Importance of ESG factors in sovereign credit ratings

Abstract

This paper analyzes the importance of Environmental, Social and Governance (ESG) factors in sovereign credit ratings, by using a two-step, data-driven methodology. First, we build ESG and non-ESG (macro-financial) meta-variables from observed data using factor analysis. Second, by employing a statistical shadow rating model, we compute variable importance scores to explore the relative importance of ESG and non-ESG factors in sovereign creditworthiness assessment. We analyze the ESG importance according to the level of economic development and by different geographic areas. In particular, we find that the importance of ESG factors is different in emerging market and developing economies (EMDEs) and in advanced economies (AEs): governance is the most important factor for AEs and non-ESG factors drive the creditworthiness of EMDEs. Lastly, the relative importance of ESG factors is tracked at different dates between 2002 and 2018. We show that the evolution of ESG importance also depends on economic development: it grows for AEs and decreases for EMDEs, especially after the 2008 financial crisis.