Editor's Note:   Our ESG sovereign global overview discusses environmental, social, and governance (ESG) credit factors that inform our analysis of 135 sovereign governments we rate globally.

ESG credit factors are important to S&P Global Ratings' analysis of sovereign creditworthiness. They are embedded in several of our rating factors. Changes in ESG credit factors therefore influence--positively and negatively--our sovereign ratings and outlooks (see "How Environmental, Social, And Governance Factors Help Shape The Ratings On Governments, Insurers, And Financial Institutions," published Oct. 23, 2018, on RatingsDirect). ESG can affect a broad range of rating factors we examine to determine our sovereign ratings, as described in "The Role Of Environmental, Social, And Governance Credit Factors In Our Ratings Analysis," published Sept 12, 2019.

Analytical Approach

ESG risks and opportunities can affect a government's capacity to meet its financial commitments in many ways. We incorporate these considerations into our ratings methodology and analytics. This enables analysts to factor in short-, medium-, and long-term impacts--both qualitative and quantitative--during multiple steps of their credit analysis. Comparatively favorable ESG credentials do not necessarily indicate strong creditworthiness (see "The Role Of Environmental, Social, And Governance Credit Factors In Our Ratings Analysis," published on Sept. 12, 2019).

Environmental risks we consider include greenhouse gas (GHG) emissions, such as carbon dioxide; pollution and waste; water and land usage; and natural conditions (the physical climate, extreme and changing weather conditions). Social risks include those from human capital management; safety management; and consumer-related effects of customer service and consumer behavior affected by environmental, health, human rights, privacy, or community considerations. For sovereigns, such societal and socioeconomic exposures arise directly because they affect a country's population. Governance risks include, among other things, the quality and timeliness of policymaking, the rule of law, control of corruption, freedom of the press, accountability, and transparency.

Governance Is A Key Pillar Of Sovereign Creditworthiness

In our sovereign analysis, we consider governance credit factors mainly in the context of our institutional assessment, one of the five key sovereign rating factors (see "Sovereign Rating Methodology," published Dec. 18, 2017).

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The GDP-weighted distribution of our institutional assessments, taken as a proxy for governance, shows governance to be a relative strength (a score of '1' or '2') for about one-half of sovereigns, and a clear weakness for 7% (or one-third for the unweighted distribution) with institutional assessments of '5' or '6'. The institutional assessment includes our analysis of how a government's institutions and policymaking affect its credit fundamentals by delivering sustainable public finances, promoting balanced economic growth, and responding to economic or political shocks. Most of these factors align closely with governance concepts.

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In addition to counting as an individual rating factor in our methodology, a very low institutional assessment serves as a cap on sovereign ratings, given the importance of this factor, regardless of the indicative rating that emerges from combining all our individual rating assessments. While institutional assessments are widely dispersed across our 1-6 scale (with '1' being the strongest assessment and '6' the weakest), advanced economies tend to, on average, have stronger governance. Therefore, the GDP-weighted share of countries with strong institutional assessments of '1' or '2', at 49%, far exceeds the GDP-weighted share of countries with assessments at '5' or '6' (7%).

Alongside the governance credit factors included in the institutional assessment, our monetary assessment also reflects our opinion on monetary policy credibility, including the independence of the central bank, its policymaking tools and effectiveness, track record on price stability, and role as a lender of last resort.

Social Factors Are Becoming Even More Important

Social factors also inform our institutional assessment, mainly because they relate to the cohesiveness of civil society in the broadest sense. Our analysis of social cohesion looks at social mobility, social inclusion, the prevalence of civic organizations, degree of social order, and the capacity of political institutions to respond to societal priorities. Socioeconomic indicators, including demographics, play an important role and can cause or signal varying degrees of stress on government finances. High and sustained net emigration or unemployment, and unaddressed age-related spending imbalances, are often linked to poor social outcomes for a country's inhabitants and put government finances under stress.

The COVID-19 pandemic, for example, has revealed varying degrees of resilience and responsiveness to health and safety risks. By and large, sovereigns with stronger governance credit factors, including from robust monetary policy, have been better able to withstand the credit impact from measures to contain the pandemic.

Environmental Risks Are Tangible And Increasingly From The Energy Transition

Environmental credit factors are the most complex to capture and, due to climate change and efforts to contain it, the most rapidly evolving. Physical risks pose a limited direct threat to our ratings on sovereigns with advanced economies, since advanced economies with exposure to natural catastrophes also tend to have solid adaptation strategies, resilience records, and infrastructure. Our ratings on many emerging-market sovereigns, on the other hand, already reflect potential risks arising from future natural disasters. This can be seen in the overall good alignment of our economic assessment with the Notre Dame Global Adaptation Initiative (ND-Gain) index.

Our economic assessment also includes a potential adjustment for volatility in economic output, often caused by constant exposure to natural disasters or adverse weather conditions. When natural disasters hit, this may also affect our fiscal assessment (through the impact on tax revenue and spending pressures) and our external assessment (through a sudden loss of exports) as damage costs rise.

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Global emissions-reduction objectives and, more broadly, energy transition risks may eventually reduce the export revenue of economies reliant on hydrocarbon exports. The energy transition may also carry significant implementation costs, particularly compared with the size of developing or resource-based economies. Our economic assessment may in those cases reflect what we see as below-average growth, or economic concentration on cyclical sectors. The U.S.' recent decision to rejoin the Paris Agreement on climate change may boost global energy transition efforts. On the other hand, it will likely also reveal which countries have not adhered to the treaty or made insufficient efforts to meet the global warming objective of "well below 2°C" compared with pre-industrial levels. Even among energy importers, failure to reduce emissions may ultimately hinder economic growth and budgets in the future. Civil society is also increasingly clamoring for governments to honor their climate commitments, since in 2016-2020 many countries across the globe reported three of the hottest November months on record.

Straddling physical and transition risks is the management of natural capital, which takes into account how a country protects or depletes its natural resources and biodiversity, while balancing short-term economic growth prospects with sustainability objectives.

While most observable environmental factors take the form of risks, we also pay attention to the potential for environmentally friendly policies to enhance sovereign creditworthiness, such as by reducing physical or energy-transition exposure. For example, infrastructure investment that augments resilience to physical risks as well as renewable energy projects that reduce input costs, net imports, or economic volatility could support economic and external outcomes and our view of sustainable policymaking. Broader bases and rates for carbon taxes may also help support our fiscal assessment in the future.

As part of our external and fiscal assessments, we also look at how sovereigns' funding access and costs are positively or negatively influenced by shifts in debt investors' asset allocation choices and by mandates, such as increased focus on sustainable, social, or green debt, or the incorporation of broader ESG selection criteria.

If ESG credit factors represent significant credit risks that are not fully captured by our five key sovereign rating factors, we can include a one-notch downward supplemental adjustment for event risk. This could apply in cases of mounting institutional instability, social or governance issues, or a rare but severe natural catastrophe.

Regional Overviews: Each Region Has A Different Risk Profile

Emerging EMEA: Some countries in this region face the greatest environmental risks.  In Europe, the Middle East, and Africa (EMEA), emerging markets, especially hydrocarbon exporters in the Middle East, are exposed to high energy transition and physical risks. Our institutional assessment considers the long-term sustainability of countries' fiscal and economic models. Our economic assessment in Sub-Saharan Africa reflects the region's commodity dependency and rising exposure to extreme weather events such as droughts. Eastern European countries have the biggest challenge in cutting the share of coal in electricity production. Air pollution is, on average, three times higher in emerging EMEA than in developed Europe. Social indicators, such as development, income, and gender inequality, are weak in Sub-Saharan Africa. Governance is typically a rating weakness in the Middle East and Sub-Saharan Africa but mildly better in Central European EU countries.

In developed EMEA, governance is a strength but aging populations remain a challenge.  Advanced economies in EMEA have solid institutional and monetary frameworks. Third-party indicators of the rule of law, control of corruption, or freedom of the press are generally strong. EU membership entails safeguards and common principles of governance. On average, countries generate relatively high carbon-dioxide emissions per capita, although less than in similar economies in Asia-Pacific or the Americas. This is partly thanks to energy-efficient public transportation and well-developed energy transition policies. The combination of moderate exposure and high resilience to environmental threats--including due to robust infrastructure--sustains developed Europe's strongest average ranking among regions on the ND-Gain index. Countries in developed Europe also rank high on the UNDP's Human Development Index (HDI) and Human Capital Index and tend to have better social cohesion, with lower income inequality than in the Americas and better gender equality. The main social challenge is aging populations, which can strain health care budgets and pension systems.

Governance is a credit weakness in Asia-Pacific, while social and environmental credentials vary widely.  In many countries, restrictions on the press reduce accountability and transparency. However, other governance indicators are mostly in the moderate range. Social outcomes show significant variation between high-income countries with favorable HDI rankings and poorer countries, especially in South Asia. Yet the average HDI is moderate for the region as a whole. High population density and scarcity of natural resources shape environmental risk in the region. Strong economic growth, rapid urbanization, and the concentration of global manufacturing production drive energy consumption and greenhouse gas emissions growth. Much of the region depends heavily on coal-generated electricity and suffers from air pollution. Asia-Pacific regularly suffers severe storms, flooding, and seismic activities on the Pacific "Ring of Fire," where most of the world's earthquakes and volcano eruptions occur.

The Americas region has a comparatively better profile in governance than in the other two ESG credit factors.   Regarding social factors, just over half the sovereigns in the region have average risk exposure and most of the remainder above-average exposure. Caribbean sovereigns have a distinct profile from that of the Americas as a whole, with above-average exposure to environmental risk factors due to natural disasters and extreme climate events, which we incorporate in our rating analysis in the fiscal and economic growth assessments. From a ratings standpoint, this regional weakness is often offset in our governance assessments on some islands, particularly due to their institutional, political, and judicial links with higher-rated sovereigns in Europe. Latin America has generally moderate carbon-dioxide emissions per capita, with varying physical risk exposures. However, it has a worse profile in terms of social and governance factors, reflected in our assessment of institutional effectiveness. This includes poor social conditions, as measured by persistently high income and gender inequality, crime, political risk, and weak rule of law.

Overall, the Americas region, mainly in Latin America and the Caribbean, has weaker social indicators than in Asia-Pacific or Europe, as a result of higher inequality and crime rates by country, which often signal threats to social cohesion. Emerging markets in EMEA are on average worse off, however. Social exclusion and emigration are also common in much of the region.

Appendix: Data Sources

To analyze ESG credit factors, we use a large set of quantitative and qualitative indicators that we benchmark globally, the natural scope for sovereign creditworthiness analysis. Among globally available data, we use a variety of sources, such as S&P Global Ratings scores and assessments, the World Bank, International Monetary Fund, United Nations Development Program, Transparency International, Reporters Without Borders, and Notre Dame University. Disclosure of environmental exposure, notably carbon emissions, is not as advanced at the country level as it is at the corporate level, which benefits from advanced disclosure standards, notably from the Task Force on Climate-Related Disclosures (TCFD). For example, the breakdown of emissions data into Scopes 1, 2, and 3 emissions, which helps capture net imported and exported emissions, are rarely available for an entire country, and the large amounts of emissions from international freight and travel are often overlooked. For certain indicators, only outliers present meaningful analytical value.

The list of indicators is by no means exhaustive, and other factors may be useful. For certain indicators, particularly social ones, perception can trump reality, as is often the case with allegations of corruption or reports of income, wealth, or other inequalities. In addition, certain indicators straddle several ESG categories. For example, air pollution fits naturally as an environmental weakness but, unlike GHG emissions, its most acute direct impact is felt by populations residing where the pollution originates; therefore, it has significant social implications for health and wellbeing. As another example, freedom of the press is both a governance factor (a yardstick for accountability) and a social factor (an indication of civil liberties).

Related Research

• Too Late For Net-Zero Emissions By 2050? The Potential Of Forests And Soils, June 4, 2020
• The EU's Drive For Carbon Neutrality By 2050 Is Undeterred By COVID-19, April 29, 2020
• The Energy Transition: How It Could Affect GCC Banks, Feb. 16, 2020
• Environmental, Social, And Governance: ESG Industry Report Card: Supranationals, Feb. 11, 2020
• The Energy Transition: Nuclear Dead And Alive, Nov. 11, 2019
• The Role Of Environmental, Social, And Governance Credit Factors In Our Ratings Analysis, Sept. 12, 2019
• The Heat Is On: How Climate Change Can Impact Sovereign Rating, Nov. 25, 2015