence to establish a rating structure for assessing institutions, nations, private banks, public banks, insurers, corporations, projects and municipal, regional and local administrations.

The credit and risk rating issued by the various rating agencies serves as a significant factor for borrowers to access international bond and loan markets, as well as to allocate foreign direct investment and portfolio equity flows. These ratings have over the years become cogent for improvement in governance, enforcement of legal frameworks, and assessment of sound economic, fiscal and investment environments and the benchmark for investors and lenders in evaluating the risk profile of borrowers.

The integration of Environmental, Social and Governance (ESG) into the scoring system was to indicate how environmental, social, and governance factors affect individual credit rating decisions. Fitch Rating agency in 2019, incorporated ESG Relevance Scores into its credit rating across all asset classes, with over 1,500 non-financial corporate ratings, banks, non-bank financial institutions, insurance, sovereigns, public finance, global infrastructure, and structured finance. Moreover, Moody’s announced ESG scores in 2021 and assigned ESG issuer profile and credit impact scores to over 1,700 issuers globally, including ESG ratings for sovereign entities and sectoral institutions. S&P’s introduced the ESG Credit Indicators in 2021 to be applied to corporate and sovereign-rated institutions at the transaction level. The ESG credit indicators are intended to improve transparency and help explain the influence of ESG factors on S&P’s credit rating analysis, based on factors such as Climate Transition risks, Waste and Pollution, Health and Safety, and Transparency and Reporting.

Sovereign credit rating has become a means to assess the riskiness of a particular country’s bonds as it evaluates its creditworthiness and its capacity to honor debt obligations when due. Also, a sovereign credit rating attracts Foreign Direct Investment (FDI) into a country. The scoring system of the major credit agencies assesses the ‘Environmental’ (E) based on CO2 emissions, resilience to natural disasters, energy, and waste management. ‘Social’ (S) is based on factors such as human capital, income equality, poverty, and education, whiles, ‘Governance’ (G) is based on factors such as accountability, transparency, rule of law, governance structure, implementation of sound policies, and political stability.

The Sovereign rating criteria for Fitch are in two folds; the Local-Currency (LC) Issuer Default Rating (IDR) and the Foreign-Currency (FC) IDR. The LC IDR reflects the likelihood of default on debt issued and payable in the currency of the sovereign entity, while the FC IDR is an assessment of the credit risk associated with debt issued in foreign currencies. Fitch’s approach to sovereign credit risk analysis is a blend of quantitative analysis and qualitative judgements that capture the willingness, as well as the capacity of the sovereign to meet its debt obligations in full and on time. S&P’s considers five areas in determining a sovereign’s creditworthiness: Institutional, Economic, External, Fiscal and Monetary assessments.

As the world focuses on sustainability, it is vital for policymakers to engage in sustainability projects and campaigns, as well as develop the macroeconomic indicators and improve their credit ratings to attract the needed finances in reaching the 2030 Sustainable Development Goal (SDG) targets.