The rationale to include ESG factors in sovereign risk analysis is based on increasing global recognition of their role to play in sustainable development. Some progress was made in the first decades of the millennium. Governments, international organisations and civil society were mobilized to implement more inclusive policies, to diminish poverty and starvation and to ensure environmental sustainability .
What is different nowadays is the international consensus about sustainable development. The agenda put forward by the United Nations includes 17 Sustainable Development Goals (SDGs) to accomplish by 2030, and the Paris Climate Agreement signed in 2016, are two key international tools to re-think sustainable development.
Nevertheless, to achieve SDGs and the commitments that arose from the Paris agreement, the finance sector must play a highly important role by allocating resources to implement sustainable projects. For instance, the Task Force on Climate-Related Financial Disclosures (TCFD) , intends to tackle the issue of how the financial sector can address climate-related risks through better disclosure, and to support a more appropriate allocation of capital in the global economy.
Furthermore, the High-Level Expert Group (HLEG) argues that the financial sector must support a more sustainable and inclusive economic system. Among other recommendations, HLEG identifies the importance for credit ratings agencies (CRAs) to take a long-term ESG approach in credit risk analysis and claims that the CRAs currently fail to adequately incorporate long-term risks, including ESG impacts on risk analysis.
In this context, Beyond Ratings believes that it is now very important to assess ESG performance in sovereign risk analysis and aims to offer answers to the following question: how do ESG factors affect the long-term performance of economies? This question will be explored through a series of research notes, including this one.
The main goal here is to have a comprehensive view of the very long-term sovereign risk and to provide information to investors that not only considers economic and financial performance, but also factors affecting long-term sustainability, for instance sovereign risk.
In this framework, very long-term sovereign risk could be defined as a function of three main fundamentals that could increase resilience to shocks: environmental, social and governance performance. These fundamentals also explain how economies could perform and react to shocks in the short- to medium-term.
In that respect, this Research Note offers a methodology to classify countries according to their ESG performance. This is an alternative approach to the World Bank classification on income level. The country classification will then be used, in a forthcoming paper, to measure the long-term relationship between ESG performance and sovereign risk to answer our research question.
This document is structured as follows: section 2 embeds relevant definitions and outlines the methodology; section 3 characterizes countries according to their ESG long-term determinants; section 4 outlines two study cases using our classification; section 5 concludes and gives some perspectives of forthcoming analysis.
Figure 1: Long-term risk components
1 - See Millennials Development Goals (MDGs), United Nations. http://www.un.org/fr/millenniumgoals/bkgd.shtml.
2 - Established in December 2015 by the Financial Stability Board, upon request from the G20 countries.
3 - HLEG highly criticizes the short-term perspective CRAs use in their credit risk and propose a longer horizon to consider more long-term factors which may not be evident in the short-term but could increase risks in a larger horizon.
4- More than 10 years.