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3 March, 2020 / Analysis

ESG: the risk management tool?

By Natalie Kenway

Federated Hermes and Beyond Ratings research the relationship between CDS spreads and ESG scores

ESG: the risk management tool?

Research carried out by Federated Hermes and Beyond Ratings into the relationship between CDS spreads and ESG scores has provided further evidence that ESG factors can be considered as a risk management tool by investors

The groups released a second instalment of the two-part study Pricing ESG risk in sovereign credit, part II which analysed five year CDS spreads and ESG scores from 28 developed market (DM) countries and 31 emerging market (EM) countries during 2009-2018.

In its first instalment, the study found an inverse relationship between CDS spreads and ESG scores; on average, the countries with lower ESG scores have the widest CDS spreads, while those with the highest ESG scores have the tightest CDS spreads.

The second part of the study was carried out to show whether the relationship is principally driven by DMs or EMs.  In more detail, the authors of the report assessed if the relationship between ESG scores and CDS spreads is statistically significant for DM and EM, even after controlling for credit risk, as measured by the sovereign credit ratings.

They found that ESG factors have a more significant effect on DM sovereign credit spreads than for EM countries, and the highly significant relationship between ESG scores and CDS spreads documented in the original study is clearly driven mainly by DM countries.

However, the study added, despite this statistically weaker relationship, ESG scores do still have an impact on EM credit spread.

Dr. Michael Viehs (pictured), head of ESG integration at Federated Hermes, further explained the results: With this study, we have provided yet another piece of evidence that ESG factors can be considered as a risk management tool. There are several key learnings which also have important implications for other debt instruments, such as money market securities. It is nowadays imperative to also consider ESG factors in the investment process. The research will help our credit team make better investment decisions and help them price ESG risks with greater precision.”

Meanwhile, Mitch Reznick, CFA, head of credit research and Sustainable fixed income at the group, added:Our first study showed that there is a clear relationship between ESG quality and sovereign risk, as measured by credit spreads. In splitting the dataset, we can see that this relationship is principally driven by DMs.

“We believe that the less pronounced, but still existing relationship for EMs, implies that the relative financial weakness of some EMs leaves them more vulnerable to deteriorating ESG factors, which translates directly into credit risk.”

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