Countries increase sovereign debt in order to finance their growth, and the cost of this debt is not universal and can vary dramatically. The cost of borrowing is commonly measured as a yield spread, which is partially linked to the risk that the borrower will default on his obligations. The default risk can be further broken into three risk types:
Country’s credit risk – its creditworthiness depending on the state of the economy
Liquidity risk – state of the country’s bond market
International risk aversion – if lenders have a higher degree of risk aversion this may ultimately lead to higher borrowing costs for risky countries
Crifo et al (2017) argued that environment, social and governance (ESG) factors could also impact a country’s yield spread. While there were no studies before that would look at all ESG elements in conjunction, some papers did investigate the impact of separate financial factors, such as the influence of corruption, environmental policies, and political risk. The paper’s main methodology framework is outlined below:
Alternative hypothesis: higher ESG ratings are associated with lower borrowing costs.
Data: panel data for 23 OECD countries from 2007 to 2012.
Main independent variable: the countries’ ‘Vigeo sustainability’ rating. This rating is calculated as the equally-weighted average of three annual ratings: the Environmental Responsibility Rating, the Social Responsibility and Solidarity Rating, and the Institutional Responsibility Rating.
Dependent variable: sovereign borrowing costs are calculated as the difference between the cost of US dollar-denominated debt minus the US Treasury bond rate of comparable maturity (two years).
Control variables: GDP growth, inflation rate, gross debt to GDP ratio, fiscal balance to GDP ratio, reserves to imports ratio, trade openness, and sovereign credit ratings. All these factors could be linked to a country’s creditworthiness and are therefore important controls when trying to capture the link between ESG ratings and sovereign borrowing costs.
Results: The study indicated that countries with higher ESG ratings are “rewarded” with lower borrowing costs. However, the impact is limited, with borrowing costs being about three times more affected by S&P credit ratings than by ESG ratings. At the same time, it is important to keep in mind the paper’s dataset, which looked at OECD countries over the 2007-2012 period.
The conclusions of the paper are economically relevant – if higher ESG rating results in lower borrowing costs, it means both investors and policymakers can use ESG factors as a tool in risk assessment. These tools could also identify more precisely where exactly in the financial system these risks are located.
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