The question of credit ratings: what can European regulators actually do?

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In 2016, 100 investors signed a PRI statement calling for credit ratings agencies (CRAs) to “enhance systematic and transparent consideration of ESG factors in the assessment of creditworthiness”. Both sovereign and corporate bond issuers could see their ability to repay debt hindered by ESG issues such as stranded assets, resource scarcity, litigation and regulatory pressure, the statement says. “As fixed-income investors, and as the primary users of credit ratings, the signatories of this statement will support formal integration of ESG factors into ratings.”
Since its launch, the statement has attracted further signatories, and now has backing from 120 investors with €19trn under management.
“Credit ratings agencies are so widely followed by market participants because of the sheer size of bond markets they analyse,” says Carmen Nuzzo, Senior Consultant at the PRI and head of its credit ratings initiative. “They have real influence over the thinking process that investors follow when assessing the credit worthiness of any issuer and can send powerful flagging signals.”
NN Investment Partners was one European investor to sign the letter. Adrie Heinsbroek, the firm’s Head of Responsible Investment, points to an instance in which, when looking at the creditworthiness of a company, his team discovered financial risks linked to the violation of environmental regulations. “It highlights that to complete the picture, ESG analysis needs to be part of either the rating or [an investor’s] own risk analysis – liabilities are currently not reflected in the widely-used ratios displayed on Bloomberg terminals.”
A handful of CRAs are already making notable moves on ESG (nine of them have also signed the letter). Moody’s and S&P have been making the most noise on this front: both have created assessment services for green bonds, for example, and S&P will launch a broader ESG evaluation next year. Moody’s has spent recent months expanding its ESG team to strengthen its coverage of the topic within its mainstream ratings. Even Fitch, quiet on ESG until recently, launched a page on its website dedicated to ESG risks earlier in the year. French agency Beyond Ratings, which performs credit ratings on sovereign bonds with an enhanced ESG assessment, plans to shake up the market further by securing ‘official credit ratings agency’ status from European regulator ESMA. If successful, this will make it the first CRA to explicitly include ESG in its methodology and systematically assess it in all its credit ratings.

“If there is something that isn’t likely to cause default, and we indicate that it might, then we’ve misinformed investors.” – Mike Wilkins, S&P Ratings

In the midst of all this is the European Commission’s High Level Expert Group on Sustainable Finance. Despite having their own section in the interim report, CRAs didn’t make it into the eight early recommendations from the group. They are, however, flagged up as a ‘policy area for further discussion’, with the report suggesting that “it is time for long-term sustainability to move from an ‘add-on’ consideration to a ‘built-in’ feature” in their work.
“Some rating agencies take account of ESG criteria, but only to the extent they consider these risks material for the credit risk of the instrument or the issuer that is being rated,” it observes.
Mike Wilkins, Head of Global Environmental & Climate Risk Research at S&P Ratings, says the observation is “absolutely correct”, but adds: “the way it’s expressed in the report makes it sound like a criticism”.
“A credit rating – one that is licensed and regulated as such – is designed to address the risk of fixed-income investors not getting paid back in full and on time. So if there is something that isn’t likely to cause default, and we indicate that it might, then we’ve misinformed investors.”There is confusion in the ESG and sustainability world, Wilkins says, about what credit ratings actually do and how they differ from assessments relating to investment risk, which look at broader issues like the value, yield and price performance of an investment. An investment-grade entity would typically (although not always) be assessed by CRAs using a three- to five-year time horizon. “This won’t capture the long-term nature of ESG risks,” says PRI’s Nuzzo, especially climate risk, which is the initial focus of HLEG’s work. The solution though, she adds, isn’t simple: portfolio managers who use the ratings tend to have an even shorter-term focus – often turning their portfolios in under three years – while the analysts and ESG specialists will often have a longer-term lens. CRAs have to cater to both.
HLEG says a “transformation” is required to fix the problem of CRAs and sustainability, and this “will require political will”.
So what could political will achieve, if it could be summoned?
“The regulator [ESMA] can have quite a lot of power in terms of reviewing the methodologies of the CRAs,” explains Nuzzo. “Currently, it’s not written anywhere that these methodologies should consider, systematically, ESG criteria. That’s probably something that should be added, or at least considered. That’s where the work really lies.”

“It is down to the exclusive judgement of the CRAs as to whether climate and sustainability risks impact on the creditworthiness of a particular rated entity or industry” – ESMA

But Wilkins says that’s not likely to happen. “There is a specific non-interference pledge within ESMA when it comes to CRAs’ methodologies: when it comes to devising our criteria and our methodologies, it must be done independently and not through regulation.”
ESMA told RI that it has not provided any input into the HLEG consultation, but confirmed that it “cannot interfere with the content of the CRAs’ methodologies”, and nor can the European Commission or any public authority – under existing regulation.
“Issuing guidelines to CRAs to incorporate climate and sustainability risks into CRAs’ methodologies would constitute interference with the content of CRAs’ methodologies,” said a spokesperson for ESMA. “It is down to the exclusive judgement of the CRAs as to whether climate and sustainability risks impact on the creditworthiness of a particular rated entity or industry, including sovereigns, and as to whether they would therefore have to be included as a factor in their rating methodologies.”
Wilkins insists the non-interference pledge is “not being used as a shield” by the industry, and that S&P Ratings and others are being proactive in addressing sustainability in their activities. To make this more visible, there is a push for transparency rules and standards around ESG at CRAs.
“The ratings agencies need to be clearer about what goes into the ratings already,” says Carmen. Wilkins agrees, saying more thorough scenario analysis is also an option for CRAs, as well as other analysis to lengthens the time horizons of ratings – a view echoed by Heinsbroek, who says they need a “backward and forward looking” perspective on ESG.
There is clearly pressure on CRAs to take ESG seriously – as well as significant commercial opportunities for those that do it well. But whether HLEG will add to this pressure by recommending regulatory and policy changes in its final recommendations in December, remains to be seen.
The PRI will host a webinar on September 13 on CRAs. See here for details.