— Impact of environmental, social and governance performance on sovereign risk in Africa
ESG — Potential cure to an impending debt crisis?
Like a soldier deep in enemy territory, Africa faces a race against time to defuse a network of interconnected bombs that are primed to trigger a massive economic explosion. In 2020, the fuse was lit when sub-Saharan African debt skyrocketed to a record US$702billion, the region’s highest debt burden in over a decade. In 2021, the first bomb went off when Zambia defaulted. A year later, the second bomb exploded when Ghana defaulted. There are several more bombs set to explode if nothing is done soon.
Africa’s borrowing binge, particularly sub-Saharan Africa, has placed it on the cusp of a seismic sovereign debt crisis as debt burdens and interest payments skyrocket to unsustainable levels. Consequently, many debt-laden African countries are confronted with two highly undesirable courses of action. On the one hand, they can offer higher yields to investors to compensate them for the elevated default risk. However, the caveat with this approach is that it only perpetuates these countries’ already burdensome debt woes. Alternatively, African governments may have to accept the reality of being locked out of international capital markets until financing conditions loosen, which might take some time.
However, we posit that there is a potential solution to this issue that has not been fully explored — ESG. Today’s financial markets are increasingly dominated by a crop of environmentally and socially conscious investors allocating capital to entities demonstrating a long-term commitment to sustainability. For instance, Central Eastern European (CEE) countries, with better overall ESG performance, have been found to have lower sovereign bond yield spreads. A unit rise in a country’s ESG score has been established to lead to as much as a 1.215 basis points decrease in sovereign bond spreads. This association is not only unique to the CEE region, but across several other parts of the world, it’s been established that a negative and statistically significant association exists between countries’ ESG scores and sovereign bond yield spreads. In other words, better sustainability lowers a country’s borrowing costs, and subsequently, its debt load.
Similarly, we hypothesise that these ESG-centric investors would be willing to lend to African nations at a lower interest rate if they are dedicated to improving their ESG standards.
What is ESG?
ESG stands for environmental, social and governance; and refers to the principles, criteria or standards that environmentally and socially conscious investors use to assess prospective investment opportunities. The environmental pillar or the ‘E’ in ESG, is concerned with issues related to the environment, climate policies, energy use, waste, pollution, natural resource conservation, among others. The social pillar examines how corporations or organisations manage relations with key stakeholders, such as employees, suppliers, customers, and the larger community. In the case of a country, some key indicators under the social dimension may include healthcare expenditure, education, gender equality, and racial discrimination. Lastly, the governance arm of ESG refers to matters and standards related to the governance of a country or government. Some relevant governance indicators for companies include transparent disclosure practices, accounting methods, protection of minority shareholders, and the composition and structure of the board. On the sovereign front, ESG-principled investors may consider governance indicators such as a country’s government effectiveness, control of corruption, and political stability.
ESG’s meteoric rise: From niche concept to US$53trillion force
The significance of ESG and sustainable investing is at its highest level in twenty years, and many experts project it to continue its upward trajectory as the demand for ESG-themed investments multiplies. It’s been reported that nearly US$60trillion in assets under management – or 50 percent of the total global institutional assets base – are currently managed by Principles for Responsible Investment (PRI) signatories. According to Bloomberg, Global ESG assets are on track to exceed US$53trillion by 2025, representing over a third of the US$140.5trillion projected total assets under management. The growth and size of ESG and related assets have been quite remarkable. But how did this relatively inchoate and niche concept grow so big and fast in such a short time? Much of this growth can be attributed to the efforts of several international organisations and governments which have actively advocated for legislation to combat ESG-related matters; for example, the 2015 United Nations Sustainable Development Goals, which seeks to combat issues such as poverty and inequality, climate change, and unsustainable production and consumption.
Furthermore, many studies and research papers have shown that investments screened based on ESG criteria have produced encouraging and impressive results. The ESG literature documents that firms with more robust ESG disclosures and performance have lower borrowing costs as financial market participants integrate ESG into their credit decisions. Several other studies have also established a similar association between ESG performance and sovereign risk, proxied by sovereign bond yield spreads.
Drowning in debt
Debt is the lifeblood of hundreds of businesses and governments worldwide. Countries raise debt to finance essential public investments such as schools, hospitals and roads. In recent years, many African nations have flocked to national and external bond markets to fund their growth. As a result, according to the World Bank, the debt of low- and middle-income countries in sub-Saharan Africa increased to a record US$702billion in 2020, the region’s highest debt burden in over a decade. In the same period, long-term interest payments skyrocketed from US$4billion to US$18billion.
Unfortunately, many sub-Saharan African nations’ debt piles have significantly outstripped their gross national income in the last decade. As a result, they are poorly positioned to repay debt, and higher interest rates have effectively neutralised the possibility of pursuing refinancings. According to the International Monetary Fund (IMF), by autumn 2021, more than 20 low-income African countries were in debt distress or at risk of debt distress. As these African nations have amassed a crippling debt load in a market increasingly dominated by environmentally and socially conscious investors, it is paramount that we fully understand and assess the link between ESG and sovereign bond yields.
These are the questions our paper aims to address:
- How does sovereign ESG performance impact bond yields and by extension, borrowing costs?
- What pillars of ESG have the most significant effect on sovereign bond yields?
Africa’s sustainability struggle
To answer these questions, we collect and analyse data on sovereign ESG and debt ratings for African countries. Firstly, our study results suggest that on average, the overall ESG performance of African countries is relatively weak, and there is significant room for improvement. The average ESG performance score was 45.03 percent, with a standard deviation of 7.02 percent. Namibia had the best overall ESG performance, with an ESGI score of 59.19 percent, while Egypt’s ESGI score of 33.29 percent made it the lowest-performing country. Out of the three ESG sub-indexes, the environmental sub-index was the strongest pillar of ESG. Its average score of 51.69 percent indicates that African countries’ natural resource management was generally better than their regulatory effectiveness and human development efforts.
ESG not the cure
Contrary to most research papers investigating the link between sustainability/ESG performance and sovereign risk, our results surprisingly indicated that African countries’ ESG performance has no statistically significant impact on their bond yield spreads and borrowing costs. We postulate that this is because investors lending to African nations are hesitant to base their credit decisions on sustainability performance for two reasons.
Firstly, ESG is a relatively nascent risk assessment framework that has only gained significant traction in the last decade. ESG remains a relatively unknown concept to emerging and African markets, and its application to sovereign debt has been comparatively minimal. According to a JP Morgan survey of EM sovereign debt investors, 65 percent of respondents report that less than one-fifth of their assets under management have explicit ESG considerations. Another 60 percent of participants assigned a 20 percent weight or less to ESG. These findings strongly indicate that EM sovereign debt investors generally do not base their sovereign credit decisions on the ESG performance of African countries — which is understandable. African debt tends to be a riskier, higher-yielding asset because of its higher perceived risk. For instance, in the last 15 years, African nations have had 10-Y bond yield spreads of approximately 6 percent and an implied average credit rating of B+. Moreover, ESG has several limitations: many ESG terminologies are unclear, concepts tend to overlap, and scoring methodologies are usually opaque and inconsistent. As a result of these flaws, investors appear to be unwilling to make credit decisions based on ESG performance, especially for junk-rated African debt.
Furthermore, we postulate that ESG performance does not significantly impact African countries’ sovereign bond yield spreads because of “ingrained income bias”. The ingrained income-bias concept argues that there is a systemic bias against low-income, developing countries because ESG performance is inextricably tied to a country’s income. There tends to be a very high association between a country’s gross national income and their ESG scores. As a result, it can be reasonably argued that ESG scores reflect nations’ income rather than their overall sustainability. For instance, higher-income countries generally have the financial flexibility and muscle to institute more robust governance structures. Furthermore, wealthier countries tend to have superior social development and welfare. This, in turn, leads to higher scores across all three pillars (E, S and G), which consequently results in a stronger ESG rating. Since ESG integration is more prominent in wealthier, developed nations and there is a finite pool of ‘ESG-themed’ capital. Nearly all of this money flows to high-income countries, which inevitably have better ESG scores. As a result, African countries, particularly sub-Saharan Africa – predominantly classified as ‘low-income’, will invariably have little to no ESG-focused capital allocated to them.
Individual pillars equally impact less
Secondly, our results suggest that the individual pillars of ESG—governance strength, human development, and environmental quality—have no impact on how expensive it is for them to borrow from the international capital markets. Firstly, we posit that sovereign debt investors seemingly do not consider governance strength in their credit decisions as African countries have had historically and persistently weak governance structures, which have been linked with sovereign defaults. For instance, Fournier and Betin (2018) find that government effectiveness is a major determinant of country defaults. According to the 2021 Corruption Perception Index, 28 of the 50 most corrupt countries were African, with a mean score of 23 percent. Due to the pervasive corruption across the continent, sovereign debt investors may be tempted to completely disregard governance strength as a basis for sovereign fixed-income investing in Africa.
Additionally, we observe that sovereign debt investors do not price in environmental performance. We believe sovereign debt investors do not consider African countries’ environmental quality to be a good determinant of their creditworthiness and, by extension, their cost of borrowing. Environmental data quality in Africa is poor because it is riddled with gaps, outdated statistics, and heterogeneous reporting standards. As a result, it would be seemingly imprudent for investors to lend billions of dollars to African countries based on such low-quality information.
Ratings reign supreme — A sovereign mistake?
However, our results suggest that sovereign credit ratings are the single most critical determinant of African countries’ borrowing costs. More specifically, a unit credit upgrade, for example, CCC- to CCC, reduces bond yield spreads by approximately 7.04 percent. This is not a surprising relationship as the credit decisions of sovereign debt investors have historically been anchored to the credit ratings assigned by the Big Three credit rating agencies (S&P, Moody, & Fitch), which are widely regarded as the best measure of a country’s creditworthiness. It is alarming that Africa’s ability to secure crucial financing for developmental initiatives and projects seemingly lies in the hands of credit rating agencies and a credit rating system, which have proven unreliable and unfavourable toward African countries. Between 2020 and the first half of 2021, 62.5 percent of rated African sovereigns were downgraded by the Big Three compared to a global average of 31.8 percent. 94 percent of African countries have a non-investment grade debt rating, which makes funding more expensive. A UNDP Report titled ‘Reducing the Cost of Finance for Africa: The Role of Sovereign Credit Ratings’ reveals a myriad of criticisms that have been levelled at CRAs and credit ratings of African nations. Firstly, CRAs adopt short-term, mechanistic credit rating methodologies that fail to consider each country’s unique circumstance and developmental stage. Additionally, the oligopolistic nature of the credit rating industry is a significant threat as it reduces transparency. Lastly, credit rating agencies played an essential role in the 2008 Global Financial Crisis due to their misrepresentation of risks associated with billions of dollars’ worth of mortgage-related securities.
The way forward: ESG – potential upgrades and reforms needed
Although ESG performance does not seem to significantly impact sovereign funding costs in sub-Saharan Africa, sustainability is still critical in today’s environmentally and socially conscious world. However, our findings indicate that African countries have relatively weak ESG performance, and there is massive room for improvement. Therefore, African governments must devise strategies to strengthen sustainability practices and standards significantly. However, it is essential to note that existing ESG standards, criteria and frameworks were developed with a focus on developed countries. As a result, they fail to account for the unique challenges and contexts confronting African nations. Additionally, since many ESG targets are tied to income (the ingrained income bias), African countries will naturally have weaker ESG performance than more developed and wealthier nations, which will have the financial flexibility and muscle to strengthen sustainability practices. On the contrary, many African governments have arguably more critical problems to prioritise and tackle with a significantly smaller budget. Therefore, to fairly and accurately gauge the ESG performance or overall sustainability of African countries, existing ESG frameworks must be modified to account for the challenges, stages of development, and priorities of African countries. Constructing a fair, transparent, context-specific ESG framework that appropriately gauges the ESG performance of African countries will require input from stakeholders, ranging from policy-makers to major ESG data providers. Additionally, there needs to be a massive improvement in the quality of ESG data not only in Africa, but worldwide.
This study also reveals that the current mechanistic, biased credit rating system is a crucial obstacle that must be addressed. We support experts’ calls for a regional/pan-African credit rating agency to provide better and more context-sensitive assessments of African countries’ creditworthiness. Alternatively, the Big 3 CRAs could collaborate with Africa-based credit rating agencies. Lastly, we recommend that the AU and other multilateral organisations work closely with individual countries to develop a common and comprehensive regulatory framework for credit ratings in Africa.
