Sustainability and Sovereign Credit Risk, d.d.2023

International Review of Financial Analysis 86 (2023) 102494
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International Review of Financial Analysis

journal homepage: www.elsevier.com/locate/irfa
Sustainability and sovereign credit risk☆

Arsh Anand a, *, Rosanne Vanpée a, Igor Lončarski b
a
KU, Leuven, Belgium
b
University of Ljubljana, Slovenia
A R T I C L E I N F O A B S T R A C T
JEL classification: The study investigates the impact of Environmental, Social, and Governance (ESG) ratings on sovereign credit
F64 risk. The study measures sovereign credit risk using a market-based, structural and an analyst-based approach,
G24 while ESG scores are obtained from three different rating agencies. The contributions of this paper are multifold.
H63
First, we discover that higher sustainability performance at the corporate level significantly decreases market-
Q51
based (CDS spreads) and structural (Distance-to-default) sovereign credit risk but has no consistent impact on
Keywords:
analyst-based (Credit ratings) sovereign credit risk measure. Second, by expanding our research to include the
Sovereign credit risk
Sustainability risk
concept of financial materiality based on the SASB materiality map, we break down and highlight the sustain
ESG ratings ability themes that require the most attention at the sovereign level and those that can affect the credit health of
Materiality countries. Third, we demonstrate that the relationship between sustainability and sovereign credit risk varies
across ESG rating providers, supporting the widespread belief that sustainability metrics lack standardization and
are difficult to compare across providers.
1. Introduction literature to one of the largest asset classes of sovereign debt. This
relationship may not appear obvious or material because sovereign risk
The case for integrating ESG factors is becoming increasingly has always been regarded a risk-free asset class; however, as more evi
compelling in investment processes. Originally motivated by a values- dence emerges highlighting the financial impact of climate and social
based approach driven by moral and ethical obligations, long-term events on the debt servicing abilities of countries (Moody's, 2020), it
value considerations have become extremely important in recent warrants the need to establish the relationship between sovereign credit
years, as investors now see ESG accounting as an essential step in risk risk and ESG and its various transmission mechanisms and understand
management. Incorporating ESG strategies have been primarily applied the strength of the impact of various ESG factors on sovereign debt risk.
to equity portfolios. However, more recently, investors have started There are several ESG transmission mechanisms which threaten the
accounting for ESG in their debt portfolios as well, although with a focus credit risk of a country. Environmental risk, for example, affects sover
on corporate debt. On the academic front, there is a general consensus eign credit risk through three channels: (1) transition risk which refers to
that corporate credit risk is negatively related to environmental and the necessary actions required to meet a country's climate commitments,
social corporate performance, such that increased investments on the (2) physical risk that materializes through physical damage due to
ESG front, help companies avoid the materialization of sustainability- climate-related events, and (3) resilience, or the country's preparedness
related contingent liabilities, lowering credit risk and resulting in a to cope with climate issues.1 In addition, environmental risk increas
lower cost of debt (Barth, Hübel, & Scholz, 2019; Cooper & Uzun, 2015; ingly poses a potential systemic financial risk.2 The increasing number of
Drago, Carnevale, & Gallo, 2019; Ge & Liu, 2015; Oikonomou, Brooks, & climatic events in the last decade is indicative of the relevance of this
Pavelin, 2014). risk factor. However, the complexity and uncertainty regarding the
This critical relationship, however, has not yet been extended in magnitude and timing of the impact of these risks pose a grave
The work in this paper was supported by Central Europe Leuven Strategic Alliance (CELSA) Research Fund.
☆
* Corresponding author.
E-mail addresses: arsh.anand@kuleuven.be (A. Anand), rosanne.vanpee@kuleuven.be (R. Vanpée), igor.loncarski@ef.uni-lj.si (I. Lončarski).
1
“Accounting for climate risk in sovereign bond portfolios”, FTSE Russell, https://www.ftserussell.com/index/spotlight/climate-wgbi.
2
Mark, Carney, “Breaking the tragedy of the horizon - climate change and financial stability”, Bank of England, 2015, https://www.bankofengland.co.uk/speech/
2015/breaking-the-tragedy-of-the-horizon-climate-change-and-financial-stability.
https://doi.org/10.1016/j.irfa.2023.102494
Received 18 July 2022; Received in revised form 13 November 2022; Accepted 9 January 2023
Available online 13 January 2023
1057-5219/© 2023 Elsevier Inc. All rights reserved.
A. Anand et al. International Review of Financial Analysis 86 (2023) 102494
challenge. the strength of the political institutions and financial health of the
In addition to that, the recent global pandemic of Covid 19, high governments as the main drivers of sovereign credit risk (among others
lighted the importance of the social and governance pillars of ESG, Afonso, 2003; Uribe & Yue, 2006; Aizenman, Pinto, & Sushko, 2013;
highlighting that good governance and human rights conditions are on Poghosyan, 2014). Until recently, sustainability risks were neglected,
the back-foot in many regions of the world and how the governments in but the increasing importance of this risk factor puts a growing strain on
these countries have struggled to deal with this social event. The government finances and makes a case for assessing the ESG perfor
pandemic has put things into more perspective by showing sovereigns mance in relation to sovereign default risk. On the corporate level, there
their limitations in dealing with large unexpected exogenous shocks. It is overwhelming evidence that corporate sustainability reduces credit
serves as a valuable analogy for how quickly sustainability risks can risk (among others Oikonomou et al., 2014; Ge & Liu, 2015; Ashbaugh-
escalate and how global financial market stability could be threatened Skaifea, Collins, & LaFondc, 2006; Tarigan & Fitriany, 2017; Sareen &
when these sustainability risks unfold. A better understanding of the Vij, 2014–2015; Aktas, Karampatsas, & Witkowski, 2019). However,
impact of ESG factors on sovereign credit risk is therefore imperative few studies investigate the impact of sustainability on credit risk at the
now more than ever. sovereign level. We discuss the findings of these studies below.
In line with the above discussion, the first contribution of the paper is Prior to the availability of ESG ratings, most studies used governance
to investigate the relationship between sovereign credit risk measures indicators as a proxy for qualitative influences on credit risk. Gover
and sustainability factors, notably environmental, social and gover nance factors are particularly indicative of the sovereign's willingness to
nance factors. Accordingly, we approach sovereign credit risk from a repay rather than its ability (Crifo, Diaye, & Oueghlissi, 2017). Countries
market-based (sovereign CDS spreads), a structural (sovereign distance- aim to preserve a good reputation for continued access to financial
to-default) and an analyst-based (sovereign credit ratings) approach to markets. In this regard, governance factors, such as government repu
provide a holistic picture of this relationship. tation and political stability signal a country's long-term orientation
Second, we broaden this analysis by incorporating the concept of towards debt management. Eichler (2014) finds evidence that a coun
materiality in order to consider the relevance of various sustainability try's political regime affects sovereign bond yield spreads. Using a
factors from a financial standpoint. In this regard, we utilize the SASB's sample of bonds of emerging economies, he establishes that countries
materiality map to identify the financially material ESG issues that with parliamentary systems (as opposed to presidential regimes) have
impact the credit quality of countries. Third, the paper investigates the higher spreads whereas, a stable government and qualitative gover
widely held belief about the lack of comparability of the sustainability nance practices result in lower bond spreads. Ciocchini, Durbin, David,
data provided by various sources. We use ESG data from three different and Ng. (2003), Connolly (2007) and Depken, LaFountain, and Butters
ESG rating providers, namely Sustainalytics, Refinitiv (formerly known (2006) observe that sovereign bond spreads and credit ratings are sen
as Thomson Reuters' ASSET4 data) and FTSE. If done right, standardized sitive to the corruption index of a country. Several other studies find
ESG information can benefit various market participants. However, evidence that political risk or stability and governance factors (e.g.,
multiplicity can be very challenging to make objective decisions when quality of legal institutions and government effectiveness) play an
there is a lack of comparability and consistency. To this end, we examine important part in determining a country's credit risk and ratings (Bal
the extent to which the different agencies' ESG ratings similarly explain dacci, Gupta, & Mati, 2011; Bekaert, Harvey, Lundblad, & Siegel, 2014;
the variability in sovereign credit risk. Benzoni, Collin-Dufresne, Goldstein, & Helwege, 2015; Erb, Harvey, &
Our results demonstrate the complexity of the relationship between Viskanta, 2005; Haque & Mark, 1998). In line with the rationale for
corporate sustainability performance in a country and the country's governance quality, we expect a country's environmental and social
credit risk. By and large, we find that higher corporate sustainability profile to also reflect its long-term commitments and to act as a hedge
standards decrease market-based and structural sovereign credit risk. against any unexpected, major exogenous shocks.
When analyzing the differentiated impact of sustainability factors based A study that is closely related to our work is Crifo et al. (2017), which
on their individual dimensions, we show that the relationship between analyzes the effects of ESG factors on sovereign credit risk. They
sustainability and sovereign credit risk is mainly driven by the envi investigate the impact of Vigeo ESG ratings for 23 OECD countries on the
ronmental and social score, although this conclusion depends on the ESG government yield spreads calculated as the difference between the in
rating provider used. With respect to analyst-based credit risk, which we terest rate the government pays on its US-dollar denominated debt and
measure with sovereign credit ratings, we find no consistent impact of the rate offered by the US treasury on debt of comparable maturity. They
sustainability factors. Depending on the ESG rating provider, the rela find that the composite ESG score has a significant negative impact on
tionship between corporate sustainability standards and sovereign bond yield spreads, implying that higher ESG scores coincide with lower
credit risk is found to be negative or positive. Overall, while we find that borrowing costs. However, Crifo et al. (2017) also show that the eco
sustainability is an important driver of sovereign credit risk, our findings nomic importance of ESG ratings in explaining bond spreads is low
illustrate the poor comparability of ESG scores across data providers and compared to financial variables and credit ratings. A related study is
an inconsistent incorporation of sustainability in the credit risk evalu Capelle-Blancard, Crifo, Diaye, Oueghlissi, and Scholtens (2019), in
ation by credit rating analysts. which the authors analyze the impact of decomposed ESG factors on 20
The remainder of the paper is structured as follows. In Section two, OECD countries' sovereign bond spreads for the period 1996–2012.
we discuss the related literature. The data and research hypothesis are Instead of using ESG scores from an external agency, they create their
presented in Section three, and Section four contains a description of the own ESG indices using the guidelines outlined by various ESG rating
methodology. Section five discusses the results, and the last section agencies and asset managers arguing that ESG ratings mostly capture
concludes. policies and symbolic activities rather than actual reductions in envi
ronmental and social impacts (Gonenc & Scholtens, 2017). Capelle-
2. Literature Blancard et al. (2019) identify a strong negative relationship between
overall ESG scores and sovereign bond spreads. In contrast to what is
Our work in this paper relates to two strands of literature, notably found for corporate credit risk, the impact of the governance rating is
studies that explore the determinants of the sovereign default risk and more prominent than the social and environmental ratings. They also
research, which examines the role of sustainability in sovereign credit find that the strong relationship between ESG factors and bond spreads
risk. There is a vast amount of literature that explains the dominant is more prevalent in the euro area than in other developed countries and
determinants of sovereign credit risk. Generally, credit risk is measured that the effect became much stronger after the global financial crisis.
by sovereign bond yields or CDS spreads and sovereign credit ratings. Margaretic and Pouget (2018) add to the literature by focusing on
Overall, the literature identifies global and local economic conditions, emerging economies. The study uses a dataset of 33 emerging economies
2
whose bonds are in the JP Morgan Emerging Markets Bond Index Global the natural log of the CDS spreads as the dependent variable. The log
for the period 2001–2010. As proxies for environmental, social and transformation of the CDS spreads helps to suppress the effects of out
governance ratings they respectively use the Environmental Perfor liers and mitigates the effects of business cycles to allow for a linear
mance Index constructed by the Yale University, the Human Develop relationship to be established (BlueBay Asset Management and Verick
ment Index of the World Bank, and the World Governance Index Maplecroft, 2019; Cantor & Packer, 1996; Drago et al., 2019; Goss &
constructed from the World Governance indicators. They find that social Roberts, 2011; Gray, Merton, & Bodie, 2007; Rodriguez et al., 2019).4
and governance factors have a significant impact on emerging market In addition to the traditional market-based indicators of credit risk,
sovereign bonds spreads, whereas environmental ratings do not influ our second measure of sovereign credit risk is the distance-to-default of a
ence the bond spreads of these countries. country. Distance-to-default (DtD) is based on public sector balance
Overall, we observe that research on the impact of sustainability sheet data and represents structural credit risk of a country. DtD is
factors on sovereign credit risk is very scant, mostly focusing on bond defined as the number of standard deviations a borrower's asset value is
spreads and using self-created ESG scores which may not be reproduc away from its contractual obligation. DtD is a measure derived from the
ible or comparable for practical use. Our paper contributes to the Contingent Claims Analysis Approach (CCA) as outlined by Gray et al.
existing literature by taking a multifold view and scrutinizing the impact (2007).5 This structural model was originally developed to calculate
of a country's sustainability performance not only on a market-based corporate credit risk, but we use the modifications proposed in Gray
credit risk measure (CDS spreads) but also on agency-based and struc et al. (2007) and Singh, Manish, and Sosvilla-Rivero (2018) to calculate
tural credit risk measures. In addition, in line with the scope and ob DtD at the sovereign level. DtD is a measure of structural credit risk
jectives of our paper we use ESG data from commercial ESG providers because default risk is calculated based on the asset (capital) structure of
which has multiple contributions. Firstly, commercial ESG ratings the borrower. The advantage of using DtD over traditional measures of
enhance the practicality of the paper. ESG ratings remain the most sovereign credit risk is that it uses public sector balance sheets and
widely relied upon tool by market participants. Our research adds to the therefore is better able to isolate default risk than traditional market-
debate on the use of ESG ratings by analyzing how useful ESG ratings are based measures. Singh et al. (2018) show that sovereign DtD is a more
in the risk management cycle of companies and countries, allowing us to accurate and timelier predictor of sovereign default than traditional
comment on the role of ESG ratings in risk management process as a credit risk measures such as CDS spreads and bond spreads. A detailed
whole. Second, the use of the external ESG ratings gives us access to a explanation of the calculation of DtD for our sample countries is pro
breadth of data that is used by each individual rating agency to develop vided in Appendix I.
their ratings. This allows us to look at not only different types of in Third, we consider an agency-based measure of credit risk. Sovereign
dicators and methodological viewpoints, but also to restructure the credit ratings reflect the opinion by a specialized committee of analysts
granular data to explore in greater detail the most relevant ESG factors on the default risk of a country. Credit ratings continue to be one of the
across specific dimensions and data providers. Lastly, as one of the aims most widely used indicators of default risk. The element of subjectivity
of the paper is to contribute to the debate of standardization of ESG and sentiment in credit ratings is an important feature that distinguishes
ratings, the use of multiple commercial ratings allows us to make that them from the previous two measures. It has been evidenced that
comparison and comment on it. sentiment towards soft or qualitative information, as well as subjectivity
regarding the rating committee's qualitative judgment, play a role in
3. Data determining credit ratings (Slapnik & Loncarski, 2019; De Moor, Luitel,
Sercu, & Vanpée, 2018). Furthermore, it has been discovered that credit
The following paragraphs describe the data used for the analysis in ratings use a through-in-time approach when assigning sovereign credit
the paper. The empirical results are based on quarterly data covering the ratings, where they take a longer time horizon and consider the entire
period from 2009-Q3 till 2019-Q2 except for FTSE ratings for which we economic cycle (Slapnik & Lončarski, 2021). Both of these aspects are
only have data from 2014-Q4 till 2019-Q2. Countries in the different crucial to our research. The goal is to examine the potential financial
samples are shown in Table 15 in Appendix B. The profile of countries impact of upcoming ESG risks. Because of the nature of the ESG factors,
differs for the different panel datasets because of the differences in the predicting what will happen in the future and its financial impact is
availability of ESG data. difficult. In this regard, rating agencies' expert judgment on the expected
impact of ESG factors, particularly for social and governance factors
3.1. Credit risk metrics where quantifiable data is lacking, is critical. Second, the first two in
dicators reflect any information immediately, whereas credit ratings
We consider three measures for credit risk, each with a unique focus. take into account impact over time, offering a different approach. We
The first credit risk measure under consideration is a market-based one, use sovereign credit ratings issued by S&P and Moody's, the two largest
notably the sovereign CDS spread. Over the last two decades, the use of
CDS spreads as a proxy for credit risk has become increasingly popular.
There is a preference for using CDS spreads over sovereign bond yields 4
A possible concern for the reader may be that the results are spurious due to
because CDS contracts are more liquid than some sovereign bonds, the possible non-stationarity of the CDS spreads. However, several studies have
making the CDS spreads more frequently available and less costly to shown that the impact of a non-stationary series is not as central in a panel
acquire (Longstaff, Pan, Pedersen, & Singleton, 2011; Rodriguez, Dan setting as it is in a pure time series (Kao, 1999; Phillips & Moon, 1999).
dapani, & Lawrence, 2019). In addition to this, the literature regards Rodriguez et al. (2019) quote Baltagi (2008): “Unlike the single time series
CDS spreads as a pure measure of default risk, while sovereign bond spurious regression literature, the panel data spurious regression estimates give a
spreads are influenced by other factors, such as central bank interest consistent estimate of the true value of the parameter as both N and T tend to infinity.
rates (Ang & Longstaff, 2013). We believe that CDS spreads are also a This is because, the panel estimator averages across individuals and the information
reflection of investor sentiment, thus enabling us to determine the extent in the independent cross-section data in the panel leads to a stronger overall signal
than the pure time series case.” Nevertheless, to address any concerns regarding
to which the investors consider ESG risks to be important and determine
the spuriousness of our results, we test for the stationarity of the CDS spreads
whether ESG factors are priced in CDS spreads. We collect 5-year sov
using two panel root tests: Levin, Chien-FuLin, and Chu (2002) (LLC) and Solm,
ereign CDS spreads, denominated in US dollars, on a quarterly basis Pesaran, and Shin (2003) (IPS). The results for both the tests reject the null for
from Refinitiv3 and follow the general practice in the literature of using non-stationarity in the log of quarterly CDS spreads, indicating that our results
are not spurious.
5
CCA is a generalization of the option pricing theory of Black and Scholes
3
Formerly Thomson Reuters. (1973) and Merton (1973) and is commonly called the Merton Model.
3
credit rating agencies in the market. An ordinal transformation of the period as the Sustainalytics sample.
credit ratings is performed, as shown in Table 16 in Appendix C. The The FTSE ESG scores are also broken down in three pillars: Envi
transformed rating scale ranges from 21 for countries with a triple-A ronment, Social and Governance. FTSE assigns ratings on a scale of 1 to
rating to 1 for countries rated C or lower. 5. The three pillar scores are based on 14 underlying themes which are
An overview of the average credit risk by region, covering our further based on almost 300 individual indicators which are applied to
sample period is presented in Table 1. each company's unique circumstances. Almost 125 indicators are
applied per company.8 We acquired semi-annual data for 6681 com
panies across the globe for the period between December 2014 and June
3.2. ESG ratings 2019. The semi-annual data are linearly interpolated into quarterly data
to match the sample frequency of Sustainalytics and Refinitiv.
3.2.1. Spread adjusted weighted-average ESG ratings Based on the corporate ESG ratings and the market capitalization of
We use ESG scores by three third-party rating providers as follows: each company, we calculate value-weighted ESG scores at the country
Sustainalytics provides an ESG score between zero and 100. Their level.9 We also account for the variability in the ESG ratings by dividing
ESG score is a composite of three dimensions of sustainability, notably the unscaled country ESG scores by the spread in company ESG scores.
an Environmental (E), Social (S), and Governance (G) score. The The main idea behind the spread-adjusted rating is that we want to
methodology involves giving specific weights to the ESG issues in each control for the fact that some countries may have very well and very
industry, so the weights vary from industry to industry. At least 70 in poorly performing companies at the same time. By taking into account
dicators are covered in each industry and the ESG indicators are based the spread in ESG scores within a country, we also reduce any outlier
on three categories: (i) Preparedness, i.e., to what extent the company is effects. The spread-adjusted ratings are calculated based on the
prepared to manage the ESG risks, (ii) Disclosure, i.e. whether the following formula:
standard international best practices disclosure requirements are met or
not, and (iii) Performance, (Quantitative and Qualitative) i.e. Practical
implementation of ESG initiatives or review of controversial ESG in
Weighted Average ESG scorei,t − Min Company ESG Scorei,t

Spread adjusted ratingi,t = (1)
Max Company ESG Scorei,t − Min Company ESG Scorei,t
cidents.6 We acquired monthly data on 3480 companies based in Europe We center the weighted average ESG score at the minimum company
and United States for the period from third quarter of 2009 till second ESG score in each time period in each country. We observe that overall,
quarter of 2019. only a few companies are rated for each country in each time period and
Refinitiv (former Thomson Reuters' ASSET4 data) uses 178 company usually only the high ESG performing companies are rated, which is why
level ESG metrics grouped into 10 categories under 3 dimensions: the weighted average scores for certain countries such as Greece and
Environmental (Resource use, emissions, innovation), Social (Work Portugal are not completely reflective of the accurate sustainability
force, human rights, community, and product responsibility), and positioning of the countries. By centering the weighted average scores at
Governance (Management, shareholders, CSR strategy). Each of these the minimum company ESG scores, we take a more prudent approach
10 categories are weighted based on the number of issues that they and reduce the bias caused by a large number of high performing ESG
include. Refinitiv also reports an ESG Controversies Scores which in companies. We then divide the deviation score by the spread of the
cludes 23 controversy topics such as anti-competition, business ethics company ESG scores i.e., the difference between the maximum and
and tax fraud. The Controversies and E, S, and G scores are combined minimum company ESG score to reduce the volatility and suppress the
and averaged in a Total ESG Combined (TESG) Score.7 We extracted effect of outliers in the ESG scores. To provide a comparison, Table 17 in
quarterly ESG pillar Scores and Total ESG Combined Scores for 6660 Appendix D provides the ranking for the countries based on the unscaled
companies covering developed and developing economies for the same ESG scores and then subsequent spread adjusted ESG scores across the
three rating agencies.10 For example, based on the ranking of the
unscaled scores, Portugal ranks third highest for the Sustainalytics rat
Table 1
Average credit risk metrics by region 2009-Q3–2019-Q2.
ings and first highest for the FTSE ratings, however, after adjusting for
the spread, the country drops down to the 8th rank for Sustainalytics and
Country Natural log of CDS Distance-to- S&P Moody's
14th rank for the FTSE ratings. Similarly, Greece drops down to the 4th
spreads default ratings ratings
rank from 3rd rank for FTSE ratings whereas, Hungary drops to 33rd
Europe 6.478 27.303 18.169 17.289
rank from the 9th rank for Refinitiv ratings.
North
America 3.293 24.098 21.000 21.000
Latin
America 5.080 26.049 13.725 13.107
Asia Pacific 4.665 17.757 16.167 15.310
Africa 5.255 20.371 12.925 13.619
8
“ESG Ratings - Measuring Environmental, Social, and Governance risk and
performance on 7200 securities across 47 Developed and Emerging markets”,
FTSE Russell, https://www.ftserussell.com/data/sustainability-and-esg-data/es
g-ratings.
6 9
“ESG Reports and Ratings: What They Are, Why They Matter?”, Davis Polk & We acknowledge that the use of company ESG ratings may not be
Wardwell LLP, July 12, 2017, https://www.davispolk.com/sites/default/file completely representative of the country level ESG risks, but most of the ESG
s/2017-07-12_esg_reports_ratings_what_they_are_why_they_matter_0.pdf. data is only available at the corporate level, particularly at a granular level.
7
“Refinitiv ESG company scores”, Refinitiv, April 2020, https://www.refinit Still, we believe that calculating an aggregate corporate ESG score at country
iv.com/content/dam/marketing/en_us/documents/methodology/refinitiv-es level gives a good indication of the overall sustainability standards in a country.
10
g-scores-methodology.pdf. For conciseness, we illustrate rankings based only on the Total ESG score.
4
3.2.2. Equally-weighted ESG ratings imperative that the materiality of risk factors be considered when per
Given the scarcity of ESG data on small-cap firms, as discussed forming this assessment. The motivation to use financially material ESG
earlier, we also use equally-weighted ESG ratings for countries, in scores also stems from previous evidence in the literature, which reports
addition to spread adjusted weighted average ratings, as a robustness mixed results for the relationship between financial performance and
check to allow meaningful comparisons. ESG ratings. One of the limitations of previous studies could be that they
did not use material ESG factors, resulting in mixed evidence.
3.2.3. ESG ratings based on Sustainability Accounting Standards Board We have granular ESG data for Refinitiv and Sustainalytics on a
(SASB) Materiality map company level. We use the individual indicator scores from each ESG
Demand for increased ESG reporting and scoring as part of better rating provider to generate ratings across 5 SASB-defined dimensions
decision making in ESG investing has called for greater transparency, (Fig. 1). We have data for the following categories for Refinitiv: resource
consistency of metrics, comparability in rating methodologies, and, use, emissions, innovation, workforce, human rights, community, and
most importantly, alignment with financial materiality (Boffo & Pata product responsibility, management, shareholders, and CSR strategy.
lano, 2020). Materiality assessment is the process of finding, analyzing, Sustainalytics has detailed data on 163 individual metrics used by the
and assessing several potential environmental, social, and governance ESG rating agency to calculate Environmental, Social, and Governance
issues that may influence your organization and/or stakeholders, and ratings. We re-categorize the companies rated by each ESG rating agency
condensing them into a short list of themes that inform company strat into the SASB industry categories in order to calculate the ratings across
egy, targets, and reporting. According to a report by Morgan Stanley, the 5 SASB dimensions. The individual indicator scores for the two ESG
companies must focus on specific issues that can have a material impact rating agencies are then mapped onto SASB's 26 categories. We compute
on their businesses in order for ESG investing to improve financial re an average score for each company based on the individual indicator
sults (Delany, 2019). The report quotes the examples of a financial scores for material issues relevant to the company's industry, which are
services company renovating its corporate headquarters to have LEED then used to calculate ESG ratings at the country level.
(Leadership in Energy and Environmental Design)certification is good
for the environment but is unlikely to improve its bottom line signifi 3.3. Control variables
cantly. A food distributor, on the other hand, reworking supply chain
logistics to reduce truck routes will reduce the planet's carbon footprint In addition to our primary independent variables i.e., the ESG rat
and fuel costs, which is a tangible result. While progress has been made ings, we also use a set of control variables in our analysis which are
in recognizing the importance of using material metrics in the mea described in Table 2. The selection of control variables is based on the
surement of ESG ratings, the discussion over which metric is material literature on the determinants of sovereign credit risk (Cantor & Packer,
continues. In this regard, the work by Sustainability Accounting Stan 1996; Afonso, 2003; Margaretic & Pouget, 2018; De Moor et al., 2018;
dards Board (SASB) in creating a Materiality Map is very valuable. Capelle-Blancard et al., 2019).
SASB's Materiality Map identifies likely materiality issues on an Table 3 provides the summary statistics for all the variables used in
industry-by-industry basis. It ranks issues by industry based on two types this work.
of evidence: evidence that industry investors are interested in the issue
and evidence that the issue has the potential to impact companies in the
3.4. Research questions
industry (Exploring Materiality, 2022). SASB identifies 26
sustainability-related business issues that vary across 11 sectors and 77
Good performance on the ESG front by a country act as a signaling
industries. These 26 business issues are grouped into five categories:
tool for investors conveying a country's commitment to safeguard itself
Environment, Social Capital, Human Capital, Business Model and
from any sustainability risks that could threaten its financial capacity.
Innovation and Leadership and Governance.
In light of the above discussion and the overview of the literature, the
In light of the objective of the paper to assess how the sustainability
following research questions are answered in this paper:
risks affect the financial capacity of countries to repay their debts, it is
(1) Do sustainability factors affect the credit risk of a country? (2)
Fig. 1. SASB Materiality Map.

Source: (Exploring Materiality, 2022).
5
Table 2 Table 3
Definition and source of control variables. Summary statistics.
Variables Definition Source Statistic N Mean Median Std. Min Max
Dev
Macroeconomic indicators
Natural log of nominal GDP in US$ Real GDP Growth Rate 2005 0.01 0.01 0.01 − 0.06 0.23
Log GDP/Capita Refinitiv Eikon
as a ratio of population Log GDP/Capita 2201 8.54 8.77 1.07 5.42 10.35
Real GDP growth Current Account/GDP 1914 0.01 0.00 0.05 − 0.33 0.27
Quarterly real GDP growth rate Refinitiv Eikon
rate External Debt/GDP 1560 1.49 1.06 1.67 0.08 11.23
Current Account Current account balance in millions Natural Log of Foreign
Refinitiv Eikon
Balance/GDP US$ (as a % of nominal GDP) Reserves 1861 10.31 10.67 2.16 0.52 14.04
Gross external debt position in Unemployment Rate 1913 0.08 0.06 0.05 0.00 0.28
External debt/GDP million US$ (as a % of nominal Refinitiv Eikon Change in Inflation Rate 1638 0.01 0.00 0.01 − 0.03 0.08
GDP) Interest Rate 1779 0.03 0.01 0.03 − 0.01 0.24
International Log of the foreign currency reserves Financial Risk Rating 2058 38.79 38.83 4.71 25.50 48.50
Refinitiv Eikon
reserves of the government Political Risk Rating 2058 73.38 74.67 10.96 44.50 92.50
Unemployment Spread adjusted Total
Quarterly unemployment rate Refinitiv Eikon
Rate ESG Score – Sustain 809 0.61 0.63 0.10 0.32 0.88
Interest Rate Quarterly Central Bank policy rate Refinitiv Eikon Spread adjusted
Change in Inflation Quarterly change in the inflation Environmental Score
Refinitiv Eikon
Rate rate – Sustain 809 0.62 0.61 0.10 0.41 0.99
A means of assessing a country's position in terms of its Spread adjusted Social
economic, financial and political risk standing; 50 (least Score – Sustain 809 0.58 0.59 0.10 0.27 0.88
Risk Rating Scores
risk), 0 (highest risk) for economic and financial and 100 Spread adjusted
(least risk), 0 (highest risk) for political. Governance Score –
Components include foreign debt as Sustain 809 0.59 0.60 0.13 0.16 0.88
% of GDP, foreign debt as % of International Spread adjusted Total
Financial Risk
exports, current account as % of Country Risk Guide ESG Score – Refinitiv 2101 0.51 0.51 0.12 0.11 0.96
Rating
exports, net liquidity, exchange rate (ICRG) Spread adjusted
stability. Environmental Score
Components include government – Refinitiv 2101 0.63 0.65 0.13 0.10 0.96
stability, socioeconomic conditions, Spread adjusted Social
investment profile, internal conflict, Score – Refinitiv 2101 0.62 0.64 0.14 0.11 0.96
external conflict, corruption, International Spread adjusted
Political Risk Rating military in politics, religious Country Risk Guide Governance Score –
tensions, law and order, ethnic (ICRG) Refinitiv 2101 0.58 0.59 0.11 0.09 0.96
tensions, democratic Spread adjusted Total
accountability, and bureaucracy ESG Score – FTSE 499 0.63 0.64 0.11 0.25 1.00
quality Spread adjusted
Environmental Score
– FTSE 499 0.62 0.63 0.13 0.00 0.92
Spread adjusted Social
Score – FTSE 499 0.61 0.61 0.11 0.28 1.00
Spread adjusted
Does considering the financial materiality of various sustainability fac Governance Score –
FTSE 499 0.60 0.60 0.12 0.27 1.00
tors help in identifying the most important ESG issues that can affect a
Business Model &
country's credit health? (3) Is the impact of ESG ratings and subscores on Innovation - Refinitiv 2130 47.41 48.81 13.35 0.88 78.06
credit risk measures homogenous across all three ESG rating providers? Environment - Refinitiv 2190 52.60 54.72 17.17 0.30 92.42
Human Capital -
4. Model framework Refinitiv 2216 54.89 57.50 19.19 1.25 91.88
Leadership &
Governance -
In line with our hypotheses, we model the relationship between ESG Refinitiv 2262 53.97 53.25 7.71 7.14 88.03
ratings and two credit risk measures, CDS Spreads and Distance-to- Social Capital - Refinitiv 2228 51.39 52.16 13.03 4.81 92.08
default using a mixed effects panel regression. Mixed effects models Business Model &
are an extension of the traditional linear models that model a combi Innovation - Sustain 801 1.66 1.65 0.54 0.72 5.00
Environment - Sustain 836 0.75 0.73 0.30 0.05 3.00
nation of fixed and random effects. Mixed models are used to analyze Human Capital - Sustain 880 1.99 1.80 0.95 0.60 5.00
non-independent, longitudinal or correlated data. When there are Leadership &
repeated measurements for a subject over time, in our case ESG ratings Governance - Sustain 886 1.69 1.65 0.30 1.00 3.08
for countries over time, the measurements within a statistical unit are Social Capital - Sustain 853 1.71 1.71 0.46 0.65 4.22
Log of CDS spreads 1872 4.47 4.46 1.14 1.99 10.52
often correlated, thus violating the assumption of independent obser
Distance-to-default 666 25.30 25.15 9.14 7.36 62.51
vations (Harrison et al., 2018). Random effects represent a grouping S&P ratings 1600 17.21 18.00 3.73 4.00 21.00
variable (Breslow & Clayton, 1993) and exclusively incorporating these Moody's ratings 2436 15.86 17.00 4.79 1.00 21.00
random effects allows the estimation of the variance in the response
Notes: (i). The column N in the Table refers to the number of quarterly-country
variable within and between these groups (Harrison et al., 2018), observations, (ii). As is commonly done in credit risk modelling, we used a log
enhancing the inference of the fixed effects. Hence, mixed effects models transformation on size variables (Baesens and Gestel, 2008), (iii) The individual
allow greater control over the sources of variability in a study and allow indicator scores for Sustainalytics have been assigned on a scale of 1 to 5.
greater flexibility in modelling the error structure, making them far
more accommodating than fixed effects models. measures given the Country ID, i.e., we account for any differences in
Our study has a different mix of countries across different regions, the magnitude of the effect of the ESG ratings on the credit risk between
including both developed and emerging economies. We expect the the countries. In addition to this, we also incorporate random time ef
country-to-country variability to be high due to the differences in ESG fects to further account for any differences between time periods.
regulations, institutional landscapes and economic conditions between The equations are specified as follows:
countries. We fit a random slope for the ESG ratings on the credit risk
6
■ CDS spreads scores are available on request. For regressions based on SASB ESG
scores, we present results for the primary variables in the main text –
Natural Log of CDS Spreadsi,t = βk− 1 x′it + (βk + u1i + v1t )ESG Ratingit− 4 + εit
detailed tables can be available on request. We mention any differences
(2) in the results between scaled and unscaled ratings where observed. In
Where x represent the vector of explanatory control variables, β
′ addition to this, we analyze the results for the segregated samples of
represents the coefficient parameter for the fixed effects, u1i and v1t developed and developing countries for Refinitiv ratings to further delve
represent the random slope for ESG rating effect varying across country i into the dynamics of ESG factors. All tables show standardized co
and time t, respectively, and εit represents the random disturbance term. efficients such that the relative importance of each factor in explaining
The equation can be intuitively understood such that the fixed effects are sovereign credit risk can be assessed.
adjusted by random terms that are allowed to vary between countries
(u1i) and time (v1t). In addition to this, we incorporate the ESG ratings 5.1. High corporate sustainability performance in a country significantly
on a four-quarter lag to allow for any sluggish adjustment of variables reduces market-based and structural sovereign credit risk, with higher ESG
and also to reduce any chances of endogeneity bias. performance rewarded by lower CDS spreads and better debt servicing
x: (Real GDP Growth rate, Current Account Balance/GDP, External ability
Debt/GDP, Natural Log of Foreign reserves, Unemployment Rate,
Change in Inflation Rate, Interest Rate, Financial Risk Rating, Political The results for the mixed effects regressions for CDS spreads are
Risk Rating) presented in Table 4 for each of the three ESG rating agencies i.e.,
Sustainalytics, Refinitiv and FTSE. The results indicate a significant
■ Distance-to-default negative relationship between sustainability ratings and CDS spreads,
supporting our first hypothesis that ESG performance lowers the price of
Distance to Defaulti,t = βk− 1 x′it + (βk + u1i + v1t )ESG Ratingit− 4 + εit (3) protection against sovereign default. This means that investors are
x: (Real GDP Growth rate, Current Account Balance/GDP, Natural certainly sensitive to the ESG performance of a country because it signals
Log of Foreign reserves, Change in Inflation Rate, Political Risk Rating). a country's capacity to cope with climate, social and governance shocks
and indicates a long-term perspective. Countries with good ESG per
■ Credit ratings (S&P and Moody's) formance have a buffer against shocks, making investors more likely to
accept lower risk premiums for high ESG performing countries.
We model the link between ESG and credit ratings using ordered Our research findings for the distance-to-default regressions, sum
probit regressions. In an ordered probit model, an underlying score is marized in Table 5 are in line with the finding for CDS spreads. The
assessed as a linear function of the covariates and a set of threshold estimation results in Table 5 show that better ESG performance, spe
values (McCullagh, 1980). An ordered probit model with r categories of cifically on an environmental front increases the distance-to-default of a
credit ratings will construct an optimal scoring rule R*, linear in country (Capasso & Gianfrate, 2019), at least for Sustainalytics and
observed characteristics x. The equation is specified as follows: Refinitiv's environmental score. Intuitively, it is reasonable to expect
that the increased number of environmental and climatic events, espe
R* = βk− 1 x + ESG Ratingt− 4 βk + ε (4) cially during the last decade, have greatly affected the debt repaying
′
capacities of the countries, such that any investment towards tran

Where R* is the unobserved underlying latent variable, x represents ′
sitioning and building resilience against the consequences of these
a vector of time-varying explanatory variables, β represents the coeffi
environmental events can help a country hedge this risk. However, for
cient parameters and ε is a random disturbance term which is assumed to
FTSE's environmental rating, we find the opposite effect. A potential
have a normal distribution. The underlying level of score R* tells us the
explanation can be the methodological focus of the environmental factor
most likely rating given the threshold values c.
of this ESG provider. Although investments in countering the transition
AAA if R* > c20 and resilience risks are likely to have a long-term impact, in the short
⎧
⎪ AA+ if c20 > R* > c19 term these heavy investments may reduce a country's current ability to
⎪
⎪
⎪
⎪ finance physical damages especially if the country has a high climate
⎨ AA if c19 > R* > c18 change exposure or when a country is highly dependent on imports for
R= (5)
⎪ :
⎪
⎪ : : its energy supply.
⎪
⎪
⎩ :
: : We assess the regression results for the equally weighted ESG ratings
for robustness, and we find comparable results as above, confirming our
C if c1 > R* assumption that small firms are underrepresented in the sample data
x: (Log GDP/Capita, Current Account Balance/GDP, External Debt/ (Boffo & Patalano, 2020).
GDP, Natural Log of Foreign reserves, Unemployment Rate, Change in
Inflation Rate, Interest Rate, Financial Risk Rating, Political Risk 5.2. ESG factors are not fully and consistently captured by the credit
Rating). rating agencies
5. Results and discussion The results for the ordered probit regressions for the credit ratings
are presented in Table 6 and Table 7. The empirical findings for the
In this section, we present and discuss the key conclusions for the credit ratings do not allow for a definitive conclusion. We hypothesize
regressions of the four panels containing four credit risk measures, that higher sustainability scores coincide with higher sovereign credit
notably CDS spreads, distance-to-default, S&P ratings and Moody's rat ratings supporting the risk mitigation theory. However, for both
ings. For conciseness, we present the results for our primary variables – agencies, we find a negative correlation between sovereign credit rat
spread adjusted ESG factors – in the main text and the detailed tables for ings and Sustainalytics' ESG scores, which is in line with the over
the results are included in the Appendices. Results using the unscaled investment theory. This means that an increase in the ESG ratings
ESG scores instead of spread-adjusted scores and equally weighted ESG reflects increased costs at the country level and therefore results in a
lower credit rating. However, the results for the ratings by FTSE and
7
Table 4
Mixed effects estimation results for ESG scores for CDS spreads.
Dependent: CDS Spreads
Sustainalytics Refinitiv FTSE
− 0.122 − 0.105
Total ESG *** *** − 0.054
(0.031) (0.029) (0.033)
− 0.089 − 0.050
Environmental *** * − 0.046
(0.032) (0.029) (0.041)
− 0.110 − 0.100 − 0.112
Social *** *** ***
(0.033) (0.030) (0.038)
− 0.162
Governance 0.0003 *** 0.019
(0.039) (0.029) (0.036)
Controls Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes
Conditional R2 0.9380 0.9490 0.9450 0.9270 0.8700 0.9000 0.8840 0.9040 0.9480 0.9600 0.9490 0.9510
Marginal R2 0.3240 0.3260 0.3640 0.3570 0.4420 0.3910 0.3940 0.5910 0.5870 0.6700 0.5930 0.5650
Number of
Observations 610 610 610 610 864 864 864 864 301 301 301 301
Note: ***p < 0.01; **p < 0.05; *p < 0.1.

(i). For Refinitiv ratings, in this table we report the results only for the subset of the developed countries to allow meaningful comparisons across similar sample of
countries for the three rating providers.
(ii). The table presents standardized coefficients to allow easy comparisons and determine the relative importance of each variable in explaining the variance of the
dependent variable.
(iii). We note that the governance score is significant for Sustainalytics for unscaled ratings.
(iv). For FTSE ratings we observe that the Total ESG and environmental scores are significant at the current level.
(v). In mixed effects models, Marginal R2 explains the variance of the fixed effects only, whereas the Conditional R2 takes both the fixed and random effects into
account.
Table 5
Mixed effects estimation results for ESG scores for Distance-to-default.
Dependent: Distance-to-Default
Total ESG 0.192 *** 0.132 ** − 0.050

(0.050) (0.063) (0.071)
Environmental 0.134 *** 0.108 ** − 0.233 ***
(0.052) (0.053) (0.075)
Social 0.098 * 0.057 0.060
(0.051) (0.057) (0.074)
Governance 0.032 0.014 0.064
(0.057) (0.070) (0.072)
Conditional R2 0.8890 0.9000 0.8650 0.8910 0.8880 0.8870 0.8680 0.8950 0.9310 0.9430 0.9260 0.8670
Marginal R2 0.1100 0.1480 0.0830 0.0940 0.2440 0.1690 0.1400 0.1180 0.2190 0.2100 0.1310 0.1240
Number of Observations 425 425 425 425 527 527 527 527 152 152 152 152
Note: ***p < 0.01; **p < 0.05; *p < 0.1.

(i). For FTSE ratings we observe positive coefficients at the contemporaneous level, however, they are not significant.
(ii). We also observe higher significance for the unscaled scores across all the three ESG rating providers.
Refinitiv are more in line with our hypothesis where sustainability rat information available from various sources, which could partly explain
ings have a significant positive impact on the credit ratings. our mixed results. In addition to that, we believe that our time horizon
It is intriguing to obtain conflicting results for the impact of sus for the study possibly consists of a structural break in the methodology
tainability factors on credit ratings especially because they are the most of the credit rating agencies and it is expected that the ratings would
commonly used credit risk measure. However, we believe that it is a bit probably reflect the sustainability factors better in future time periods.
premature to test the significance of these sustainability metrics in That being said, our results are in line with other recent findings. An
determining credit ratings because it is only very recently that the credit independent study conducted by the Allianz Global Investors GmbH
rating agencies have started communicating about incorporating ESG (2017) investigates the relationship between MSCI ESG scores and S&P
variables in their credit rating methodologies. Most of the credit rating credit ratings for 123 different countries. The authors report that credit
agencies, especially the big three, are either developing their own in- rating agencies do not incorporte ESG risks in a systematic and contin
house ESG ratings or are working with different commercial ESG rat uous manner and argue that the credit rating agencies are incorportaing
ing providers for their ESG data. The weak correlations across ESG only a few ESG factors which mostly fall under the governance dimen
ratings from different providers, as presented in Table 14 (in Appendix sion. This is typically not picked up by the governance factor of the ESG
A), show that there indeed is a lack of comparability between the ESG scoring because it is much broader than the few indicators considered by
8
Table 6
Standard ordered probit regression results for ESG scores for S&P ratings.
Dependent: S&P ratings
− 3.219 − 1.950 4.880

Total ESG *** *** ***
(0.722) (0.496) (1.006)
− 6.108 − 1.323 6.791
Environmental *** *** ***
(0.793) (0.455) (1.074)
8.769
Social − 1.027 0.217 ***
(0.672) (0.389) (1.095)
− 5.049 1.015 1.627
Governance *** *** **
(0.658) (0.463) (0.900)
McFadden R2 0.4420 0.4660 0.4310 0.4660 0.3060 0.3030 0.3002 0.3020 0.4590 0.4860 0.5310 0.4290
Number of
Observations 582 582 582 582 798 798 798 798 270 270 270 270
Note: ***p < 0.01; **p < 0.05; *p < 0.1.
Table 7
Standard ordered probit regression results for ESG scores for Moody's ratings.
Dependent: Moody's ratings
− 1.920 − 2.063 5.214

Total ESG *** *** ***
(0.643) (0.466) (0.834)
− 4.959 − 1.237 7.011
Environmental *** *** ***
(0.677) (0.443) (0.875)
5.516
Social 0.237 0.004 ***
(0.604) (0.372) (0.783)
− 4.023
Governance *** 0.598 0.244
(0.592) (0.410) (0.788)
McFadden R2 0.3839 0.4041 0.3799 0.4009 0.5300 0.5280 0.5260 0.5270 0.4257 0.4537 0.4357 0.3926
Number of
Observations 654 654 654 654 914 914 914 914 316 316 316 316
Note: ***p < 0.01; **p < 0.05; *p < 0.1.
the rating agency. They further say that the credit rating agencies do not reinforcing the lack of comparability in the ESG scores.
seem to account for social and environmental risks and appear to be
adjusting their ratings on an ad-hoc basis in response to specific events.
5.3. ESG risks are asymmetric in their impact on sovereign credit risk
In an attempt to find more intuitive and consistent results for the
which is driven by differences in the economic specificities of the countries
credit ratings, we replace our corporate-based ESG scores in the re
and inherent multifaceted characteristics of the ESG factors
gressions with country sustainable development scores that were
introduced by Refinitiv in October 2020.11 The results for all the
To understand the different impact of the ESG scores and their sub
dependent variables are similar to our earlier results whereby, we find a
components, we first focus on the impact of the governance score on the
negative relationship between sovereign ESG ratings and CDS spreads
CDS spreads (Table 4). We find no significant impact of governance
whereas, a positive relationship with the DtD. Moreover, we again
score of Sustain and FTSE ratings on CDS spreads suggesting that good
observe that the coefficient estimate for the country sustainable devel
governance does not necessarily result in lower CDS spreads. A possible
opment score is negative for both the credit rating agencies. To leave no
justification for this could be that markets respond better to enhance
stones unturned, we also test the relationship using different econo
ments in governance performance and institutional strength by low or
metric methods but we consistently find an inverse relationship. The
medium ESG performing countries rather than to already high ESG
correlations (shown in Table 14 in Appendix A) between Refinitiv's
performing countries (BlueBay Asset Management and Verick Maple
country sustainable development scores and the ESG scores are also in
croft, 2019). For Sustainalytics and FTSE, our profile of countries con
line with the correlations between various providers of ESG scores,
sists mainly of developed nations which have well-developed
governance systems and political institutions thus, corroborating our
rationalization.
11
“Refinitiv debuts country sustainable development scores to measure how The asymmetric impact of ESG sub-scores is further explained by the
extensively a country meets UN SDGs”, Refinitiv, October 19, 2020, htt multifaceted nature of the ESG risks. Take for example the impact of
ps://www.refinitiv.com/content/dam/marketing/en_us/documents/methodo environmental risk on distance-to-default (Table 5). It has been estab
logy/refinitiv-country-sdg-scores-methodology.pdf. lished that environmental factors can affect sovereign credit risk
9
through various channels, however, there is a possibility of an overlap of explaining the prominent significance of the governance factor in
risks from these various channels and countering a single risk can expose addition to the social and environmental factors for Refinitiv ratings.
the country to other risks. An independent research by BlueBay Asset For distance-to-default, the environmental rating pops up as the most
Management and Verick Maplecroft (2019) reports that investors do not significant factor. According to a report by Moody's, natural disasters
consider the environmental performance of a country, but rather and climate events have contributed to 21% of sovereign defaults since
penalize high performing countries with higher spreads. They identify 1997 where they have either directly contributed to sovereign defaults
the physical climate change risk and biodiversity to be the main pre or significantly impaired a country's debt repaying capacity (Moody's,
dictor variables in terms of environmental performance. Countries with 2020), corroborating the prominent significance of the environmental
higher exposure to physical climate change – categorised as low score on default probability in our results. The recent pandemic has
enviornmnetal performers in the study - are also the countries with high highlighted the social component of ESG and how being unprepared can
biodiversity. Investors weigh biodiversity higher than climate change seriously derail a country's servicing ability. We believe it will probably
exposure resulting in lower spreads for low ESG scoring countries be reflected better in future periods. With regards to the lack of signif
because any investment in strengthning the environmental profile is icance of the governance aspect, Margaretic and Pouget (2018) also find
likely to be expensive and intended to payoff in the long term i.e. outside similar results when testing the importance of the governance indicator
the investment horizon of the investors. To this end, the negative coef in the estimated probability of sovereign debt default and/or debt
ficient for the environmental score in FTSE could be indicative of a restructuring and provide a convincing explanation for the lack of sig
higher weightage given to biodiversity variables underlying the envi nificance. The paper argues that institutional strength of a country can
ronmental score of the FTSE ratings, while it is known that the Europe greatly contribute to make corrective fiscal adjustments in periods of
does not have the richest biodiversity. Yet European countries are a large turmoil, however, beyond certain debt levels, the required adjustments
majority in our FTSE sample (see Table 15 in the Appendix B). may be extremely large and not enough to ease the probability of a
The individual random effects for the countries also provide insights sovereign default or a restructuring of the debt.
into the disparate impact of the ESG scores on sovereign credit risk. The In terms of the economic importance compared to other explanatory
random slopes for countries such as Poland, Greece and Russia are variables, the sustainability scores appear to be the third or fourth
positive in association with the CDS spreads whereas, for countries such important variable after Current Account-to-GDP, foreign reserves and
as Hungary and Portugal the random slopes are negative with respect to political risk, explaining about 11% to 12% of the absolute variance in
the distance-to-default of a country indicating the differences in the DtD on average. As observed in the results for CDS spreads, the impact of
impact of ESG across countries such that an investment in ESG by the three dimensions is again heterogeneous with environmental and
countries with weak economic positioning is perceived as an added social having the greater effect. However, as discussed earlier, the
expense by the investors at least for the period of their investment ho environmental score does a better job at explaining the variation in the
rizons and structurally also affects the debt servicing capability of the DtD.
countries which have tight fiscal spaces, at least in the short run. Time To investigate the difference between developed and developing
random effects also supplement the above evidence to the extent that the countries, we run a sub-sample analysis for developing countries only.
random slopes for ESG scores are positive for the brief period between We can only do this for Refinitiv ESG scores and CDS spreads and credit
last quarter of 2011 till the last quarter of 2012 – the period of the Eu ratings because we do not have enough data on developing countries for
ropean sovereign debt crises - with respect to CDS spreads suggesting the other ESG providers and distance-to-default. The findings for the
that investment in sustainability is considered positive or negative in subset of the developing countries for the Refinitiv ratings, summarized
relation to the other macroeconomic variables in play. in Table 8, show that the default risk for the developing countries is
driven by the environmental and social scores. The developing countries
are usually more exposed to climate shocks such as severe drought and
5.4. The impact of ESG factors on sovereign credit risk is economically
floods and have fewer resources for adaptation and mitigation than the
significant, but the importance of disaggregated component factors on the
developed countries. In addition to this, social risks such as human rights
credit risk is heterogeneous
and labor issues are more prevalent in developing countries making
them more susceptible to downside risk. Note also the different results
Our empirical findings suggest that ESG risks are transmitted to CDS
for the sovereign credit ratings in Table 8 compared to the developed
spreads mainly via environmental and social risks. We find that there is a
countries in Tables 6 and 7. While the relationship between ESG and
discernable economic effect of sustainability information on the CDS
credit ratings is found significantly negative for the developed countries,
spreads. The standardized coefficients show that the ESG ratings explain
Table 8 shows that the relation is significantly positive for the devel
a significant portion of the variance in the CDS spreads in addition to
oping countries.
other important variables such as External Debt-to- GDP, Unemploy
ment rate, Financial and Political risk ratings. A one unit increase in ESG
5.5. There is a lack of comparability between the ESG scores provided by
ratings decreases the CDS spreads within the range of 10–12 basis
the three ESG rating agencies
points.12 While the social rating of Sustainalytics and FTSE explain the
greater variance in CDS spreads, for Refinitiv ratings, the governance
It can already be established from the above discussion that there is a
score has the largest impact for the developed countries. Although the
significant difference in the underlying metrics used by the ESG rating
sample of countries includes the developed nations and is comparable
providers to calculate the aggregated scores. This finding is further
for the three ESG providers, the Refinitiv sample includes additional
supported by the low correlation between ESG ratings across rating
countries such as Czech Republic, Hungary, Greece and Japan which
agencies as shown in Table 14 (in Appendix A), and also reported by
have comparatively weaker governance strength and institutional
Berg, Koelbel, and Rigobon (2019). The correlations of the total ESG
quality than other developed countries in the sample, possibly
scores of the three providers range between 0.23 and 0.73. The provider
cross-correlations for the environmental and social scores are compa
12 rable and range between 0.43 and 0.73. The lowest comparability is
The dependent variable is log transformed, therefore, the coefficient value
represents the percentage change. To have an idea of how much the spread among the governance scores, ranging from 0.26 to 0.44. For compari
changes in basis points, we multiply the average percentage change in ESG son, the correlation between sovereign credit ratings of Moody's and
scores with the mean CDS spread i.e. one unit change in the Total ESG score of S&P is as high as 0.96.
Sustainalytics causes the CDS spreads to change by {(exp(− 0.122)-1)*exp. The relationship between ESG sub-scores and sovereign credit risk
(4.47)} = 11.30 basis points. measures is homogenous in terms of the sign of the coefficient estimates
10
Table 8
Results for the subset of the developing countries for Refinitiv ratings.
Results for the subset of Developing countries for Refinitiv ratings
CDS spreads S&P ratings Moody's ratings
− 0.144 5.162 6.894

Total ESG *** *** ***
(0.038) (0.887) (0.792)
− 0.131 4.333 3.707
Environmental ** *** ***
(0.059) (0.772) (0.660)
− 0.209 4.198 6.614
Social *** *** ***
(0.054) (0.900) (0.757)
2.509 2.960
Governance − 0.030 *** ***
(0.050) (0.911) (0.859)
Conditional R2 0.9110 0.9350 0.9190 0.9600
Marginal R2 0.6530 0.5920 0.5830 0.5950
McFadden R2 0.2670 0.2640 0.2540 0.2400 0.3119 0.2741 0.3118 0.2577
Number of
Observations 312 312 312 312 258 258 258 258 334 334 334 334
Note: ***p < 0.01; **p < 0.05; *p < 0.1.
Table 9
Mixed effects estimation results for SASB materiality-based ESG scores for CDS spreads.
Dependent: CDS Spreads
Sustainalytics Refinitiv
Business Model & Innovation Score 0.001 − 0.149 ***

(0.054) (0.035)
Environment Score 0.084 − 0.088 **
(0.063) (0.042)
Human Capital Score − 0.216 *** − 0.146 ***
(0.055) (0.039)
Leadership & Governance Score − 0.035 − 0.049 ***
(0.036) (0.019)
Social Capital Score − 0.163 *** − 0.155 ***
(0.039) (0.030)
Controls Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes
Conditional R2 0.9310 0.9130 0.9090 0.9200 0.9220 0.9020 0.9170 0.8980 0.8920 0.8940
Marginal R2 0.3750 0.4890 0.4840 0.3280 0.4680 0.4070 0.3640 0.5110 0.4460 0.4600
Number of Observations 605 615 617 617 617 864 864 864 864 864
Num. groups: Country 18 18 19 19 19 23 23 23 23 23
Num. groups: Date 36 36 38 38 38 40 40 40 40 40
Note: ***p < 0.01; **p < 0.05; *p < 0.1.

countries for the three rating providers (ii). The table presents standardized coefficients to allow easy comparisons and determine the relative importance of each
variable in explaining the variance of the dependent variable. (iii). In mixed effects models, Marginal R2 explains the variance of the fixed effects only, whereas the
Conditional R2 takes both the fixed and random effects into account.
for CDS spreads and DtD. However, we see a noticeable variation in the 5.6. SASB materiality-based ESG scores provide insights into what drives
significance and magnitude of the impact of the scores. The divergence each of the three credit risk measures
between the different ESG data providers is the most prevalent when
they are used to explain sovereign credit ratings. The results for the two Tables 9 and 10 represent results for CDS spreads and DtD re
credit rating agencies are quite similar and the differences arise mainly gressions for Sustainalytics and Refinitiv ratings. SASB materiality
across the three ESG rating providers. The scores by Sustainalytics have findings have two implications. For starters, they provide information at
a negative impact on the credit ratings, which is quite surprising. In a more granular level, rather than just the E, S, and G component levels.
addition, the total and the environmental scores for Refinitiv are also This helps us understand which indicators are most important within the
negative for the subset of the developed nations for both credit rating three broad component groups. Second, using the SASB materiality map
agencies. We do not have a concrete explanation for this, but as eluded allows for a comparison of results when sectoral differences are taken
earlier, we believe that a longer time horizon will enable us to make into account when incorporating ESG factors vs when all sectors and
better conclusions. their exposure to ESG risks in a country are given equal weightage.
11
Table 10
Mixed effects estimation results for SASB materiality-based ESG scores for Distance-to-default.
Dependent: Distance-to-Default
Business Model & Innovation Score − 0.046 0.171 **

(0.092) (0.077)
Environment Score 0.063 − 0.003
(0.072) (0.089)
Human Capital Score 0.250 *** − 0.095
(0.074) (0.075)
Leadership & Governance Score − 0.071 0.030
(0.050) (0.034)
Social Capital Score − 0.066 0.066
(0.075) (− 0.058)
Conditional 0.9270 0.7880 0.9100 0.9020 0.8940 0.8950 0.8710 0.8860 0.8990 0.8890
Marginal 0.0620 0.1040 0.1040 0.1220 0.0540 0.1770 0.1630 0.1850 0.2050 0.1740
Num. groups: Country 13 13 13 13 13 15 15 15 15 15
Num. groups: Date 36 36 36 36 36 38 38 38 38 38
Note: ***p < 0.01; **p < 0.05; *p < 0.1.

variable in explaining the variance of the dependent variable. (iii). In mixed effects models, Marginal R2 explains the variance of the fixed effects only, whereas the
Conditional R2 takes both the fixed and random effects into account.
Table 11
Standard ordered probit regression results for SASB materiality-based ESG scores for S&P ratings.
Dependent: S&P ratings
Business Model & Innovation Score 0.824 *** -0.018 ***

(0.167) (0.004)
Environment Score − 0.928 *** 0.003
(0.238) (0.004)
Human Capital Score 0.460 *** 0.004
(0.128) (0.003)
Leadership & Governance Score − 2.072 *** 0.015
(0.356) (0.010)
Social Capital Score − 0.709 *** − 0.015 ***
(0.182) (0.004)
McFadden 0.4449 0.4373 0.4361 0.4484 0.4373 0.3064 0.3003 0.3005 0.3008 0.3039
Note: ***p < 0.01; **p < 0.05; *p < 0.1.

variable in explaining the variance of the dependent variable.
Table 12
Standard ordered probit regression results for SASB materiality-based ESG scores for Moody's ratings.
Dependent: Moody's ratings
Business Model & Innovation Score 0.239 * 0.005

(0.138) (0.004)
Environment Score − 0.737 *** − 0.010 ***
(0.224) (0.004)
Human Capital Score − 0.290 *** − 0.005 **
(0.089) (0.002)
Leadership & Governance Score − 1.349 *** 0.001
(0.271) (0.009)
Social Capital Score − 0.630 *** − 0.008 **
(0.133) (0.004)
McFadden 0.3877 0.3979 0.3796 0.3893 0.3891 0.9683 0.9682 0.9684 0.9682 0.9682
Note: ***p < 0.01; **p < 0.05; *p < 0.1.

variable in explaining the variance of the dependent variable.
12
To begin, the relationship between CDS spreads and SASB
Notes: (i). The table presents standardized coefficients to allow easy comparisons and determine the relative importance of each variable in explaining the variance of the dependent variable. (ii). In mixed effects models,
0.024 ***
materiality-based ESG scores is both negative and significant, particu
(0.007)
0.2479
larly for Refinitiv. The significance of results for DtD and ESG scores, on
337
Yes
the other hand, was reduced when compared to what we evidenced with
spread adjusted ESG ratings.
0.084 ***
The three most important variables that stand out in terms of
(0.015)
0.2891
magnitude and significance for CDS spreads and DtD regressions are
341
Yes
business model and innovation ratings, human capital ratings and social
0.012 *** capital ratings, for both Sustainalytics and Refinitiv ratings collectively,
(0.004) compared to the results for spread adjusted ratings where the environ
0.2575
mental and social ratings had the most impact on CDS spreads and DtD.
341
Yes
The reduced significance of the environmental score, particularly for the
Sustainalytics score, is intriguing because it demonstrates that when
0.048 ***
only material issues on a sector level are considered, environmental

(0.006)
0.2434
performance plays a less important role in determining CDS spreads and
341
Yes
DtD. As we all know, the majority of the countries in our Sustainalytics

Moody's ratings
data sample are from Europe. Europe, in general, is at the forefront of

0.019 ***
efforts to transition to a low-carbon economy, which may make envi

(0.007)
0.2421
ronmental performance less important to market participants. Human

341
Yes
capital and social capital, on the other hand, have a significant impact.
Europe's emphasis on the social aspect has increased in recent years, and
(0.009)
0.2266
with the upcoming social taxonomy, it appears that social factors are
0.005
263
Yes
becoming more relevant for investors. However, the reduced importance

of environmental score in the determination of DtD is surprising at first
Marginal R2 explains the variance of the fixed effects only, whereas the Conditional R2 takes both the fixed and random effects into account.
glance; however, if we consider that the majority or all of the environ

(0.020)
0.2279
0.026
263
mental events in the past have affected default probabilities of devel

Yes
oping countries, whereas our data sample is mostly representative of

developed countries, it becomes more plausible. Furthermore, the high
− 0.006
(0.008)
0.2268
importance of human capital, business model, and resilience score in the

263
Yes
DtD models reconcile the results with the results for CDS spreads, and it
appears that transition risks and human capital risks play a larger role in
0.020 **
(0.009)
market-based and structural-based credit risk measures when specific

0.2311
263
sector based risks are taken into account.

Yes
Results for SASB materiality-based ESG ratings for the subset of the Developing Countries for Refinitiv ratings.
The social and human capital categories include risks related to, but
S&P ratings
no limited to, human rights and community relations, equal access to

0.017 **
(0.008)
0.2311
products and services, customer welfare over health and safety issues,
263
Yes
customer data privacy, labor practices, employee health and safety, and
employee engagement and inclusion. A discernible economic impact of
− 0.105
(0.076)
human capital and social capital on the CDS spreads is not surprising, as
0.9610
0.5730
319
social demands can put pressure on fiscal accounts (case in point is

Yes
40
9
Covid 19) and can also increase political risk if governing institutions do
not address them, in turn impacting the credit risk of a country (Nuzzo,
− 0.035
(0.046)
0.9770
0.5730
2018). The human capital and social factors can also affect investor
319
Yes
40
9
confidence, particularly among socially responsible investors, and in

turn can increase government liquidity risk (Nuzzo, 2018), thus
− 0.163 *
explaining the significance of two variable categories for CDS spreads

(0.084)
0.9610
0.6310
and DtD.
319
Yes
40
9
The results for the credit ratings are presented in Tables 11 and 12.
Results for the subset of Developing countries for Refinitiv ratings
Once again, the results are inconclusive and contradict our hypothesis.
− 0.096
(0.070)
0.9630
0.5910
There is a positive and negative relationship between various ESG scores

319
Yes
40
and credit ratings. The expectation was that calculating ESG scores
9
based on financial materiality would yield more conclusive results

CDS spreads
− 0.158 **
because credit rating agencies are primarily concerned with a company's

(0.071)
0.9320
0.4550
or country's financial ability to repay its debts; however, the inconclu

319
Yes
40
siveness of the results reinforces our belief that there is a structural break
9
in credit rating agencies' methodology and that future time periods will
Business Model & Innovation Score
allow for a better measurement of this relationship.

Leadership & Governance Score
Finally, Table 13 shows the relationship between SASB materiality-

based Refinitiv ESG scores and dependent variables for a subset of
Number of Observations
developing countries. In terms of market reaction to ESG risks, business

Num. groups: Country
Human Capital Score
model and innovation, as well as human capital rating, have the most
Social Capital Score
Environment Score
Num. groups: Date
significant impact. This implies that when a developing country dem

onstrates a commitment to building a more resilient economy, the
Conditional
McFadden
Marginal
market responds positively. The lack of significance of the environ

Controls
Table 13
mental score is surprising for developing countries, but the significance

of the business model and innovation score explains why. An in-depth
13
examination of the specific indicators of each SASB component reveals 6.1. Policy perspective
that under environmental ratings, there are more individual metrics
such as GHG emissions, the presence of waste and water management The policy landscape has changed dramatically in the aftermath of
facilities, which may be more relevant at the company level, whereas the the global financial crisis, the European debt crisis, and the imminent
business model and innovation variable demonstrates the resilience, climate challenges. Policymakers and regulators recognize the need to
physical impacts of climate change, and transition risks to a low-carbon transition to a green economy with strong and qualitative governance.
economy, making it more relevant at the country level. Human rights The recent pandemic has stressed the urgency to achieve sustainable
conditions in many developing countries remain deplorable, and development goals (SDGs). However, despite of a growing body of
improved human capital performance is positively rewarded by the research, enhanced product offerings and technological advances, there
market. In terms of the relationship with credit ratings, the results are remains a number of issues which hinder the shift towards sustainable
comparable to previous findings, indicating a positive relationship be investing. The role of policymakers and regulators is vital in achieving
tween the variables ESG ratings and credit ratings. Though the results the set SDGs and successful transition to a green economy.
remain more consistent for the credit ratings with respect to earlier re The results of this paper lead to several policy implications. First,
sults, however we cannot comment on the exact nature of the relation there is an urgent need for standardized global non-financial reporting
ship as the results remain mixed for the rest of the regressions. frameworks. As evidenced, it is essential that policymakers enforce
standard global ESG disclosure and reporting frameworks not just in
6. Conclusion developed but also in emerging economies. Lack of standardized regu
lation has resulted in non-financial information that is very diverse,
Our paper contributes to assessing the role of ESG factors in granular, incomplete and hence not comparable. Lack of accounting
explaining sovereign credit risk. Our work is important and innovative standards has also given rise to greenwashing, where companies are
in its approach to understand how ESG directly or indirectly determines engaging in false reporting regarding their ecological footprint. Stan
the credit risk of a sovereign issuer. The empirical evidence clearly dardization goes hand in hand with increased transparency. Right now,
supports the conjecture that ESG considerations alongside macroeco the ESG rating providers are unregulated, resulting in rating method
nomic and political factors contribute to more robust sovereign debt ologies that are not transparent. It is important that the ESG rating
analysis as compared to standalone analysis based on only economic agencies are regulated and supervised by the policymakers.
variables. Good ESG performance is generally perceived as a buffer Second, policymakers should make impact reporting compulsory.
against shocks and rewarded with lower risk premia. It is also indicative One of the major issues in ESG investment is the availability of the ESG
of the sovereign's ability to service its debt. However, modelling the data, especially for smaller firms or at the sovereign level. Lack of
relationship between disaggregated ESG factors and sovereign credit regulation on compulsory reporting means that there is a huge scarcity
risk also provides insights into the multifaceted impact of the individual of ESG data and most of the data that is available is patchy and of
dimensions on credit risk in relation to their interaction with the na questionable reliability. Most of the data is self-reported by large com
tional and global economy. Furthermore, the paper emphasizes that panies, whereas small and medium-sized enterprises are not part of this
using financial materiality information is critical in informing the true database. It is important that SMEs are provided support in taking up
impact of sustainability risk factors as well as assessing the financial ESG practices in their business processes and ensuring that the transition
significance of specific measures for sustainability analysis. Our findings remains profitable for the SMEs. In addition to this, data is almost
indicate that, at the country level, building resilience and transitioning exclusively available for developed economies. Data on high yield debt
to a low-carbon economy through innovation is critical, as is prioritizing or emerging economies is extremely scant. The issue of the availability
better governance of human and social capital to avoid the long-term of data at the sovereign level is even more grave. Structured ESG data is
consequences of sustainability risks. We find that ESG information almost non-existent at the country level.
from various sources reflects differences in the underlying data and the Last but not least, the current scenario calls for the need to devise
scoring system frameworks. These differences make ESG data weakly techniques and strategies to manage sustainability risks at the sovereign
comparable and hinder their use for market participants. Reflecting on level. Until now, the focus of regulatory actions was mainly on corpo
the results show that the interactions between ESG factors, global eco rations and largely neglected the risks at the sovereign level. However,
nomic factors and sovereign credit risk are quite complex. The interplay sustainability failures at the corporate level risk to quickly spill over to
between sovereign credit risk and ESG is not a simple input-output the country level, for example, under the form of increased bankrupt
relationship rather is driven by the metrics underlying the aggregated cies. Apart from that, climate and social risks are a direct threat to
ESG scores, country specificities, interaction of the ESG factors with the sovereign financial health, as explained in the beginning. We find that
national and global factors and inherent multidimensional characteris CDS markets already price these risks (to some extent), but sustainability
tics of the ESG risks. risks are still underestimated by credit rating agencies.
We acknowledge the limitations of our study. Firstly, the lack of Our paper attempts to be comprehensive, however, it is not non-
available sovereign level ESG data forces us to rely on company ESG exhaustive. The paper opens opportunities for further research, both
data. In addition, the use of multiple ESG ratings and credit risk mea in terms of data and methodology. As we saw, the impact of the three
sures results in a varied sample of countries. Also, due to data avail components E, S, and G on various credit risk measures, particularly
ability, the assessment period for FTSE ESG data is shorter than the credit ratings, varies. It would be interesting to investigate further where
selected period. However, we believe that our research design and the variability is coming from using more granular data, as well as to
methodology in assessing the importance of sustainability factors in broaden the research to include a larger sample of countries with a
credit risk assessment overcomes data limitations, and we do not allow greater representation of developing countries. Furthermore, various
data limitations to impede the assessment of our research questions. methodological approaches can be used to investigate the relationship
between ESG and credit risk, for example, the use of non-linear meth
odological approaches may explain the mixed results for credit ratings.
14
Appendix A. Correlation Matrix for ESG ratings and credit risk measures
Table 14
Correlation Matrix for ESG ratings and credit risk measures.
(1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (12) (13) (14) (15) (16)
Env. Refinitiv (1)

0.88
Soc. Refinitiv (2) ***
0.45 0.40
Gov. Refinitiv (3) *** ***
0.59 0.57 0.33
Tot. Refinitiv (4) *** *** ***
0.52 0.46 0.30 0.30
Env. Sustain (5) *** *** *** ***
0.61 0.53 0.32 0.35 0.72
Soc. Sustain (6) *** *** *** *** ***
0.47 0.46 0.40 0.35 0.68 0.71
Gov. Sustain (7) *** *** *** *** *** ***
0.61 0.54 0.37 0.37 0.89 0.92 0.85
Tot. Sustain (8) *** *** *** *** *** *** ***
0.70 0.65 0.34 0.26 0.43 0.44 0.36 0.44
Env. FTSE (9) *** *** *** *** *** *** *** ***
0.72 0.73 0.30 0.22 0.60 0.56 0.41 0.59 0.88
Soc. FTSE (10) *** *** *** *** *** *** *** *** ***
0.32 0.34 0.26 0.16 0.12 0.47 0.44 0.41 0.47 0.54
Gov. FTSE (11) *** *** *** *** ** *** *** *** *** ***
0.68 0.68 0.35 0.23 0.46 0.62 0.51 0.60 0.90 0.94 0.73
Tot. FTSE (12) *** *** *** *** *** *** *** *** *** *** ***
0.62 0.52 0.26 0.28 0.49 0.45 0.33 0.50 0.31 0.37 0.25 0.37
Sov. Refinitiv (13) *** *** *** *** *** *** *** *** *** *** *** ***
− 0.42 − 0.34 − 0.43 − 0.05 − 0.44 − 0.34 − 0.33 − 0.44 − 0.25 − 0.21 − 0.11 − 0.22 − 0.53
CDS spreads (14) *** *** *** ** *** *** *** *** *** *** ** *** ***
0.15 − 0.06 0.10 − 0.13 0.14 0.13 0.19 0.37 − 0.50
DtD (15) *** * *** *** *** 0.07 0.05 *** *** − 0.05 − 0.07 − 0.02 *** ***
0.36 0.20 0.34 − 0.13 0.11 0.09 0.32 0.27 0.25 0.60 − 0.79 0.46
S&P (16) *** *** *** *** *** 0.00 0.07 * ** *** *** 0.08 *** *** *** ***
0.35 0.24 0.27 0.10 0.07 0.57 − 0.80 0.53 0.96
Moody's (17) *** *** *** − 0.01 0.06 * − 0.02 *** ** 0.08 * 0.02 − 0.02 0.01 *** *** *** ***
Note: ***p < 0.01; **p < 0.05; *p < 0.1.
Appendix B. List of countries

Table 15
List of countries.
Panel A: CDS Spreads Panel B: Distance-to-default
Sustainalytics Refinitiv (Developing Refinitiv (Developed FTSE Sustainalytics Refinitiv (Developing Refinitiv (Developed FTSE
Countries) Countries) Countries) Countries)
Austria Brazil Australia Australia Austria Indonesia Austria Austria

Belgium Indonesia Austria Austria Belgium Mexico Belgium Belgium
Canada Malaysia Belgium Belgium Canada South Africa Canada Canada
Denmark Mexico Canada Canada Finland Czech Republic Finland
Finland Philippines Czech Republic Denmark France Finland France
France Russia Denmark Finland Germany France Germany
Germany South Africa Finland France Italy Germany Italy
Ireland Thailand France Germany Netherlands Hungary Netherlands
Netherlands Turkey Germany Greece Portugal Italy Portugal
Norway Greece Ireland Spain Netherlands Spain
Poland Hungary Japan Sweden Portugal Sweden
United United
Portugal Ireland Netherlands Kingdom Spain Kingdom
Russia Japan New Zealand United States Sweden United States
Spain Netherlands Norway United Kingdom
Sweden New Zealand Portugal United States
Switzerland Norway Spain
United
Kingdom Poland Sweden
United States Portugal Switzerland
United
Spain Kingdom
Sweden United States
Switzerland
United Kingdom
United States
(continued on next page)
15
Table 15 (continued )
Panel A: CDS Spreads Panel B: Distance-to-default
Sustainalytics Refinitiv (Developing Refinitiv (Developed FTSE Sustainalytics Refinitiv (Developing Refinitiv (Developed FTSE
Panel C: S&P ratings Panel D: Moody's ratings

Refinitiv (Developing Refinitiv (Developed Refinitiv (Developing Refinitiv (Developed
Sustainalytics FTSE Sustainalytics FTSE
Austria Brazil Australia Australia Austria Brazil Australia Australia

Belgium Indonesia Austria Austria Belgium Indonesia Austria Austria
Canada Mexico Belgium Belgium Canada Malaysia Belgium Belgium
Denmark Russia Canada Canada Denmark Mexico Canada Canada
Finland South Africa Czech Republic Denmark Finland Philippines Czech Republic Denmark
France Thailand Denmark Finland France Russia Denmark Finland
Germany Turkey Finland France Germany South Africa Finland France
Ireland France Germany Ireland Thailand France Germany
Norway Germany Ireland Italy Turkey Germany Greece
Poland Hungary Japan Netherlands Greece Ireland
Portugal Ireland New Zealand Norway Hungary Italy
Russia Japan Norway Poland Ireland Japan
Spain New Zealand Poland Portugal Italy Netherlands
Sweden Norway Portugal Russia Japan New Zealand
Switzerland Poland Spain Spain Netherlands Norway
United Kingdom Portugal Sweden Sweden New Zealand Poland
United States Spain Switzerland Switzerland Norway Portugal
United United
Sweden Kingdom Kingdom Poland Spain
Switzerland United States United States Portugal Sweden
United Kingdom Spain Switzerland
United
United States Sweden Kingdom
Switzerland United States
United Kingdom
United States
Appendix C. Ordinal transformation of credit ratings

Table 16
Ordinal transformation of credit ratings.
Linear transformation
Grade Moody's S&P Scale
Investment Aaa AAA 21

Aa1 AA+ 20
Aa2 AA 19
Aa3 AA- 18
A1 A+ 17
A2 A 16
A3 A- 15
Baa1 BBB+ 14
Baa2 BBB 13
Baa3 BBB- 12
Speculative Ba1 BB+ 11
Ba2 BB 10
Ba3 BB- 9
B1 B+ 8
B2 B 7
B3 B- 6
Caa1 CCC+ 5
Caa2 CCC 4
Caa3 CCC- 3
Ca CC 2
C C,SD,C 1
16
Appendix D. Country ranking based on weighted average and spread-adjusted ratings

Table 17
Country Ranking based on Weighted average and Spread-adjusted ratings.
Country ranking based on the Weighted average and Spread-adjusted Total ESG Score
Sustain FTSE Refinitiv
Country WA Score Rank Spread Adj. Score Rank WA Score Rank Spread Adj. Score Rank WA Score Rank Spread Adj. Score Rank
Norway 71.058 1 0.687 2 3.673 8 0.669 9 54.341 11 0.533 11
Denmark 70.373 2 0.746 1 3.514 13 0.644 12 49.211 27 0.433 29
Portugal 70.363 3 0.632 8 4.005 1 0.612 14 64.057 1 0.645 2
Netherlands 70.082 4 0.625 10 3.753 6 0.692 7 49.749 24 0.473 25
Spain 69.984 5 0.667 5 3.969 2 0.761 2 61.176 3 0.605 4
Finland 69.781 6 0.672 4 3.559 11 0.573 19 58.069 5 0.513 16
Germany 69.010 7 0.673 3 3.486 14 0.731 3 51.241 21 0.480 22
France 68.636 8 0.615 12 3.659 9 0.626 13 52.625 17 0.476 24
Italy 68.573 9 0.657 6 3.778 4 0.668 10 54.678 8 0.536 10
Sweden 66.880 10 0.601 14 3.585 10 0.693 6 56.654 6 0.568 6
Switzerland 66.717 11 0.622 11 3.772 5 0.795 1 51.529 19 0.479 23
United Kingdom 66.165 12 0.570 16 3.741 7 0.687 8 49.589 25 0.481 20
Austria 64.471 13 0.626 9 3.236 16 0.584 16 53.224 15 0.481 21
Russia 64.217 14 0.611 13 43.602 31 0.472 26
Belgium 63.610 15 0.641 7 3.195 17 0.591 15 42.209 33 0.428 30
Ireland 62.426 16 0.592 15 2.728 19 0.459 22 55.606 7 0.524 13
Canada 61.572 17 0.552 17 3.242 15 0.654 11 50.849 22 0.533 12
United States 59.499 18 0.456 19 2.925 18 0.574 18 44.397 29 0.427 31
Poland 56.048 19 0.481 18 2.436 22 0.576 17 48.335 28 0.553 8
Greece 3.923 3 0.708 4 62.444 2 0.672 1
Australia 3.552 12 0.701 5 51.299 20 0.502 18
New Zealand 2.491 21 0.568 20 50.123 23 0.497 19
Japan 2.498 20 0.556 21 53.429 13 0.549 9
Thailand 59.077 4 0.608 3
Indonesia 54.351 10 0.568 5
Malaysia 51.551 18 0.556 7
Brazil 52.664 16 0.521 14
South Africa 53.338 14 0.516 15
Turkey 53.604 12 0.508 17
Philippines 49.238 26 0.467 27
Mexico 44.282 30 0.447 28
Czech Republic 42.424 32 0.408 32
Hungary 54.624 9 0.323 33
Average 66.288 0.617 3.459 0.644 52.165 0.507
Std. Dev 4.090 0.067 0.413 0.078 5.494 0.057
Note: (i). We rank the countries from the best performing (Rank 1) to the worst performing based on the mean of the weighted average and spread adjusted ESG scores
for each country.
Appendix E. Results for CDS spreads
E.1. Results with sustainalytics ESG scores

Table 18
Mixed effects estimation results for CDS spreads with Sustainalytics ESG Scores.
Dependent: Natural Log of CDS Spreads
Spread adjusted Sustainalytics ESG Scores
Variables Expected sign Total ESG Score Environmental Score Social Score Governance Score
Real GDP Growth Rate ¡ − 0.030 *** − 0.021 − 0.023 ** − 0.031 ***
(0.011) (0.011) (0.012) (0.012)
Current Account/GDP ¡ − 0.055 *** − 0.041 ** − 0.055 *** − 0.064 ***
(0.020) (0.019) (0.020) (0.020)
External Debt/GDP þ 0.392 *** 0.537 *** 0.502 *** 0.274 ***
(0.068) (0.068) (0.062) (0.071)
Natural Log of Foreign Reserves ¡ − 0.132 *** − 0.07 ** − 0.118 *** − 0.044
(0.036) (0.035) (0.035) (0.036)
Unemployment Rate þ 0.269 *** 0.172 *** 0.177 *** 0.362 ***
(0.044) (0.043) (0.044) (0.041)
Change in Inflation Rate þ 0.057 *** 0.043 *** 0.056 *** 0.059 ***
(0.015) (0.015) (0.015) (0.015)
Interest Rate þ 0.127 *** 0.046 *** 0.142 *** 0.224 ***
(0.035) (0.033) (0.031) (0.031)
Financial Risk Rating ¡ 0.110 *** − 0.130 0.042 0.030
(0.043) (0.040) (0.042) (0.044)
Political Risk Rating ¡ − 0.101 ** 0.159 *** − 0.141 *** − 0.097 **
(0.045) (0.044) (0.042) (0.043)
Spread adjusted Total ESG Score (lagged) ¡ − 0.122 ***
17
(0.031)
Spread adjusted Environmental Score (lagged) ¡ − 0.089 ***
(0.032)
Spread adjusted Social Score (lagged) ¡ − 0.110 ***
(0.033)
Spread adjusted Governance Score (lagged) ¡ − 0.0003
(0.039)
2
Conditional R 0.9380 0.9490 0.9450 0.9270
Marginal R2 0.3240 0.3260 0.3640 0.3570
Number of Observations 610 610 610 610
Note: ***p < 0.01; **p < 0.05; *p < 0.1.
E.2. Results with Refinitiv ESG scores

Table 19
Mixed effects estimation results for CDS spreads with Refinitiv ESG Scores for the subset of Developed countries.
Spread adjusted Refinitiv ESG Scores (Developed Countries)
Real GDP Growth Rate ¡ − 0.005 − 0.012 − 0.011 − 0.025 **

(0.012) (0.012) (0.012) (0.012)
Current Account/GDP ¡ 0.010 − 0.001 0.004 0.001
(0.021) (0.020) (0.021) (0.021)
External Debt/GDP þ 0.033 0.143 ** 0.064 0.002
(0.052) (0.056) (0.052) (0.064)
Natural Log of Foreign Reserves ¡ − 0.048 − 0.162 *** − 0.147 *** − 0.202 ***
(0.036) (0.036) (0.036) (0.036)
(0.042) (0.040) (0.041) (0.041)
Change in Inflation Rate þ 0.007 0.011 0.009 0.013
(0.014) (0.014) (0.014) (0.014)
Interest Rate þ 0.041 − 0.025 0.030 0.052 **
(0.022) (0.023) (0.024) (0.022)
Financial Risk Rating ¡ 0.103 *** 0.101 *** 0.125 *** 0.100 ***
(0.034) (0.036) (0.037) (0.036)
Political Risk Rating ¡ − 0.112 *** 0.030 0.001 0.017
(0.035) (0.038) (0.040) (0.039)
(0.029)
Spread adjusted Environmental Score (lagged) ¡ − 0.050 *
(0.029)
(0.030)
Spread adjusted Governance Score (lagged) ¡ − 0.162 ***
(0.029)
2
Conditional R 0.8700 0.9000 0.8840 0.9040
Marginal R2 0.4420 0.3910 0.3940 0.5910
Note: ***p < 0.01; **p < 0.05; *p < 0.1.
Table 20
Mixed effects estimation results for CDS spreads with Refinitiv ESG Scores for the subset of developing countries.
Spread adjusted Refinitiv ESG Scores (Developing Countries)
Real GDP Growth Rate ¡ 0.001 − 0.012 − 0.003 − 0.011

(0.025) (0.025) (0.025) (0.024)
Current Account/GDP ¡ − 0.060 − 0.080 ** − 0.048 − 0.099 ***
(0.038) (0.040) (0.040) (0.038)
External Debt/GDP þ 0.345 *** 0.360 *** 0.355 *** 0.350 ***
(0.058) (0.064) (0.065) (0.064)
Natural Log of Foreign Reserves ¡ 0.244 *** − 0.207 − 0.001 − 0.206
(0.084) (0.117) (0.110) (0.115)
(0.086) (0.137) (0.121) (0.118)
18
Change in Inflation Rate þ 0.060 ** 0.085 *** 0.080 *** 0.060 **

(0.028) (0.028) (0.028) (0.027)
Interest Rate þ 0.404 *** 0.276 *** 0.284 *** 0.272 ***
(0.043) (0.043) (0.042) (0.039)
Financial Risk Rating ¡ − 0.204 *** − 0.140 *** − 0.149 *** − 0.232 ***
(0.049) (0.052) (0.051) (0.052)
Political Risk Rating ¡ − 0.225 *** − 0.269 *** − 0.289 *** − 0.279 ***
(0.049) (0.055) (0.052) (0.057)
(0.038)
Spread adjusted Environmental Score (lagged) ¡ − 0.131 **
(0.059)
(0.054)
Spread adjusted Governance Score (lagged) ¡ − 0.030
(0.050)
Conditional R2 0.9110 0.9350 0.9190 0.9600
Marginal R2 0.6530 0.5920 0.5830 0.5950
Note: ***p < 0.01; **p < 0.05; *p < 0.1.
E.3. Results with FTSE ESG scores

Table 21
Mixed effects estimation results for CDS spreads with FTSE ESG scores.
Spread adjusted FTSE ESG Scores
Real GDP Growth Rate ¡ 0.009 0.003 0.005 0.006

(0.014) (0.015) (0.015) (0.015)
Current Account/GDP ¡ − 0.051 ** − 0.043 − 0.041 − 0.033
(0.022) (0.022) (0.022) (0.022)
External Debt/GDP þ 0.199 *** 0.114 0.021 0.145 **
(0.066) (0.070) (0.069) (0.061)
Natural Log of Foreign Reserves ¡ 0.08 − 0.033 0.057 − 0.071
(0.089) (0.087) (0.086) (0.083)
(0.069) (0.062) (0.071) (0.065)
Change in Inflation Rate þ 0.003 − 0.005 0.006 − 0.003
(0.017) (0.017) (0.018) (0.017)
Interest Rate þ 0.093 ** 0.075 * 0.088 ** 0.072 *
(0.040) (0.043) (0.041) (0.040)
Financial Risk Rating ¡ − 0.017 0.014 0.06 − 0.027
(0.062) (0.066) (0.065) (0.058)
Political Risk Rating ¡ − 0.204 *** − 0.205 *** − 0.215 *** − 0.173 ***
(0.055) (0.058) (0.060) (0.058)
Spread adjusted Total ESG Score (lagged) ¡ − 0.054
(0.033)
Spread adjusted Environmental Score (lagged) ¡ − 0.046
(0.041)
(0.038)
Spread adjusted Governance Score (lagged) ¡ 0.019
(0.036)
Conditional R2 0.9480 0.9600 0.9490 0.9510
Marginal R2 0.5870 0.6700 0.5930 0.5650
Note: ***p < 0.01; **p < 0.05; *p < 0.1.
19
Appendix F. Results for distance-to-default regressions
F.1. Results with sustainalytics ESG scores

Table 22
Mixed effects estimation results for Distance-to-default with sustainalytics ESG scores.
Dependent: Distance to Default
Real GDP Growth Rate þ − 0.015 − 0.016 − 0.018 − 0.013

(0.028) (0.029) (0.030) (0.029)
Current Account/GDP þ − 0.373 *** − 0.367 *** − 0.331 *** − 0.392 ***
(0.049) (0.052) (0.052) (0.052)
Natural Log of Foreign Reserves þ − 0.235 *** − 0.363 *** − 0.19 *** − 0.165 **
(0.070) (0.073) (0.069) (0.073)
(0.030) (0.031) (0.032) (0.032)
Political Risk Rating þ − 0.004 − 0.04 0.036 − 0.002
(0.073) (0.073) (0.078) (0.073)
Spread adjusted Total ESG Score (lagged) þ 0.192 ***
(0.050)
Spread adjusted Environmental Score (lagged) þ 0.134 ***
(0.052)
Spread adjusted Social Score (lagged) þ 0.098 *
(0.051)
Spread adjusted Governance Score (lagged) þ 0.032
(0.057)
2
Conditional R 0.8890 0.9000 0.8650 0.8910
Marginal R2 0.1100 0.1480 0.0830 0.0940
Note: ***p < 0.01; **p < 0.05; *p < 0.1.
F.2. Results with Refinitiv ESG scores

Table 23
Mixed effects estimation results for Distance-to-default with Refinitiv ESG Scores for the subset of the developed countries.
Real GDP Growth Rate þ − 0.028 − 0.011 0.006 0.012

(0.027) (0.026) (0.026) (0.026)
(0.046) (0.043) (0.045) (0.044)
Natural Log of Foreign Reserves þ − 0.585 *** − 0.400 *** − 0.348 *** − 0.245 ***
(0.068) (0.065) (0.063) (0.062)
(0.028) (0.028) (0.028) (0.028)
Political Risk Rating þ 0.061 − 0.101 − 0.109 − 0.039
(0.059) (0.062) (0.063) (0.062)
Spread adjusted Total ESG Score (lagged) þ 0.132 **
(0.063)
Spread adjusted Environmental Score (lagged) þ 0.108 **
(0.053)
Spread adjusted Social Score (lagged) þ 0.057 *
(0.057)
(0.070)
Conditional R2 0.8880 0.8870 0.8680 0.8950
Marginal R2 0.2440 0.1690 0.1400 0.1180
Note: ***p < 0.01; **p < 0.05; *p < 0.1.
20
F.3. Results with FTSE ESG scores

Table 24
Mixed effects estimation results for Distance-to-default with FTSE ESG Scores.
Real GDP Growth Rate þ − 0.023 0.015 − 0.032 − 0.038

(0.033) (0.032) (0.033) (0.037)
Current Account/GDP þ − 0.203 * − 0.073 − 0.201 * − 0.114
(0.116) (0.113) (0.115) (0.116)
Natural Log of Foreign Reserves þ − 0.567 *** − 0.413 ** − 0.439 ** − 0.361 **
(0.171) (0.171) (0.165) (0.169)
(0.040) (0.038) (0.040) (0.043)
Political Risk Rating þ 0.209 * 0.216 * 0.229 * 0.198
(0.116) (0.117) (0.117) (0.120)
Spread adjusted Total ESG Score (lagged) þ − 0.05
(0.071)
Spread adjusted Environmental Score (lagged) þ − 0.233 ***
(0.075)
Spread adjusted Social Score (lagged) þ 0.06
(0.074)
(0.072)
Conditional R2 0.9310 0.9430 0.9260 0.8670
Marginal R2 0.2190 0.2100 0.1310 0.1240
Note: ***p < 0.01; **p < 0.05; *p < 0.1.
Appendix G. Results for S&P ratings
G.1. Results with Sustainalytics ESG scores

Table 25
Standard ordered probit estimation results for S&P ratings with Sustainalytics ESG Scores.
Dependent: S&P Ratings
Log GDP/Capita þ 4.207 4.238 *** 3.903 *** 5.204 ***

(0.277) (0.281) (0.262) (0.326)
Current Account/GDP þ − 3.424 *** − 2.603 ** − 4.505 *** − 3.606 ***
(1.408) (1.416) (1.390) (1.389)
External Debt/GDP ¡ − 0.211 *** − 0.176 *** − 0.180 *** − 0.211 ***
(0.050) (0.051) (0.049) (0.050)
Natural Log of Foreign Reserves þ 0.411 *** 0.393 *** 0.432 *** 0.408 ***
(0.052) (0.052) (0.051) (0.052)
Unemployment Rate ¡ − 8.423 *** − 10.657 *** − 8.365 *** − 8.953 ***
(1.757) (1.808) (1.741) (1.779)
Change in Inflation Rate ¡ − 1.052 − 7.123 − 5.961 14.341
(13.276) (13.393) (13.174) (13.668)
Interest Rate ¡ 11.951 *** 5.362 11.874 *** 11.810 ***
(5.226) (5.356) (5.446) (5.277)
Financial Risk Rating þ 0.020 0.021 0.018 0.058 **
(0.030) (0.030) (0.030) (0.032)
Political Risk Rating þ 0.011 − 0.005 0.020 − 0.006
(0.015) (0.015) (0.014) (0.015)
Spread adjusted Total ESG Score (lagged) þ − 3.219 ***
(0.722)
(0.793)
Spread adjusted Social Score (lagged) þ − 1.027
(0.672)
Spread adjusted Governance Score (lagged) þ − 5.049 ***
(0.658)
McFadden R2 0.4420 0.4660 0.4310 0.4660
Note: ***p < 0.01; **p < 0.05; *p < 0.1.
21
G.2. Results with Refinitiv ESG scores

Table 26
Standard ordered probit estimation results for S&P ratings with Refinitiv ESG Scores for the subset of developed countries.
Log GDP/Capita þ 3.231 *** 3.448 *** 3.185 *** 3.116 ***
(0.168) (0.187) (0.178) (0.175)
(1.137) (1.122) (1.119) (1.138)
(0.039) (0.038) (0.038) (0.039)
Natural Log of Foreign Reserves þ 0.109 *** 0.123 *** 0.093 *** 0.066
(0.038) (0.039) (0.038) (0.040)
(1.598) (1.453) (1.438) (1.473)
Change in Inflation Rate ¡ 24.638 *** 27.706 *** 24.164 *** 23.930 ***
(9.099) (9.158) (9.105) (9.088)
Interest Rate ¡ 13.038 *** 14.169 *** 16.551 *** 16.950 ***
(4.513) (4.517) (4.495) (4.483)
Financial Risk Rating þ 0.022 − 0.005 − 0.0003 − 0.003
(0.020) (0.019) (0.019) (0.019)
Political Risk Rating þ 0.005 − 0.014 − 0.008 − 0.012
(0.013) (0.013) (0.013) (0.013)
(0.496)
(0.455)
(0.389)
Spread adjusted Governance Score (lagged) þ 1.015 ***
(0.463)
2
McFadden R 0.3060 0.3030 0.3002 0.3020
Note: ***p < 0.01; **p < 0.05; *p < 0.1.
Table 27
Standard ordered probit estimation results for S&P ratings with Refinitiv ESG Scores for the subset of developing countries.
Log GDP/Capita þ 2.659 *** 2.051 *** 2.436 *** 1.991 ***
(0.262) (0.230) (0.252) (0.228)
Current Account/GDP þ 13.359 *** 13.140 *** 11.752 *** 12.693 ***
(2.522) (2.533) (2.507) (2.521)
External Debt/GDP ¡ 2.178 ** 2.930 *** 2.206 ** 2.980 ***
(1.266) (1.258) (1.270) (1.252)
(0.252) (0.262) (0.279) (0.247)
(2.052) (2.260) (2.245) (2.059)
Change in Inflation Rate ¡ 2.729 4.771 4.209 1.868
(7.010) (7.032) (7.027) (6.983)
Interest Rate ¡ − 6.603 *** − 7.195 *** − 5.637 ** − 5.259 **
(3.050) (3.048) (3.029) (3.021)
Financial Risk Rating þ 0.078 *** 0.097 *** 0.083 *** 0.074 ***
(0.036) (0.036) (0.036) (0.035)
Political Risk Rating þ 0.237 *** 0.248 *** 0.232 *** 0.207 ***
(0.028) (0.029) (0.028) (0.028)
(0.887)
(0.772)
Spread adjusted Social Score (lagged) þ 4.198 ***
(0.900)
(0.911)
2
McFadden R 0.2670 0.2640 0.2540 0.2400
Note: ***p < 0.01; **p < 0.05; *p < 0.1.
22
G.3. Results with FTSE ESG scores

Table 28
Standard ordered probit estimation results for S&P ratings with FTSE ESG Scores.
Log GDP/Capita þ 7.552 *** 7.970 *** 9.029 *** 7.132 ***
(0.769) (0.827) (0.952) (0.716)
Current Account/GDP þ − 3.089 ** − 3.791 *** − 3.505 ** − 3.394 **
(1.818) (1.837) (1.879) (1.808)
(0.099) (0.101) (0.109) (0.098)
Natural Log of Foreign Reserves þ 0.207 *** 0.117 0.322 *** 0.263 ***
(0.101) (0.105) (0.110) (0.096)
(3.887) (3.990) (4.160) (3.692)
Change in Inflation Rate ¡ 3.197 − 4.348 − 21.283 14.957
(23.386) (23.815) (24.631) (22.903)
Interest Rate ¡ 31.010 ** 67.364 *** 89.401 *** 19.415
(16.931) (19.006) (20.373) (16.874)
Financial Risk Rating þ − 0.158 *** − 0.067 − 0.174 *** − 0.153 ***
(0.063) (0.065) (0.066) (0.061)
Political Risk Rating þ − 0.104 *** − 0.084 *** − 0.094 *** − 0.098 ***
(0.027) (0.027) (0.027) (0.027)
(1.006)
(1.074)
(1.095)
Spread adjusted Governance Score (lagged) þ 1.627 **
(0.900)
2
McFadden R 0.4590 0.4860 0.5310 0.4290
Note: ***p < 0.01; **p < 0.05; *p < 0.1.
Appendix H. Results for Moody's ratings
H.1. Results with sustainalytics ESG scores

Table 29
Standard ordered probit estimation results for Moody's ratings with Sustainalytics ESG Scores.
Dependent: Moody's Ratings
Log GDP/Capita þ 3.137 *** 3.186 *** 2.999 *** 3.909 ***
(0.217) (0.216) (0.210) (0.257)
Current Account/GDP þ 2.567 *** 2.362 *** 1.652 3.500 ***
(1.207) (1.202) (1.210) (1.210)
(0.043) (0.043) (0.042) (0.042)
Natural Log of Foreign Reserves þ 0.335 *** 0.271 *** 0.362 *** 0.340 ***
(0.051) (0.051) (0.050) (0.050)
Unemployment Rate ¡ 2.470 1.736 2.432 2.292
(1.616) (1.628) (1.611) (1.632)
Change in Inflation Rate ¡ 14.660 10.956 10.797 28.245 ***
(11.813) (11.837) (11.733) (12.087)
Interest Rate ¡ 23.444 *** 18.811 *** 26.707 *** 22.228 ***
(5.225) (5.234) (5.519) (5.210)
(0.028) (0.028) (0.028) (0.030)
(0.014) (0.014) (0.014) (0.014)
(0.643)
(0.677)
(0.604)
Spread adjusted Governance Score (lagged) þ − 4.023 ***
(0.592)
McFadden R2 0.3839 0.4041 0.3799 0.4009
23
Note: ***p < 0.01; **p < 0.05; *p < 0.1.

H.2. Results with Refinitiv ESG scores
Table 30
Standard ordered probit estimation results for Moody's ratings with Refinitiv ESG Scores for the subset of developed countries.
Log GDP/Capita þ 2.780 *** 2.972 *** 2.776 *** 2.707 ***
(0.151) (0.168) (0.161) (0.159)
Current Account/GDP þ − 0.619 0.376 0.230 0.368
(1.027) (1.008) (1.008) (1.014)
(0.034) (0.034) (0.034) (0.035)
Natural Log of Foreign Reserves þ 0.072 *** 0.089 *** 0.067 *** 0.049
(0.034) (0.034) (0.034) (0.036)
Unemployment Rate ¡ 0.367 − 1.955 − 2.869 *** − 3.421 ***
(1.460) (1.301) (1.289) (1.314)
Change in Inflation Rate ¡ 15.428 *** 15.618 *** 13.863 ** 13.157 **
(7.147) (7.165) (7.142) (7.150)
Interest Rate ¡ 32.921 *** 36.203 *** 37.126 *** 38.002 ***
(4.614) (4.561) (4.573) (4.584)
(0.018) (0.018) (0.018) (0.018)
(0.012) (0.012) (0.012) (0.012)
(0.466)
(0.443)
(0.372)
(0.410)
McFadden R2 0.5300 0.5280 0.5260 0.5270
Note: ***p < 0.01; **p < 0.05; *p < 0.1.
Table 31
Standard ordered probit estimation results for Moody's ratings with Refinitiv ESG Scores for the subset of developing countries.
Log GDP/Capita þ 2.235 *** 1.569 *** 2.107 *** 1.545 ***
(0.228) (0.208) (0.223) (0.208)
Current Account/GDP þ 3.237 2.330 2.647 1.707
(2.353) (2.324) (2.340) (2.301)
External Debt/GDP ¡ − 0.180 1.359 − 0.093 1.890 ***
(0.911) (0.847) (0.885) (0.791)
Natural Log of Foreign Reserves þ − 0.911 *** − 0.656 *** − 1.592 *** − 0.249
(0.217) (0.215) (0.251) (0.208)
(1.515) (1.575) (1.735) (1.449)
Change in Inflation Rate ¡ 1.742 1.816 3.693 0.248
(6.842) (6.864) (6.843) (6.798)
Interest Rate ¡ − 21.764 *** − 24.632 *** − 20.330 *** − 21.619 ***
(3.145) (3.304) (3.090) (3.225)
Financial Risk Rating þ 0.061 *** 0.031 0.061 *** 0.034
(0.031) (0.031) (0.031) (0.030)
(0.019) (0.018) (0.018) (0.016)
(0.792)
(0.660)
(0.757)
(0.859)
McFadden R2 0.3119 0.2741 0.3118 0.2577
Note: ***p < 0.01; **p < 0.05; *p < 0.1.
24
H.3. Results with FTSE ESG scores

Table 32
Standard ordered probit estimation results for Moody's ratings with FTSE ESG Scores.
Log GDP/Capita þ 5.900 *** 6.142 *** 5.901 *** 5.286 ***
(0.526) (0.548) (0.543) (0.488)
Current Account/GDP þ 2.711 ** 1.991 2.569 ** 2.986 **
(1.546) (1.556) (1.550) (1.533)
(0.068) (0.068) (0.068) (0.069)
(0.072) (0.074) (0.071) (0.071)
Unemployment Rate ¡ − 8.126 *** − 5.650 ** − 6.510 ** − 4.355
(3.224) (3.288) (3.207) (3.164)
Change in Inflation Rate ¡ − 6.03 − 13.991 − 5.32 4.024
(14.325) (15.361) (14.273) (14.269)
Interest Rate ¡ 135.069 *** 167.746 *** 157.111 *** 151.100 ***
(27.728) (27.017) (27.054) (32.416)
(0.047) (0.048) (0.047) (0.048)
Political Risk Rating þ 0.023 0.061 *** 0.042 ** 0.014
(0.025) (0.025) (0.025) (0.025)
(0.834)
(0.875)
(0.783)
(0.788)
2
McFadden R 0.4257 0.4537 0.4357 0.3926
Note: ***p < 0.01; **p < 0.05; *p < 0.1.
Appendix I. Data and methodology for calculating the distance-to-default measure at sovereign level using the contingent claims
analysis approach
I.1. Background and calculation of DtD
We use distance-to-default to measure and analyze sovereign credit risk using the Contingent Claims Analysis Approach (CCA) as outlined by Gray
et al. (2007). CCA is a generalization of the option pricing theory of Black and Scholes (1973) and Merton (1973) and is also called the Merton Model.
The CCA approach is commonly used to measure corporate credit risk where the equity of firm is modelled as a call option on the market value of assets
with a strike price that is equal to the face value of debt of a firm.
The first paper to adapt the model to the sovereign balance sheet was by Gray et al. (2007) and we follow the process outlined in the paper to
compute distance-to-default at the sovereign level. Default risk at the sovereign level is driven by interaction between three elements: the value of
sovereign assets, asset volatility which captures the uncertainty in the future market value of sovereign assets and the value of liabilities. The like
lihood of a sovereign default increases when the market value of sovereign assets falls relative to the debt obligations or when the asset volatility
increases such that the value of sovereign assets become uncertain increasing the default probability (Gapen, Gray, Lim, & Xiao, 2005). Unlike the
liabilities, the market value of sovereign assets and their volatility are not directly observable from a sovereign balance sheet. The CCA approach
applies the Merton Model to derive an implied market value of sovereign assets and volatility using the observable values on the liability side of a
sovereign balance sheet.
The sovereign balance sheet is constructed as an consolidated balance sheet of the government and the central bank as shown in the table below:
Table 33
Sovereign balance sheet.
Assets Liabilities
Foreign reserves Guarantees

Net fiscal assets Foreign currency debt
Credit to other sectors Local currency debt
Other public assets Monetary base
Essentially, the sovereign CCA model is similar to the corporate CCA model, where the market value of the company's equity is replaced by the
market value of local currency liabilities. The distress barrier is based on the foreign currency debt.
The seniority of sovereign liabilities is not pre-defined. Therefore, foreign currency liabilities are regarded as senior claims because in times of
crisis, governments like to stay current on their foreign currency obligations, whereas, they say that the local currency liabilities have “equity-like”
features such that local currency debt and base money are like “equity” on a sovereign balance sheet making the domestic debt obligations junior
25
claims.
An interesting outlook is proposed by the study Singh et al. (2018) for European Area (EA) countries where they argue that the structure of debt is
different for EA countries because the denomination of the currency in which the debt is issued is determined by the European Central Bank (ECB) so
they propose an alternative framework to determine the priority structure of debt for EA countries instead of treating foreign and local currency debt
as senior and junior claims respectively as in the previous study. They use the data provided by Bruegel database which classifies liabilities into
resident banks, non-resident banks, other public institutions, other residents and non-residents. They consider the market value of non-resident bank
holdings (external) and resident bank holdings as senior claims and the rest as the junior claims. We follow the same methodology for all the 11
countries for which the classification was available at the Bruegel website including the non-European developed countries i.e. UK and US, because we
believe that amount of foreign currency debt may not be necessarily be high for developed economies whereas, using alternative methodology to
distinguish between senior and junior claims is likely to portray better credit health of the developed nations.
The data used for the calculation of DtD are:
1. Market value of sovereign debt: We use the Quarterly Public Sector Debt Statistics (QPSD) database, which has been jointly developed by World
Bank and International Monetary Fund (IMF) which provides public sector debt data at a country level.13
2. Risk-free interest rate: We extract quarterly data on 10-year government bond yields as the risk-free interest rate from Refinitiv.
3. Volatility of sovereign debt: We use the Total Return Index on 5-year government bonds, extracted from Refinitiv, to calculate the volatility of
sovereign debt. The standard deviation is calculated on a quarterly basis and is then annualized for each quarter.
4. Sectoral sovereign bond holdings: For the classification of public debt in senior and junior claims for European countries and other developed
nations, we use the cross-country sectoral sovereign bond holdings data developed by Merler and Pisani-Ferry (2012) available at Bruegel (2018).
The dataset provides sectoral break-down of the public debt for the following countries (Belgium, Finland, France, Germany, Ireland, Italy,
Netherlands, Portugal, Spain, UK and US).
I.2. Methodology for DtD calculation
We perform the classification of debt for the 11 countries based on the sectoral holdings provided by the Bruegel website. Singh et al. (2018)
consider the non-resident debt holdings(external) and resident holdings as senior claims. We follow the same procedure and in order to calculate the
value of senior claims we multiply the percentage attributed to non-resident debt holdings and resident holdings to the amount of Total Debt (in US$)
from the QPSD database. The value of junior claims is calculated by subtracting the value of senior claims from the Total Debt figure. For the remaining
countries, we extract the total debt in domestic currency (in US$) and foreign currency (in US$) from the QPSD database to be used as junior and senior
debt claims respectively.
For the calculation of DtD in R, we use the package “ifrogs”. The function “dtd” in the “ifrogs” package implements the Merton Model methodology
at the firm level and requires four set of values: market value of the equity of the firm (‘mcap’), its volatility (‘vol’), the face value of debt (‘debt’), and
the annualized interest rate (‘r’). The function is as follows:
dtd (mcap, debt, vol, r).
For the calculation of DtD of the 11 countries, we plug in the value of senior public debt as the face value of debt and the value of junior public debt
as the market value of equity, whereas, for the calculation of DtD for the remaining countries, we plug in foreign currency debt as the face value of debt
and the domestic currency debt as the market value of equity. The annualized volatility and risk-free interest rate are also plugged in respectively. The
function returns three values: asset value of the sovereign, volatility of the asset value and the distance to default of the sovereign. Table 34 provides
the summary statistics per country for distance-to-default.
Appendix J. Summary statistics for Distance-to-default

Table 34
Summary statistics for Distance-to-default.
Country Mean Std. Dev. Min Max
Austria 33.84 11.56 24.38 62.51

Belgium 28.50 2.87 23.58 36.56
Canada 28.23 7.09 21.63 42.39
Czech Republic 28.12 3.56 23.93 40.38
Finland 33.66 9.45 23.37 59.52
France 28.86 7.06 22.43 48.03
Germany 30.58 11.00 20.39 55.16
Hungary 13.75 5.24 8.86 25.49
Indonesia 17.76 1.51 13.45 20.14
Italy 21.68 4.44 17.16 30.26
Mexico 26.05 3.01 18.71 30.38
Netherlands 29.72 8.51 22.80 56.18
Portugal 15.34 11.27 7.36 40.78
South Africa 20.37 6.15 13.82 31.91
Spain 23.57 4.87 18.06 36.55
Sweden 26.48 7.42 19.73 42.77
United Kingdom 24.40 6.14 18.90 39.35
United States 21.81 5.44 17.23 32.25
13
“Quarterly Public Sector Debt”, The World Bank, Last updated November 04, 2020, https://datacatalog.worldbank.org/dataset/quarterly-public-sector-debt.
26
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International Review of Financial Analysis 86 (2023) 102494

Contents lists available at ScienceDirect

International Review of Financial Analysis

Sustainability and sovereign credit risk☆

Weighted Average ESG scorei,t − Min Company ESG Scorei,t

Fig. 1. SASB Materiality Map.

capacities of the countries, such that any investment towards tran­

Sustainalytics Refinitiv FTSE

Note: ***p < 0.01; **p < 0.05; *p < 0.1.

Sustainalytics Refinitiv FTSE

Total ESG 0.192 *** 0.132 ** − 0.050

Note: ***p < 0.01; **p < 0.05; *p < 0.1.

Sustainalytics Refinitiv FTSE

− 3.219 − 1.950 4.880

Note: ***p < 0.01; **p < 0.05; *p < 0.1.

Sustainalytics Refinitiv FTSE

− 1.920 − 2.063 5.214

Note: ***p < 0.01; **p < 0.05; *p < 0.1.

CDS spreads S&P ratings Moody's ratings

− 0.144 5.162 6.894

Note: ***p < 0.01; **p < 0.05; *p < 0.1.

Business Model & Innovation Score 0.001 − 0.149 ***

Note: ***p < 0.01; **p < 0.05; *p < 0.1.

Business Model & Innovation Score − 0.046 0.171 **

Note: ***p < 0.01; **p < 0.05; *p < 0.1.

Business Model & Innovation Score 0.824 *** -0.018 ***

Note: ***p < 0.01; **p < 0.05; *p < 0.1.

Business Model & Innovation Score 0.239 * 0.005

Note: ***p < 0.01; **p < 0.05; *p < 0.1.

To begin, the relationship between CDS spreads and SASB

only material issues on a sector level are considered, environmental

DtD. As we all know, the majority of the countries in our Sustainalytics

data sample are from Europe. Europe, in general, is at the forefront of

efforts to transition to a low-carbon economy, which may make envi­

ronmental performance less important to market participants. Human

becoming more relevant for investors. However, the reduced importance

glance; however, if we consider that the majority or all of the environ­

mental events in the past have affected default probabilities of devel­

oping countries, whereas our data sample is mostly representative of

importance of human capital, business model, and resilience score in the

market-based and structural-based credit risk measures when specific

sector based risks are taken into account.

no limited to, human rights and community relations, equal access to

social demands can put pressure on fiscal accounts (case in point is

confidence, particularly among socially responsible investors, and in

explaining the significance of two variable categories for CDS spreads

There is a positive and negative relationship between various ESG scores

based on financial materiality would yield more conclusive results

because credit rating agencies are primarily concerned with a company's

or country's financial ability to repay its debts; however, the inconclu­

allow for a better measurement of this relationship.

Finally, Table 13 shows the relationship between SASB materiality-

developing countries. In terms of market reaction to ESG risks, business

Num. groups: Date

significant impact. This implies that when a developing country dem­

market responds positively. The lack of significance of the environ­

mental score is surprising for developing countries, but the significance

Env. Refinitiv (1)

Appendix B. List of countries

Panel A: CDS Spreads Panel B: Distance-to-default

Austria Brazil Australia Australia Austria Indonesia Austria Austria

Panel C: S&P ratings Panel D: Moody's ratings

Austria Brazil Australia Australia Austria Brazil Australia Australia

Appendix C. Ordinal transformation of credit ratings

capacities of the countries, such that any investment towards tran

Note: p < 0.01; p < 0.05; p < 0.1.

Total ESG 0.192 * 0.132 − 0.050

Note: p < 0.01; p < 0.05; p < 0.1.

Note: p < 0.01; p < 0.05; p < 0.1.

Note: p < 0.01; p < 0.05; p < 0.1.

Note: p < 0.01; p < 0.05; p < 0.1.

Note: p < 0.01; p < 0.05; p < 0.1.

Note: p < 0.01; p < 0.05; p < 0.1.

Business Model & Innovation Score 0.824 * -0.018 *

Note: p < 0.01; p < 0.05; p < 0.1.

Note: p < 0.01; p < 0.05; p < 0.1.

efforts to transition to a low-carbon economy, which may make envi

glance; however, if we consider that the majority or all of the environ

mental events in the past have affected default probabilities of devel

or country's financial ability to repay its debts; however, the inconclu

significant impact. This implies that when a developing country dem

market responds positively. The lack of significance of the environ

Change in Inflation Rate þ 0.060 0.085 * 0.080 * 0.060

Log GDP/Capita þ 4.207 4.238 * 3.903 * 5.204 ***

Note: p < 0.01; p < 0.05; p < 0.1.