How Governance and Social Factors Shape Sovereign Risk in Emerging Economies

An IMF study finds that stronger Environmental, Social, and Governance (ESG) performance significantly lowers sovereign borrowing costs in emerging markets. Governance and social indicators, in particular, reduce spreads more effectively than some traditional macroeconomic factors.

In a new IMF Working Paper released in April 2025, researchers Carmen Avila-Yiptong, Mahamoud Islam, Ayah El Said, and Chima Simpson-Bell from the International Monetary Fund’s African Department present compelling evidence that Environmental, Social, and Governance (ESG) considerations meaningfully affect sovereign bond spreads in emerging and developing economies (EMDEs). Drawing on collaboration across several IMF teams, including the Research Advisory Group and IMF Ecuador’s country team, the study advances existing knowledge by unpacking ESG into its core elements, measuring their respective influence on investor behavior, and proposing a novel ESG index to consolidate these effects. While prior research acknowledged the role of ESG in shaping risk perceptions, this paper is distinctive in its scope, rigor, and clarity in demonstrating how ESG reforms can lower borrowing costs for sovereigns.

ESG Is No Longer Just for Corporations

Historically, ESG frameworks were applied almost exclusively in corporate finance, where investor scrutiny of ethical and sustainable practices shaped market valuations. In recent years, however, sovereign debt markets have seen a parallel shift. International norms like the UN Sustainable Development Goals and the Principles for Responsible Investment have pushed financial institutions and rating agencies to rethink how sovereign creditworthiness is evaluated. Governance, long a soft but acknowledged consideration, is now joined by explicit assessments of social and environmental performance. The researchers argue that ESG is no longer peripheral it is a material part of how investors perceive long-term sovereign risk. With EMDEs carrying significant debt burdens in the wake of COVID-19 and facing tightening global financial conditions, ESG-related reforms could serve as critical levers to ease fiscal pressure.

A Data-Rich Dive into Spreads

To investigate how ESG factors influence sovereign spreads, the researchers construct a comprehensive dataset spanning 79 EMDEs over 2001–2021, using J.P. Morgan’s Emerging Market Bond Index Global (EMBIG) to measure spreads. These spreads reflect the premium investors demand over U.S. Treasuries for holding emerging market debt. The regression model includes a mix of global financial indicators (such as the VIX and the Federal Funds Rate), traditional domestic macroeconomic factors (like GDP growth, reserves, and debt-to-GDP), and a carefully chosen set of ESG indicators. Environmental risk is proxied by changes in per capita greenhouse gas (GHG) emissions, social development is captured through gross national income (GNI), and governance quality is measured using three World Governance Indicators: government effectiveness, regulatory quality, and control of corruption.

Governance Leads the Pack

The analysis shows a clear and consistent pattern: better ESG performance is associated with lower sovereign spreads, indicating reduced perceived risk by investors. Among the ESG factors, governance stands out as the most influential. A one-point improvement in governance indicators can reduce spreads by 22 and 29 percent, a reduction often larger than that driven by global financial volatility. Strong institutions, credible public policies, and low levels of corruption appear to assure investors of a country’s ability and willingness to repay debt. Social indicators follow closely behind. Higher GNI per capita, a proxy for standards of living and social stability, is also linked to significantly lower spreads. This reflects investors’ growing concern with socio-political stability and human capital development, both seen as essential for sustained economic growth. Environmental factors, though statistically significant, have a smaller effect. Rising GHG emissions tend to push spreads higher, suggesting that climate risk is starting to register in sovereign bond pricing, but the influence remains moderate. The authors note that this could reflect the relative novelty of climate risk integration in sovereign investment strategies.

A New ESG Index to Guide Policy

To provide a single, actionable measure of ESG performance, the researchers construct an ESG index using principal components analysis. This index combines the five ESG variables used in the model into one comprehensive score. When plugged into the regression model in place of the individual ESG variables, the index remains negatively and significantly correlated with spreads, confirming that better overall ESG performance improves a country’s standing with investors. Further robustness checks, including controlling for outliers, testing with multi-year averages, and adding supplementary indicators like tree cover loss or external arrears, validate the central finding: ESG considerations, particularly governance and social factors, are powerful predictors of borrowing costs. Interestingly, when testing whether the importance of ESG has increased since the 2016 Paris Agreement, the results show no significant time trend. This suggests that while awareness of ESG is growing, its full integration into sovereign pricing models may still be underway.

Policy Lessons: Reforming for Fiscal Relief

The study concludes with a powerful message for policymakers in emerging and developing economies: improving ESG performance isn’t just good governance, it’s sound fiscal strategy. A one standard deviation improvement in GNI per capita, debt-to-GDP ratio, or regulatory quality delivers the greatest reductions in spreads, underscoring the potential of ESG reforms to unlock cheaper financing. Policymakers focused solely on austerity or economic stimulus may be missing out on more politically feasible and socially beneficial ways to strengthen creditworthiness. Measures to combat corruption, increase policy transparency, or expand access to education and healthcare not only improve lives but also reduce the risk premium in capital markets. Although environmental performance ranked lower in its influence, this likely reflects a lag in how climate risk is priced, something that may change rapidly as climate finance and sustainability-linked debt products become more mainstream.

In sum, this research reframes ESG not as a normative goal but as a quantitative, material variable in global financial markets. For EMDEs navigating tight budgets and skeptical investors, ESG reforms may offer not only reputational benefits but a real, measurable path to lower borrowing costs.