· 4 min read
Under debate: ESG and sovereign credit ratings
Sovereign credit ratings are used to assess countries’ credit risks. They affect countries’ cost of borrowing on markets, with major implications for both governments and individual citizens.
Credit ratings have been around for many years. (In fact, 2024 marks the 100th anniversary of the first version of the familiar alphabetical rating systems – e.g. AAA, AA etc.)
In contrast, the incorporation of environmental, social and governance (ESG) factors in sovereign credit ratings is relatively recent. The major ratings agencies only formally and systematically incorporated ESG into sovereign ratings between 2017 and 2019.
I think it’s clear that incorporating ESG criteria will provide a more comprehensive view of a country’s creditworthiness. Climate change, for example, is likely to have a varying impact on economic growth across countries, as highlighted by multiple studies. We may already be seeing the implications in the form of lower sovereign ratings for countries or regions seen to be more at risk.
But we need a continued debate about how ESG factors are incorporated. Is the process transparent, and on what metrics and information is it based? Does it adequately assess the risks of climate change and biodiversity loss for economies? Are rating systems flexible enough to reflect our growing understanding of these risks?
Getting it right on incorporating ESG in sovereign ratings is important. If we get it wrong, or markets ignore ESG factors, then they will operate less efficiently. Prices won’t accurately reflect future risk and, as a result, investment won’t deliver the best results – for the planet, or for us.
Investor perspective: China’s carbon-credit market
Carbon credits come in for a lot of flak, some of it justified. There are questions about how exactly carbon markets work and the end results. Still, although carbon markets are imperfect, I think that putting a price on CO₂ emissions can help drive economic transition to less destructive alternatives.
Consider, for example, the growing Chinese carbon-credit market. At present, only firms in the Chinese energy sector are required to participate in this “compliance” market (trading credits for the right to produce carbon emissions) and the monitoring of emissions is incomplete. (Global “voluntary” markets, where firms buy credits in separate projects that reduce carbon emissions, are much smaller and quite different beasts.)
Even so, the Chinese carbon-credit market is, like a market should, starting to anticipate future developments. A recent CO₂ price rally in China has been mainly driven by expectations of a future reduction in the supply of carbon permits (and concerns that some of the existing stock of credits could become invalid due to new regulations).
What happens next? China’s environment ministry is preparing a draft plan to include more industries in the carbon market (aluminium and cement, both big power users, could be next). This would be a useful step along the decarbonization path (as will be the emergence of other carbon markets in Asia). But don’t expect the complexities of carbon markets to be resolved anytime soon. These will remain local or regional markets, subject to different drivers. They will also deliver radically different prices for a ton of carbon: China’s is still only around 20% of the carbon price in the EU, the world’s largest carbon market.
Our view: markets and the energy transition
We have just published a report written by myself and my colleague Daniel Sacco on the energy transition and investment perspectives. What do I take from it? Well, to start with the obvious: Despite all the political and market noise, renewable energy continues to experience remarkable growth (global renewable capacity additions were up by nearly 50% in 2023, according to the IEA) and this is likely to continue.
Within this broad positive trend, however, some individual renewables sectors face major challenges. The solar photovoltaic industry, for example, faces significant price pressures due to oversupply, particularly from Chinese manufacturers who are now globally dominant. Lower prices for renewables technology cuts both ways, of course: They threaten (non-Chinese) domestic production, but also should encourage further adoption of renewables technologies worldwide.
My impression is that investors (and thus markets) still don’t see the energy transition as an integrated whole – they may not fully link up the implications of change across sectors. Market valuations for utilities, for example, still seem more influenced by the past than by the essential role they will play in delivering a clean energy transition. And we are also likely to see further growth in new areas – e.g. in energy storage. As we know, battery storage capacity has already quadrupled between 2020 and 2023, but there will be other energy storage areas too. Energy transition should therefore be seen as an opportunity, not a problem for markets. But we do need to work out how best to use markets and governments to do it.
This article is also published on the author's blog. illuminem Voices is a democratic space presenting the thoughts and opinions of leading Energy & Sustainability writers, their opinions do not necessarily represent those of illuminem.
