Backing Away from ESG? The Effect of Sovereign Rating Downgrades on Corporate Sustainability

Abstract

We examine how sovereign rating downgrades affect firms’ environmental, social, and governance (ESG) policies, leveraging the sovereign “ceiling” rule as a quasi-natural experiment that generates exogenous variation in corporate credit ratings. Using a difference-in-differences (DiD) setting, we find that firms bound by this rule experience a significant decline in ESG performance following a sovereign downgrade. This decline occurs only after the downgrade, not before, validating the parallel trends assumption. Our analysis further indicates that this effect is not driven by financing frictions and is concentrated in countries with a shareholder-centric orientation, and among firms with low institutional ownership from countries with strong social norms. Additional evidence suggests that these firms experience an increase in ESG-related incidents, damaging their reputation post-downgrade. Overall, our findings highlight the crucial role of sovereign risk in shaping corporate sustainability practices. 

Keywords: JEL classification: G24, H63, M14 Credit Ratings, Sovereign Downgrade, ESG, Corporate Sustainability, Markets and Institutions JEL classification: G24, H63, M14 Credit Ratings, Sovereign Downgrade, ESG, Corporate Sustainability, Markets and Institutions

JEL Classification: G24, H63, M14