Published: June 07, 2022
Europe’s financial health and sovereignty depends on having home-grown capacity to assess credit and ESG risk. American rating agencies currently dominate the market but, as Guillaume Jolivet, Chief Operating Officer, Scope Group, argues, European corporates and governments should no longer be shoehorned into the one-size-fits-all US model.
The emergence of Europe’s unified capital market for corporate and government financing has triggered fresh urgency to having a greater diversity of opinion on credit risk, ESG risk and ESG impacts.
Credit ratings are a fundamental building block of the efficient capital markets necessary for funding the real economy. ESG ratings are increasingly influencing the behaviour of public and private institutions and ultimately impact society at large.
Conventional rating approaches developed outside Europe can lead to structural disadvantages for European issuers. Therefore, it is essential for European policymakers – determined as they are to enhance the role, resilience, and independence of Europe’s capital markets – to ensure that there is an equally robust and reliable European source of financial and non-financial ratings.
A robust European rating agency – independent, credible, and sensitive to the unique characteristics of European issuers, legal systems and policymaking – is critical for Europe’s financial health and sovereignty.
Europe’s need for a more unified and increasingly active capital market is little questioned these days. Brexit has focused minds. Europe’s emphatic response to the Covid pandemic, notably with the launch of EU bonds to finance the NextGenerationEU (NGEU) economic recovery fund, has provided another boost. Russia’s invasion of Ukraine has given extra impetus to the need to bolster Europe’s financial resilience.
Yet, as the financing of business in Europe moves more in step with vibrant US financial markets, the region still has one strategic disadvantage in debt capital market development: credit ratings.
European and US debt capital markets differ significantly in size and depth, even though the European Commission (EC) has been eager to reduce European businesses’ dependence on the banking sector and strengthen capital-market financing. Back in 2015, the EC set about creating a capital markets union that would broaden and deepen Europe’s financial markets and more closely integrate them to encourage bank disintermediation. In September 2020, the EC revised and enhanced the planned integration of national markets to form a true EU-wide internal capital market.
As capital markets become more important for European businesses, so too do public credit ratings.
With a conventional bank loan, a bank typically makes its own assessment of the credit of a prospective borrower. In the debt capital market, rating agencies provide the independent assessments of credit quality that bond investors need.
However, unlike banks, the agencies publish their credit ratings and associated rating methodologies, providing information that levels the playing field for market participants. Investors can also compare different issuers more easily. Rating agencies have become a fundamental part of the liquid and efficient debt capital markets needed for financing the real economy.
US rating agencies have long dominated the sector, even in Europe, benefitting from the rapid growth of global bond markets in recent decades.
Yet they have also had their critics, especially when it comes to their analytical practices and business conduct. As a result, investors, issuers, and regulators in Europe have called for a greater diversity of credit opinion and alternative rating approaches, ideally through the creation of a European rating agency. European policymakers renewed their appeals for a European alternative to US rating agencies after the global financial crisis of 2008 and the European sovereign debt crisis of 2011.
Widespread as agreement is that Europe needs credit-rating capacity of its own, there is an equally wide range of opinions on what would or should set a European agency apart. Does ‘European’ mean just having headquarters in Europe? Would the analysts need to be European? Would there need to be a specific analytical approach?
Our answer is simple: a European rating agency needs to offer an alternative and distinctively European perspective on credit risk.
Such a perspective does not mean introducing a European rather than American home bias to credit rating. Rather, it means recognising that credit ratings need to take local differences into account, such as the complex interplay of national and regional regulations and the different ways in which banks and companies can obtain institutional support, not to mention the local business culture.
A rating agency with this perspective sets itself apart from the three largest US agencies, which have relatively similar approaches to the analysis of credit risk. Their views all stem from a traditionally American view of business and they set great store by the ‘analytical consistency’ of applying to foreign markets the same assessment grids initially designed for the US.
Credit ratings based on methodologies developed outside Europe tend to undermine the diversity of business models in the region and typically ignore the cultural preference in Europe for long-term stability over near-term shareholder value. They also tend to reflect an inflexible treatment of unfunded pension liabilities and often a mechanistic relationship between sovereign and bank creditworthiness while underplaying the importance of Europe’s supranational financial institutions.
If we examine some of these issues in greater depth, one distinctive feature of US capital markets is the credo of maximising shareholder value, which tends to make businesses concentrate on one core area. Diversified business models are in the minority in the US, whereas in Europe they are relatively common, often with owners and executives who purposely avoid a narrow focus on maximising near-term shareholder value. Corporate philosophies are often orientated towards longer-term criteria, particularly among family-owned businesses.
US-centric rating models often do not sufficiently reflect the creditworthiness of such diversified European businesses. A European rating agency, by contrast, would value business diversification in its credit ratings, because diversified business models often exhibit greater stability. At the same time, rating analysts need to ensure that a rating properly reflects the sum and interplay of the risks in each sector that a business sits within.
Another weakness – and one of the most striking limitations of American methodologies – is that bank ratings are capped at the score of the relevant sovereign. Considering that banks typically hold large quantities of government bonds from their country of origin, this constraint generally makes sense. However, rigidly capping a bank rating at that of the sovereign can lead to inappropriate results – especially when that bank holds relatively few government bonds while also having a pan-European or global business model.
What increasingly distinguishes a European perspective at a credit rating agency is the integration of ESG factors – and, crucially, the concept of double materiality. The idea that companies need to report on how issues related to sustainability affect their businesses and on their own impacts on people and environment is central to EU regulation.
At Scope, our credit ratings are evolving to reflect material ESG risks – the so-called outside-in perspective – while our ESG impact ratings focus on an issuer’s ESG footprint: the impact on the environment and society from the inside-out perspective.
Such an approach is in line with rationale behind the EU’s evolving regulatory framework – the Taxonomy, the Sustainable Finance Disclosure Regulation (SFDR), and the Corporate Sustainability Reporting Directive (CSRD) – and accommodates the growing regulatory focus in Europe in looking at the impacts of a company’s entire value chain. In other words, the ESG footprint of its suppliers and its products, not just its own activities. With the introduction of the EU Taxonomy and the reform of disclosure regulations, from next year large listed European businesses will have to systematically report information on the sustainability of their activities.
At the same time, the US rating agencies remain largely focused on assessing ESG risks. Such an important analytical difference is material when the dominance of the European credit-rating sector by the oligopoly of US firms is in danger of replicating itself in ESG ratings. Though there is still a range of analytical approaches to ESG, the number of players in the field is shrinking and concentrated around US firms. With US rating agencies buying up European providers of ESG analytics and absorbing the relevant ratings into the oligopoly, there is the danger that Europe might find itself setting the global standards for ESG for capital market participants but with little independent capacity to verify how businesses and governments meet them.
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