Rating Methodology 13 July 2018 Contacts Jakob Suwalski Alvise Lennkh Giacomo Barisone Associate Director Director Managing Director Public Finance Public Finance Public Finance +49 69 6677 389 45 +49 69 6677 389 85 +49 69 6677 389 22 j.suwalski@scoperatings.com a.lennkh@scoperatings.com g.barisone@scoperatings.com 13 July 2018
Table of Contents 1. Introduction... 3 Definition of Government Related Entity... 3 Scope s Segmentation approach... 3 Integration with Government... 6 Legal status & resolution framework... 6 Purpose/ Activities... 7 Shareholder structure and government control... 7 Top-Down Approach... 8 Equalisation factor... 8 Control and regular government support... 9 Organisational Structure... 9 Government Control... 9 Financial Support... 9 Likelihood of exceptional support... 9 Strategic importance... 9 Ease of substitution... 10 Default implications... 10 Bottom-Up Approach... 12 Capacity to provide support... 12 Willingness to provide support... 12 Supplementary Analysis... 13 Annex: Case Studies... 14 13 July 2018 2/16
1. Introduction This report sets out Scope Ratings GmbH (hereafter: Scope) methodology for assigning issuer credit ratings to government related entities (GRE) globally. The criteria set out in this methodology is intended to be applicable in conjunction with Scope s rating methodology for corporates and financial institutions. These methodologies are also used to determine the rating to specific debt obligations issued by GREs. Scope would rate specific obligations, which may differ from the issuer rating based on Scope s assessment of the instrument in line with the relevant sector criteria. Scope s GRE-methodology is not intended to be applicable to secured obligations. In assigning a GRE issuer rating, Scope believes that a segmentation-approach, i.e. a qualitative, principles-based approach to determining a GRE rating is best suited due to the wide variety of entities and organisations, varying jurisdictions and resulting different relationships with their respective governments. The advantage of Scope s approach is that it is transparent and analytically rigorous, based on three scorecards highlighting the relative importance of key rating drivers and considering not only the nature and evolution of the relationship between the GRE and the government but also the operational and financial links between the two entities. Definition of Government Related Entity Due to the difference of each jurisdiction and government, the organisational set-up of a GRE or GRE-sector varies from one (national or local) government to another. GREs can include administrative public bodies, agencies, entities with private legal forms and partially or totally controlled public companies established by government to carry out a specific public policy mandate and provide key services. A complete and comprehensive list of organisations that would be included is thus not feasible. This is also because the universe of GREs changes, sometimes significantly, over time. Under Scope s GRE rating methodology, a GRE is defined as a standalone issuer that fulfils both of the following conditions: (1) it is directly or indirectly majority owned and/or sufficiently controlled by a government (typically by the government exercising a majority of voting rights) and (2) its activities fulfil a public-sector mandate by implementing government policies or delivering essential public services 1. For example, if the entity s activities fulfil a social-sensitive public-sector mandate and a government is likely to support the entity in financial distress to avoid, for example, political costs of a default or interruption of the provision of services, then Scope will likely consider a GRE-status for the entity. The relationship between the GRE, usually a public-sector entity, and the government, depending on the rated GRE either a sovereign or other layer of government such as a subsovereign, is therefore reflected by either the GRE s legal status, its mandate and activities or some form of public sector ownership and control. Scope s Segmentation approach Scope s approach to rating GRE s is split into two fundamental steps. As a first step, Scope initially analyses the relationship between the GRE and the relevant government and assesses its level of integration with the government. Based on this first segmentation, Scope then chooses either the Top-Down or Bottom-Up approach to determine the primary driver of the GRE s rating. Where appropriate, in a third step, Scope performs a supplementary analysis, which, under the Top-Down approach includes the assessment of the GRE s stand-alone fundamentals. Finally, if applicable, Scope also assesses the potential risk for negative interventions by the government or additional constraints affecting the creditworthiness of the GRE under either approach. Given the idiosyncratic nature of GREs, Scope s assessment does not mechanistically cap a GRE s issuer rating at the government s rating level. For example, in those cases where a GRE s standalone credit profile is stronger than that of its respective government, Scope would apply, in most cases, the stand-alone credit rating. At the same time, Scope is mindful that 1 A clear public-sector mandate is visible in cases of the constitution or a specific law, government policy, statute or mandate that stipulates the provision of a certain good or service as being in the public interest. Absent such a clear and precise provision, Scope assesses whether the entity s revenue-generating activities are constrained or largely determined by the government as opposed to being conducted under a profit maximisation function. Scope would likely assign GRE status to those entities whose operational activities and price-setting mechanisms, in Scope s opinion, are mostly defined by the government. Finally, for diversified entities with both public-sector mandates that is, activities that are stipulated as being in the public interest and activities that are conducted purely under a profitmaximisation function, Scope would likely assign a GRE status to those entities which fulfil at least one of the following two assessments: i) the disruption of one of the public-sector mandated activities of the GRE would likely result in government intervention to ensure an ongoing provision of that good or service, and/ or ii) the share of public-sector mandated activities, as measured, for instance, in terms of revenues, employees or EBITDA is a critical component of the total activities of the entity. Scope notes that in an Emerging Market context, macro-economic variables, such as the employment share of the total population, would also be considered. In Scope s view, the higher the share of an entity s activities are deemed an essential public service, the likelier it is to benefit from government support and thus treated as a GRE under this methodology. 13 July 2018 3/16
a default by a sovereign can lead to actions which cause the GRE to default, and further, that government defaults are sometimes accompanied by a freeze on foreign currency convertibility, limiting the circumstances in which a GRE is rated higher than the government 2. Step 1: Level of integration with government: Scope analyses the relationship between the GRE and the relevant government in the context of a continuum of relationships between the government and the organizations it relies on to achieve its objectives. At one end of the continuum are entities very closely integrated with or under the control of their governments 3, with some GREs so closely integrated into government finances that they can be rated at the same level as its sponsoring government. At the other end of this scale, GREs subject to insolvency laws, operating as a commercial, profit-maximising entity or which are highly likely privatised, make financial support from a government less likely. Figure 1: Government-GRE Relation Government Continuum of Relation Government-Related Entity Source: Scope Ratings GmbH Scope assesses various factors to determine whether the level of integration of a GRE with the government is integral/strong or more limited/weak. These factors include the GRE s legal status, purpose and activities and shareholder structure and control. Based on this assessment, Scope chooses either the top-down or bottom-up approach. Details are provided in Section 2. Step 2a: Top-Down Approach: Provided that the GRE benefits from an integral/strong level of integration with the government, Scope may apply the Top-Down approach which takes the government s rating as the starting point and then negatively adjusts it by up to three notches in most cases (although exceptions can apply 4 ). The extent of the downward notching is based on Scope s assessment of: i) the control and regular government support and ii) the likelihood of exceptional support for the GRE. In case of statutory guarantees for the GRE, Scope will directly align the GRE s with the government s rating. Usually, such GREs benefit from a special legal public status and a very strong level of integration of the GRE with the government. Details are provided in Section 3. Step 2b: Bottom-Up Approach: In case of a more limited/weak integration between the GRE and the government, or if the legal status and resolution framework is signalling a limited/weak level of integration of the GRE with the government irrespective of other criteria, Scope may apply the Bottom-Up approach. This approach takes the GRE s stand-alone credit quality determined by either Scope s Financial Institutions or Corporates group as a starting point, and then assesses the potential rating uplift, usually by a maximum of three notches for most cases (although exceptions can apply). The extent of the upward notching is based on the (i) government s capacity to provide support, defined as the rating differential between the government and the GRE-standalone credit quality rating, and Scope s assessment of the (ii) government s willingness to provide support to a particular GRE. Details are provided in Section 4. 2 This is most likely the case in an emerging market context. 3 In the case of a subsidiary of a GRE, which is not directly owned by the government, Scope would first assess the relationship between the government and the parent owning the subsidiary, and second, the relationship between the parent and its subsidiary. This assessment, which takes into consideration the respective jurisdiction as well as the complexity and transparency of the ownership structure, is conducted in accordance with the Financial Institutions and Corporate methodologies where appropriate. 4 Where Scope assigns ratings to GRE in a sector (for example, public hospitals or public housing associations), it may decide to assign a broader notching range to allow for greater rating differentiation as their aggregate relationship may be stronger than the relationship between one single GRE and its public owner. 13 July 2018 4/16
Step 3: Supplementary Analysis The supplementary analysis can have both credit-positive and negative implications for the rating, capturing the fundamentals of the GRE under the Top-Down as well as the potential risk for negative interventions by the government or additional constraints affecting the creditworthiness of the GRE under either approach. Figure 2: Scope s segmentation approach to GREs Government Related Entity (GRE) 1. Level of integration of GRE with government Integral/ Strong Limited/ Weak 2a. Top-Down Approach 2b. Bottom-Up Approach Baseline Government's rating Stand-alone rating Financial Institutions; Corporates Yes Adjustment factors Criteria for Equalisation? No Control and regular government support Credit uplift factors Stand-alone > Government's rating? No Yes Capacity to provide support Likelihood/ willingness of exceptional support Supplementary analysis Indicative downward notching Indicative upward notching Source: Scope Ratings GmbH 13 July 2018 5/16
Integration with Government To determine the level of integration of a GRE with its government, Scope structures its analysis around three key categories: (i) legal status and resolution framework, (ii) purpose or activities and (iii) shareholder structure and control. Figure 3: Criteria to assess GRE integration with government Legal Status & Resolution Framework Purpose/ Activities Shareholder Structure & Government Control Source: Scope Ratings GmbH For each category, Scope identifies a group of key criteria that serve to provide an analytical framework to assess whether the state of the relationship of a GRE with the government is either more integral/strong or limited/weak. While Scope acknowledges that the degree of importance of each criteria depends on the specific circumstances, usually two of the three criteria serve as a useful benchmark in determining whether the Top-Down or Bottom-Up approach is more applicable. However, in case the criteria Legal status & Resolution Framework indicates a rather limited/weak level of integration with the government, the Bottom-Up approach can be applied regardless of the other two criteria. This ensures that the stand-alone credit quality, provided by either Scope s financial institutions or corporates team, may be chosen as the primary rating driver for those GREs which are subject to private insolvency procedures, if deemed appropriate. Figure 4: Overview of assessment of GRE integration with government Criteria Level of integration with government High/ Strong Limited/ Weak Legal Status & Resolution Framework Public; Insolvency, bankruptcy and resolution laws unlikley to apply Private; Insolvency, bankruptcy and resolution laws do apply Purpose/ Activities Good/ service is backed by constitution or in the public interest Good/ service has mostly a commercial purpose Shareholder Structure & Control Significant public ownership and control Approach Top-Down or Bottom-Up * Two of the three parameters indicate the chosen approach for most instances. Legal status & resolution framework Mostly private ownership Source: Scope Ratings GmbH Scope views the legal status of a GRE as a suitable indicator for the assessment of its level of integration with its respective government. The more the legal status of the GRE resembles a government agency, ministerial department or an entity created under public law, the closer the relationship between the GRE and its government. At the other extreme, Scope assesses the link between a GRE and its respective government as weaker or more limited in cases of entities operating under private law, resembling corporations or financial institutions. To assess the legal status of the GRE, Scope reviews, among other documents, i) the legal frameworks and structures for the GRE, including national and local laws; ii) the legal form chosen for the GRE; iii) the legal relationship between the GRE and its shareholders or owners; and iv) the efficacy of legal frameworks in resolving any potential conflicts between the GRE, its shareholders or owners and/or third parties. 13 July 2018 6/16
This assessment is conducted as a point-in-time analysis covering existing laws and institutions. Changes, including but not limited to changes in existing legislation governing the GRE, the introduction of new legislation affecting the GRE such as a privatisation programme or a more active competition policy programme, as well as court decisions affecting such laws with a material effect on the relation of the GRE with the sponsoring government, would potentially change Scope s assessment of the level of integration of the GRE with the government. Scope believes that, depending on the jurisdiction, a certain degree of judgement is necessary to assess a government s ability to change legislation. In forming its opinion, Scope considers, among other criteria, the recent track record of legal status changes, the government s strategy of mandating GREs in fulfilling its policy objectives, as well as the form and strength of a government. For example, amendments to a GRE s statutes and policies that enhance (weaken) its importance to the government would be assessed as indicating a stronger (weaker) relationship with the government. In addition, Scope explicitly considers the existence of special national laws and legal procedures governing GREs, particularly regarding cases of insolvency, bankruptcy and resolution. Depending on the national law, the legal status of a GRE signals a very strong relationship with the respective government. Purpose/ Activities Scope views the purpose or activities of a GRE as another factor to be included in the assessment of the level of integration between a GRE and its respective government. The more important the GRE s role is in fulfilling public tasks or services on behalf of the government, the closer the level of integration of the GRE with the government. Scope views GREs that provide a service which is backed by a defined public responsibility or even enshrined in the sovereign s constitution as essential, and thus a good indication of a very close integration with the government. For example, Scope views GREs operating essentially on behalf of the government with the main purpose to provide a key public service which cannot be easily replaced by other GREs or private companies, as providing a service in the public interest. However, Scope is mindful that many traditional utilities (for example, in the energy, electricity or transport sector) which provide a public service operate in semi-competitive business environments. In addition, the existence of mixed structures, combining competitive and non-competitive business activities, underpins Scope s approach of conducting both analyses ( Top-Down and Bottom-Up ) as indicated under the Supplementary Analysis. Shareholder structure and government control GREs are often partially or wholly owned by one or more government(s). High levels of government ownership are usually associated with a stronger link with the respective government. A 100%-owned GRE would tend to have a narrower rating differentiation from the government than a public majority-owned GRE. Scope reviews the public ownership structure of the GRE, paying close attention to the extent to which the government exercises control over the financial and operating policies of the GRE, including its representation in governing bodies. In this context, the question of ownership also extends to ownership rights of the GRE s assets and potential privatization plans or related strategies of the respective sectors in which the GRE operates. An integral/strong level of government control is typically indicated in cases where the government s ownership is greater than 60% and, in addition, i) has the power to govern the financial and operating policies of the GRE and/or ii) can unliterally appoint or remove a majority of the organization s governing body, and/or iii) has ongoing access to the assets of the GRE, and/or iv) has an ongoing responsibility for losses and/or v) has the power to step in and dissolve a GRE without consultation. In addition, Scope assesses the complexity of the ownership structure. Direct ownership structures with a clear and straightforward delineation of ownership will be assessed as having a stronger level of integration with the government than complex and indirect ownership structures, which often weigh on the transparency of the relationship with the respective government. When a GRE is owned by more than one government, Scope s general approach is to assess the support based on the owner with the dominant share which is usually the government most likely to provide support to the GRE. In cases where more than two governments have similar or significant shareholdings, Scope would assess the probability of support depending on the shareholder structure. This assessment would be conducted on the basis of either the largest (dominant) shareholder or, if available, based on the weighted average of the credit profiles of the governments based on their controlling stakes. Finally, in cases with several owners with minority controlling stakes, Scope could assess the level of integration with the government as limited. However, for those cases where a group of minority shareholders are governed by an agreement that legally defines them as one shareholder group, Scope could assess the government structure and control higher. 13 July 2018 7/16
Top-Down Approach Provided that the GRE benefits from an integral/strong level of integration with the government, Scope may apply the Top- Down approach which takes the government s rating as the starting point and then negatively adjusts it by up to three notches in most cases (although exceptions can apply). The extent of the downward notching is based on the assessment of i) the control and regular government support and ii) the likelihood of exceptional support for the GRE. The higher of the two assessments, which is completed on a three-point scale from High, Medium and Limited is then used to map an indicative notching range. Control and regular government support is assessed on eight key criteria while the likelihood of exceptional support is assessed on three key criteria. A simple conservatively rounded average of the individual assessments of these criteria determines the overall assessment of either dimension 5. The higher of the two assessments is chosen to reflect Scope s view that a government intervention in case of need ultimately drives Scope s assessment of government support. For example, relatively independent GREs, assessed with a Medium or Limited degree of regular government support, can still benefit from a High likelihood of exceptional government support, and should therefore be closer aligned with the government s rating. GREs with a High degree of control and regular government support are most likely to benefit from a high likelihood of exceptional support as well. In cases of statutory guarantees 6 for the GRE, or laws to similar effect, Scope will directly align the GRE s with the government s rating. Usually, such GREs benefit from a special legal public status and an integral level of integration with the government, which Scope captures via its Equalisation factor. In case of need, Scope may apply an additional degree of notching to account for special circumstances related to the GRE s characteristics and operating environment. Finally, in case the government s rating or outlook were to change, Scope would reassess the creditworthiness of the related GRE. Equalisation factor In cases where the GRE benefits from a statutory guarantee or specific guarantee or laws to similar effect covering all, or most of the specific issuer s obligations, Scope follows the equalisation approach and aligns the GRE s with that of the government s rating. Statutory guarantees are often included in the GRE s statutes or national or regional laws. Usually, an entity with a statutory guarantee benefits from a full integration with the government, which is typically reflected by a special public legal status of the GRE, a socially-sensitive or strategically important public mandate, and relatively tight operational and financial control exercised by the government. Equalisation of a GRE s rating with that of its government is also possible in case of an explicit guarantee with the following characteristics: enforceable, irrevocable, unconditional, on demand, general and indefinite. If the GRE were to experience difficulties in payment, these forms of guarantees usually offer investors a direct and unconditional claim against the guarantor. In Scope s view, this is, along with statutory guarantees, the strongest type of government support. Scope also views joint and several guarantees as special forms of an explicit guarantee, and in such cases, may also apply the equalisation approach. In such arrangements, each shareholder usually guarantees the entirety of liabilities of the relevant GRE s liabilities. If a credit event were to occur triggering the calling of these guarantees, creditors could demand honouring of their claim directly from every single guarantor. Guarantors might thus be obliged to service the overall claim even if one of the guarantors is unable to make the necessary payments, enhancing the strength of this type of guarantee 7. Where a statutory guarantee is unclear, Scope normally relies on a legal opinion to ascertain the degree of support in the underlying instrument. Scope notes that in case of an equalisation of the GRE s rating with that of its respective government, the supplementary analysis, as outlined in Section 5, may provide further insights into the final rating decision. 5 For example, if four criteria under the control and regular government support dimension are assessed as high (1 points) and another four as medium (2 points), Scope would calculate the overall assessment as follows: (4 x 1 + 4 x 2) / 8 = 1.5. Rounded to 2, therefore Medium. Low is treated with 3 points. 6 This type of guarantee is usually included either in the statute of the entity or in certain laws passed by its public-sector owner. Where a statutory guarantee is unclear, or a debt guarantee is in place Scope typically may require a legal opinion to determine the degree of support by assessing whether such guarantees are enforceable, irrevocable, unequivocal and unconditional. 7 This stands in contrast to pro-rata or liability quotas which often need to be specified through internal agreements. 13 July 2018 8/16
Control and regular government support This sub-category is assessed by analysing the GRE s Organisational structure, Government control and Financial support. For each category, Scope identifies a group of key analytical questions that serve to provide a framework to assess whether the degree of government control and regular support is either High, Medium or Limited. The average of the three assessments determines the indicative classification of this sub-category. Organisational Structure To assess a GRE s organisational structure, Scope analyses its Legal Status as well as the ownership of and rights to the GRE s assets. Legal Status To assess the legal status of the GRE, Scope reviews, among other documents, i) the legal frameworks and structures for the GRE, including national and local laws; ii) the legal form chosen for the GRE; iii) the legal relationship between the GRE and its shareholders or owners; and iv) the efficacy of legal frameworks in resolving any potential conflicts between the GRE, its shareholders or owners and/or third parties. Scope assesses the level of control and regular government support as High ( Limited ) the more (less) the legal status of the GRE resembles a government department or ministry. Legal structures with significant government involvement are likely to be assessed as Medium. Ownership of & rights to GRE s assets To assess the ownership of the GRE and the access rights to its assets, Scope reviews the entity s ownership structure. Scope assesses the level of control and regular government support as High ( Limited ) the higher (lower) the government s ownership of the GRE and/ or access to its assets. GRE s with some government ownership are likely to be assessed as Medium. Government Control Scope views government control as one of the most important categories to determine the rating differentiation between the GRE and its respective government. Usually, the tighter the control exercised by the government of the GRE decision-making process, the stronger the GREs level of integration with the government. Key for determining a government s control is not the willingness and execution of control, but rather the government s ability to control the GRE. This includes the government s ability to i) alter, amend or otherwise control a GRE s mission, mandate or strategy, ii) set operating policies and establish financial goals, including portfolio investment policies, and iii) appoint and dismiss key personnel including members of the governing and oversight bodies. This includes the financial supervision, such as the approval of accounts or borrowing and budget reporting, official audits, interventions of the stakeholder in tariff-setting policies and decision-making processes. Scope assesses the level of government control as High ( Limited ) the higher (lower) the government s ability to direct the mandate, operations and personnel of the GRE. GRE s with some government influence are likely to be assessed as Medium. Financial Support Scope also assesses a government s financial support to the GRE, which can be in the form of its funding options, dividend payments (eg. the government can forgo its dividends), capital injections, or defined support agreements such as credit lines. Funding options that include the government, as well as a track record of timely financial aid under most circumstances are likely to be assessed as High government support. Likelihood of exceptional support This sub-category is assessed by analysing the GRE s Strategic importance, the Ease of Substitution of its activities and the Default Implications to the government. For each category, Scope identifies a key analytical question to assess whether the likelihood of exceptional government support is either High, Medium or Limited. The average of the three assessments determines the indicative classification of this sub-category. Strategic importance Scope views a GRE s strategic importance to its government as a critical criterion for determining the likelihood of exceptional support. A GRE can be important to the government because it, for instance, implements a key national policy, provides an important public service or ensures the proper functioning of an important economic sector. Scope s qualitative assessment may 13 July 2018 9/16
be underpinned by quantitative indicators including the number of employees, GRE revenues relative to the government s revenue base or share in national exports, or production of energy for the region or country. However, Scope notes that the strategic importance of a GRE might vary over time. Sectors are classified as strategic or non-strategic to the government, amongst other aspects, based on national security and development policies and the associated government s (dis)investment policy or allocation of funds to different sectors. In cases where the good or service provided by the GRE is in the public interest and even protected by the constitution Scope will most likely assess the strategic importance as High. This is usually the case when the GRE operates essentially on behalf of the government and its main purpose is to provide a key public service that could not be readily replaced by a private company or if the GRE plays a central role in meeting key economic, social, or political objectives of the local, regional or national government. For those situations where the disruption of the good or service is likely to be damaging to the government, possibly even in the form of political costs, the assessment is likely to be Medium. This can be the case when the GRE provides essential infrastructure, goods, or services to the population, or if part of the GRE s activities are related to an important public role. Finally, if the disruption of the provision of the good or service is unlikely to be damaging to the government, or of secondary importance for the government in terms of revenue generation or social and political consequences, the strategic importance is likely to be assessed as Limited in most cases. Ease of substitution Scope views the ease of substitution of a GRE s provision of a good or service as a critical criterion for determining the likelihood of exceptional support. In cases where the GRE is very difficult to be replaced, Scope would expect a High likelihood of exceptional support. For those situations where the prospect of private players entering the market is a feasible possibility, the assessment is likely to be Medium. Finally, if private sector operators are already providing the same good or service, Scope is likely to assess the likelihood of exceptional support as Limited. For example, the GRE could be one of many GREs or its services could easily be undertaken by another GRE or private company. Default implications Scope views a GRE s default implications to a government as a critical criterion for determining the likelihood of exceptional support. Scope considers in its assessment the potential consequences from the absence of government intervention, that is, the default implications of the GRE for the regional or national economy and the government. Scope assesses whether the potential default of the GRE would have a localised impact or spill over effect to other entities or sectors, including the government. In cases where the GRE s default would likely result in the government s default, for instance in the case of systemically important institutions, Scope would usually expect a High likelihood of exceptional support. For those situations where the GRE s default would have some financial impact on the government, the assessment is likely to be Medium. Finally, if the GRE s default would be unlikely to affect the government s finances or reputation, Scope is likely to assess the likelihood of exceptional support as Limited. 13 July 2018 10/16
Likelihood of exceptional support Control and regular government support Rating Methodology Figure 5: Top-down approach Top-down approach Analytical considerations Assessment High Medium Limited Outcome & indicative notching Equalisation Factor Statutory guarantee or laws to similiar effect Yes No Equalisation Organisational Structure Legal Status Ownership of & rights to GRE's assets Government department or similar Legal structure with significant government involvement Mostly government Somewhat government Public and private Legal structure with limited government involvement Mission, mandate and strategy Mostly directed by government Government-influenced Possible, but mostly independent Government Control Financial, operating and investment policies Key personnel and oversight bodies Mostly directed by government Government-influenced Possible, but mostly independent Mostly directed by government Government-influenced Possible, but mostly independent High/ Medium/ Limited Financial Support Funding options Support agreements Mostly via government Mix of government and market funds Mostly market funds Regular cash or capital injections or similar Active/ open credit lines or similar Implicit arrangements in place High/ Medium/ Limited Track record History of timely support under all circumstances History of support under select circumstances Support expected but not yet required Strategic importance Ease of substitution Good/ service protected by the constitution Good/ service is difficult to replace Disruption of good/ service likely damaging to government; expected political costs Prospects of private players entering the market Disruption of good/ service unlikely damaging to government; limited political costs Private sector operators provide same good/ service High/ Medium/ Limited Default implications Large; default likely to affect government's creditworthiness Some financial inter-dependence (eg. Dividends) Limited, not a major concern Aggregation Overall Assessment Indicative notches Indicative notching -- The indicative downward notching is determined by the higher of the Equalisation 0 two assessments for 'Control and regular government support' and High 0-1 Additional adjustment -- 'Likelihood of exceptional support'. The scores of both criteria are Medium 1-2 derived via an average of the respective points. Limited 2-3 Final indicative notching -- Source: Scope Ratings GmbH 13 July 2018 11/16
Bottom-Up Approach In case of a more limited/weak integration between the GRE and its respective government, Scope may apply the Bottom-Up approach which starts with the assessment of the GRE s stand-alone credit quality, and then, positively adjusts this indicative rating upward by up to three notches in most cases (although exceptions can apply). The extent of the upward notching is based on Scope s assessment of: i) the government s capacity to provide support, defined as the rating differential between the government and the GRE-standalone credit quality rating, and ii) the government s willingness to provide support, defined as the likelihood of providing exceptional support to a particular GRE. The combined assessment, which is completed on a three-point scale of High, Medium and Limited is then used to map an indicative rating uplift. Capacity to provide support A government could have a strong commitment, moral obligation or willingness to support a GRE, but be financially constrained in its capacity to provide support on a timely basis. Scope defines the government s maximum capacity to provide support to a GRE as the rating-differential between the government and the stand-alone credit rating of the GRE. This first indicative assessment is then refined to account for several factors, including the share and composition of the government owners. The higher (lower) this differential the higher (lower) the (in principle) capacity of a government to provide a rating-notch uplift to the GRE. In cases where the GRE s stand-alone credit quality is above that of the sovereign, the capacity to provide support is assessed as limited, allowing for, in principle, an uplift under extraordinary circumstances. Willingness to provide support Scope s assessment of the government s willingness to provide support is defined as the likelihood of providing exceptional support and rests on i) the strategic importance of the GRE to the government (defined in chapter 3.3.1), ii) the ease of substitution of the services provided by a GRE (defined in chapter 3.3.2) and iii) the implications a default of the GRE or a disruption of the provision of the GRE services (defined in chapter 3.3.3) might have. The more systemic the GRE and the higher the potential costs of its default to the government, the higher Scope would assess the government s willingness to provide support to the GRE. Analytical considerations include the number of people employed in the GRE, the share of GRE s revenues relative to government revenues, public statements of support, defined support agreements, and reputational risk to the government if the GRE defaults. Scope analyses the government s willingness to support a particular GRE amongst other aspects as demonstrated by the government s policy, track record of past interventions, level of supervision and involvement in daily operations. In determining the willingness to provide support, Scope also considers the GRE s operating environment and would attribute a higher willingness to provide support for those entities which operate in highly regulated environments. Finally, Scope notes that in cases in which the policy transparency or predictability is constrained, the assessment of a government s willingness to provide support is likely to be Medium or Limited. 13 July 2018 12/16
Willingness to provide exceptional support Rating Methodology Figure 6: Bottom-up approach Capacity to provide support Bottom-up approach (indicative notches) High Medium Limited 2-3 more notches 1-3 notches 0-2 notches High Medium Limited - Strategic sector/ critical public service, systemic relevance - Difficult to replace and no private players in the market - High level of operational or regulatory government control - Politically costly to disrupt provision of good/ service - High default impact on government - Somewhat strategic sector/ critical public service - Prospects of private players entering the market - Some level of operational or regulatory government control - Some political costs to disruption of provision of good/ service - Some default impact on government - Not a strategic sector/ critical public service - Private players operate in the market - Limited level of operational or regulatory government control - Limited or no political costs to disruption of provision of good/ service - Limited or no default impact on government 3 3 2 3 2 1 2 1 0 Indicative notching -- Additional adjustment -- Final indicative notching -- Supplementary Analysis Source: Scope Ratings GmbH In the final step of the Top-Down approach, Scope can perform a supplementary analysis which assesses the fundamentals of the GRE, including its business and financial risk profile as well as its commercial viability. In order to determine whether such analysis is needed analysts will assess whether elements of Scope s corporate or bank methodologies provide additional insight which could bear an impact on the GRE s creditworthiness. The supplementary analysis can have credit-positive or negative implications for the final rating as well as no implications at all. In addition, under both approaches, Scope considers the potential risk for negative interventions by the government or additional constraints affecting the creditworthiness of the GRE. These refer to additional economic, financial, legal or political constraints, which are limiting the government s capacity to provide support, as well as government interventions or legal changes which affect the creditworthiness of a GRE or the sector in which the rated GRE operates 8. Scope acknowledges that the government s actual ability to provide support to a GRE may be constrained by additional considerations, including the macro-economic environment, the number of entities relying on government support, possible off-balance sheet liabilities, legal or policy barriers such as anti-trust or competition laws as is the case in the European Union 9. Should the above result in the supplementary analysis having no impact on the creditworthiness of the GRE, analysts will indicate such conclusion in the GRE s rating report and can choose to present such analysis in the rating report for information purposes. 8 For instance, this could refer to special taxes, dividend payments or cash stripping. Depending on circumstances, this could also refer to the government s intervention to force a merger within a GRE sector. 9 Legal or policy barriers, such as the European Union (EU) state aid rules affect the ability of the government to provide support. However, despite the general prohibition of state aid, the EU Treaty leaves room for a number of policy objectives for which state aid can be granted. In practice, EU member states do provide regular and exceptional financial support for certain GREs, referring, for example, to all active aid measures to industries qualifying for exemption under the socalled General Block Exemption Regulation. In this context, Scope considers the likelihood that the government would obey these barriers, should they exist. http://ec.europa.eu/competition/state_aid/legislation/compilation/index_en.html 13 July 2018 13/16
Likelihood of exceptional support Control and regular government support Rating Methodology Annex: Case Studies Case Study 1: Top-Down Approach The hypothetical GRE is i) not subject to resolution laws, ii) fulfils a public-sector mandate and iii) is fully owned by the government. As such, the level of integration with the government is assessed as strong which results in the application of the Top-Down approach. Step 1: Level of integration Criteria Level of integration with government High/ Strong Limited/ Weak Legal Status & Resolution Framework Public; Insolvency, bankruptcy and resolution laws unlikley to apply Private; Insolvency, bankruptcy and resolution laws do apply Purpose/ Activities Good/ service is backed by constitution or in the public interest Good/ service has mostly a commercial purpose Shareholder Structure & Control Significant public ownership Approach* Top-down * Two of the three parameters indicate the chosen approach for most instances. Step 2: Downward notching from government rating Mostly private ownership Top-down approach Analytical considerations Assessment High Medium Limited Outcome & indicative notching Equalisation Factor Statutory guarantee or laws to similiar effect Yes No Equalisation Organisational Structure Legal Status Ownership of & rights to GRE's assets Government department or similar Legal structure with significant government involvement Mostly government Somewhat government Public and private Legal structure with limited government involvement Mission, mandate and strategy Mostly directed by government Government-influenced Possible, but mostly independent Government Control Financial, operating and investment policies Key personnel and oversight bodies Mostly directed by government Government-influenced Possible, but mostly independent Mostly directed by government Government-influenced Possible, but mostly independent Medium Funding options Mostly via government Mix of government and market funds Mostly market funds High Financial Support Support agreements Regular cash or capital injections Active/ open credit lines or similar Support framework in place but rarely used Track record History of timely support under all circumstances History of support under select circumstances Support expected but not yet required Strategic importance to government Good/ service protected by the constitution Disruption of good/ service likely damaging to government; expected political costs Disruption of good/ service unlikely damaging to government; limited political costs Ease of substitution Good/ service is difficult to replace Prospects of private playeres entering the market Private sector operators provide same good/ service High Default implications Large; default likely to affect government's creditworthiness Some financial inter-dependence (eg. Dividends) Limited, not a major concern Overall Assessment Equalisation High Medium Limited Indicative notches Indicative notching 0-1 0 0-1 Additional adjustment 0 1-2 2-3 Final indicative notching 0-1 The government which owns and controls the GRE is rated by Scope at AA. In this second step, Scope assess the degree to which the GRE s rating can be aligned with (or deviate from) the government s rating. In this hypothetical case, the GRE does not benefit from a statutory guarantee on its liabilities which would allow for a direct alignment with the government s rating. Instead, the categories comprising the government s control and regular government support and the likelihood of exceptional support are assessed. In this case, the assessments are Medium and High respectively. As the higher of the two assessments is chosen, the overall level of government support is assessed as High, which indicates a 0-1 notches downward adjustment from 13 July 2018 14/16
Willingness (Likelihood of support) Rating Methodology the sovereign rating. A Rating Committee would then discuss whether the rating of the GRE will be aligned at AA, or whether a 1-notch downward adjustment to AA- (or, if deemed appropriate, even lower) is justified. Case Study 2: Bottom-Up Approach The hypothetical GRE is i) subject to resolution laws, ii) its services fulfil mostly a commercial purpose and iii) it is majority owned and controlled by the government. As such, the level of integration with the government is assessed as limited and the methodology thus suggests the Bottom-Up approach. Step 1: Level of integration Criteria Level of integration with government High/ Strong Limited/ Weak Legal Status & Resolution Framework Public; Insolvency, bankruptcy and resolution laws unlikley to apply Private; Insolvency, bankruptcy and resolution laws do apply Purpose/ Activities Good/ service is backed by constitution or in the public interest Good/ service has mostly a commercial purpose Shareholder Structure & Control Significant public ownership Approach* Bottom-up * Two of the three parameters indicate the chosen approach for most instances. Step 2: Upward notching from stand-alone rating The hypothetical GRE has a stand-alone rating, determined by the Corporate methodology, of BBB. In this step, Scope assesses the government s capacity and willingness to provide support. The government s rating is assessed at A-. Mostly private ownership The resulting rating differentiation of two notches indicates a relatively Medium capacity to provide support. At the same time, Scope assesses this entity s systemic relevance as Medium. This is due to its strategic importance for the local economy, the difficulty in substituting the entity s service quickly with private sector entities and the adverse effect the government would have if dividend payments were to end. The scorecard therefore recommends for an uplift of up to two notches to A-, which would have to be discussed and confirmed in a Rating Committee. Capacity to provide support Bottom-up approach (indicative notches) High Medium Limited 2-3 more notches 1-3 notches 0-2 notches High Medium Limited - Strategic sector/ critical public service - Difficult to replace and no private players in the market - High level of operational or regulatory government control - Politically costly to disrupt provision of good/ service - High default impact on government - Somewhat strategic sector/ critical public service - Prospects of private players entering the market - Some level of operational or regulatory government control - Some political costs to disruption of provision of good/ service - Some default impact on government - Not a strategic sector/ critical public service - Private players operate in the market - Limited level of operational or regulatory government control - Limited or no political costs to disruption of provision of good/ service - Limited or no default impact on government 3 3 2 3 2 1 2 1 0 Indicative notching 2 Additional adjustment 0 Final indicative notching 2 13 July 2018 15/16