Rating action

Scope Ratings GmbH (Scope) has today affirmed the Land of North Rhine-Westphalia’s (NRW) local- and foreign-currency long-term issuer and senior unsecured debt ratings at AAA. Scope has also affirmed the local- and foreign currency short-term issuer ratings at S-1+. All Outlooks are Stable.

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Key rating drivers

The German federal institutional framework under which all German Länder operate is highly integrated and results in a close alignment of German Länder’s ratings with the AAA-rating of the federal government. Key elements of the framework include: i) a strong revenue equalisation mechanism; ii) wide-ranging participation of the Länder in national legislation and veto rights; iii) equal involvement of the Länder in negotiations on federal reforms; and iv) a solidarity principle that ensures extraordinary system support in budgetary emergencies.

A further key element of the institutional framework is the constitutional debt brake, which limits structural deficits. Budgetary practices under the debt brake rule were impacted by the federal constitutional court’s ruling from 15 November 2023 on the Second Supplementary Budget Act 2021 of the federal government. The ruling effectively limits the budgetary practice of using emergency credit authorisations to create budgetary reserves for future spending, which was also commonly used by Länder governments since 2020, thus also impacting budgetary practices of the Länder.

The ruling did not affect NRW’s budgetary planning since both the Land’s special funds set up since 2020 are closed since YE 2023. The Land had already reacted to requirements set out by its Court of Audit (LRH) in late 2022 and had separated credit authorisations and funds borrowed between its two special funds. Funds borrowed under the Covid-19 related special fund, but not expensed, will be used to redeem around EUR 4.6bn in debts in 2023-24.

NRW’s ‘mid-range’ individual credit profile with the following credit strengths: i) an outstanding market access and funding flexibility as a European benchmark sub-sovereign debt issuer, leading to low funding costs; ii) very strong financial, liquidity and debt management with a favourable debt profile; iii) forward-looking management of pension provisions via its well-equipped pension fund; and iv) sound economic fundamentals as Germany’s largest regional economy, although some exposure to energy-intensive industries entails transition costs.

NRW’s capital market access and funding flexibility are assessed as the strongest among peers and constitute a key credit strength. NRW’s standing as the largest sub-sovereign issuer in Europe and its benchmark issuer status afford it with excellent funding flexibility and conditions. In 2023, the Land issued the equivalent of EUR 14.1bn, and the issuance programme for 2024 amounts to EUR 10.1bn. Higher issuance volumes, a more liquid curve, higher issuance sizes and bigger investor tickets lead to lower aggregate funding costs via-a-vis other Länder.

Further, NRW is a pioneer with respect to ESG capital market issuance. In 2015, it was the first among German Länder to issue an ESG bond and has since regularly issued sustainability bonds, having placed its tenth issue with of a maturity of ten years and a volume of EUR 2bn in 2023. With over EUR 20bn in sustainability bonds outstanding, NRW is the largest seller of ESG bonds among German Länder and among the largest in the European SSA debt capital markets. Scope views ESG-labelled bond issuance as credit positive, as it increases the capital market presence and visibility as an issuer and widens the Land’s investor base.

The state’s liquidity management and cash buffers are sound due to comprehensive inter-year cash planning and the availability of numerous sources of liquidity, as well as available cash buffers. Additional continued access to liquidity to bridge intraday needs, if required, is available through credit facilities from major financial institutions. An additional source of liquidity is also provided by commercial cash transactions between the German Länder, which lend excess liquidity to each other. As a consequence, liquidity is assured.

NRW’s debt management is very robust, resulting in a favourable debt profile. The Land limits interest-rate and foreign-exchange risks and increases predictability for budgetary planning. Exposure to interest rate risk is limited as most of the Land’s debt is at fixed rates, with 84% at the end of March 2024. The Land uses interest-rate derivatives to steer and hedge interest-rate risks. Long average maturities and no exposure to unhedged exchange rate risk further strengthen NRW’s debt profile. The average maturity stood at 19.9 years, which is the longest among peers. 50% of outstanding debt comes due in the next ten years, with the other 50% due between 2034 and 2122. Only around 8% of debt comes due within a year or less. A stand-out feature of NRW’s issuer profile are its 100-year bonds, which it first issued in 2019.

NRW manages its pension liabilities prudently and in a forward-looking manner, and its pension fund is well-equipped in a national comparison. In line with other Länder, NRW faces unfunded pension provisions related to its civil servants. To partially cover these, the Land’s pension fund (‘Pensionsfonds des Landes Nordrhein-Westfalen’) held assets worth EUR 14.7bn at YE 2023, invested roughly equally in stocks and fixed income. From 2024, contributions to the fund cease, and an annual amount limited to the realised return of the portfolio can be withdrawn. The fund’s forward-looking management will ensure the assets do not fall below their 2022-level of EUR 13.1bn. The funds are invested according to sustainability criteria, for example stocks are invested according to the STOXX ESG Länder Eurozone PAB (Paris-Aligned Benchmark) and STOXX ESG Länder Global Ex-Eurozone PAB.

NRW has the country’s largest regional economy, supporting its robust economic profile. In 2023, the Land’s GDP made up 20.4% of national GDP. GDP per capita stood at 94.8% of national average in 2023. NRW’s economic structure is highly diversified and the sectoral contribution of services to overall gross value added has grown to over 70%, but NRW also remains relatively more reliant on energy-intensive industry, including basic chemicals, basic metals and steel-making. In addition, the region ‘Rheinisches Revier’ remains an important hub for lignite extraction until the planned phaseout by 2030. The importance of energy-intensive industrial production poses transition challenges and left the regional economy more exposed to high and volatile energy prices since 2022. This also partly necessitated the Land’s 2023 budgetary special fund, with budgeted measures of around EUR 400m for businesses and to increase energy resilience.

Rating challenges include: i) a relatively high debt burden; ii) moderate budgetary performance and flexibility, and limited budgetary reserves, mitigated by strong budgetary management and a commitment to the debt brake; and iii) some exposure to contingent liability risks, including via its municipalities’ legacy short-term debt burden (‘Kassenkredite’).

NRW’s debt is higher than the peer average, but associated risks are mitigated by a robust debt profile, very high funding flexibility and strong debt affordability.

The Land’s debt of around EUR 177bn amounted to 183% of operating revenue at YE 2023, above the Länder average of 144% in 2022. This includes core budget debt of EUR 163bn and extra-budgetary debt of around EUR 14bn. NRW’s debt as a share of operating revenue has been falling substantially from 278% in 2016 to 183% in 2023, supported by an 28% increase in operating revenue over the same period. While debt in nominal terms declined to EUR 170bn by YE 2019, it rose to EUR 177bn until YE 2023, due to net borrowing under the Land’s two special funds, under which it borrowed an aggregate EUR 22.5bn between 2020-23. The Land has already started with net redemptions of EUR 1.6bn in 2023 for its Covid-19 special fund.

Until 2026, Scope expects the debt-to-operating-revenue ratio to fall to around 170%, due to expected net debt redemptions of around EUR 4bn and a simultaneous rise in operating revenue to around EUR 100bn. This is driven by the Land’s commitment to the debt brake with no net borrowing and debt redemptions in line with financial planning of EUR 3bn in 2024, representing leftover funds borrowed, but not expensed, under the Covid-19 special fund, and EUR 430m annually from 2025 in line with mandatory debt redemption rules under the state’s debt brake.

NRW’s budgetary performance is moderate compared to peers with limited budgetary buffers. At the same time, its strong budgetary management and a commitment to the debt brake should enable NRW to limit additional borrowing in coming years. Between 2016 and 2019, operating margins averaged 10% of operating revenue, while the balance after capital accounts averaged 0.4% of total revenue. From 2020-2023, the Covid-19 pandemic and energy crisis necessitated sizeable net borrowing of an aggregate EUR 22.5bn via special funds, while its core budget remained in surplus. Altogether, NRW recorded operating surpluses of 5.1% of operating revenue between 2020-23, while its total balance after capital accounts averaged -5.2% over the same period.

For 2024-27, NRW is returning to budgetary normalcy, without resorting to special funds as in the previous four years, as laid out in its financial planning. At the same time, operating spending pressures will persist, predominantly on personnel spending. Together with a moderate rise in tax revenue, operating margins should remain robust at around 10% of operating revenue. However, gradually rising interest costs and high planned capital expenditure should weigh on the Land’s final budgetary balance, which Scope expects at around -2.4% of total revenue on average. Given that the Land’s budgetary reserves were nearly exhausted at YE 2023, balancing future budgets will be challenging, as seen by budgeted but unidentified lower expenditure (‘Globale Minderausgaben’) and higher revenue (‘Globale Mehreinnahmen’) of a total EUR 2.9bn, or 3% of operating revenue. Overall, the Land’s commitment to its debt brake and corresponding conservative budgetary management should help limit any net borrowing as outlined in latest financial planning.

Finally, NRW is exposed to some contingent liability risks, although Scope deems the overall impact on its individual credit profile to be low. Main contingent liabilities stem from: i) the former state bank's wind-down units Erste Abwicklungsanstalt (EAA, NRW holds 48.2%) and Portigon AG (100%); ii) outstanding guarantees, mostly for self-supporting entities such as NRW.BANK; iii) pension provisions, which are partly funded by a well-equipped pension fund; and iv) municipalities’ legacy short-term debt (‘Kassenkredite’), with the Land exploring debt relief with the federal government.

Outlook and rating sensitivities

The Stable Outlook represents Scope’s view that risks to the ratings over the next 12 to 18 months are balanced.

Downside scenarios for the rating and Outlooks are (individually or collectively):

1. The German sovereign rating/Outlook were downgraded;
    
2. Changes to the institutional framework were to result in notably weaker support;
    
3. The individual credit profile deteriorated significantly and structurally.

Institutional framework assessment

Scope’s institutional framework assessment determines the intergovernmental integration between sub-sovereigns and their rating anchor, which is the sovereign or a higher-tier government. To perform this assessment, Scope applies the Institutional Framework scorecard (QS1), centred on six analytical components: i) extraordinary support and bailout practices; ii) ordinary budgetary support and fiscal equalisation; iii) funding practices; iv) fiscal rules and oversight; v) revenue and spending powers; and vi) political coherence and multilevel governance.

Scope considers the institutional framework under which the German Länder operate to display ‘full’ integration for: i) extraordinary support and bailout practices; ii) ordinary budgetary support and fiscal equalisation; iii) fiscal rules and oversight; iv) revenue and spending powers; and v) political coherence and multilevel governance. The institutional framework displays ‘medium’ integration for funding practices. Consequently, Scope’s assessment results in an indicative downward rating distance of up to one notch between the German sovereign (AAA/Stable) and the rating of an individual state.

Individual credit profile

Scope assesses the individual credit profile based on quantitative and qualitative analysis of four risk categories: i) debt and liquidity; ii) budget; iii) economy; and iv) governance. These are further complemented by additional adjustments for environmental and social factors & resilience.

The outcome of these assessments, as reflected in the application of the Individual Credit Profile scorecard (QS2), is an individual credit profile score for NRW of 55 out of 100.

The mapping of this score to the range defined by the Institutional Framework assessment results in an indicative rating for NRW aligned with the sovereign rating, corresponding to an AAA indicative rating.

The review of potential exceptional circumstances that cannot be captured by the Institutional Framework and Individual Credit Profile scorecards did not lead to further adjustments. As such, the final rating corresponds to the indicative rating of AAA.

The results have been discussed and confirmed by a rating committee.

Environmental, social and governance (ESG) factors

ESG factors material to NRW’s credit quality are captured by Scope’s rating approach through several analytical areas.

Scope’s assessment of Germany’s sovereign credit quality includes an appraisal of ESG risks, as detailed in Scope’s Sovereign Rating Methodology.

Governance considerations are material to NRW’s rating and are included in Scope’s institutional framework assessment and its assessment of the Land’s individual credit profile. These highlight the high quality of governance alongside the administration’s record of sound liquidity and debt management practices.

The institutional framework assessments capture governance factors under fiscal rules and oversight, assessed as ‘full integration’ for the German Länder. This reflects the comprehensive and credible fiscal framework in the form of the debt brake, as well as the strong oversight role of the Stability Council. Governance factors are also captured under political coherence and multilevel governance, assessed as ‘full integration’, reflecting Germany’s predictable and supportive federal system, where any major reforms are discussed and agreed upon well in advance and in consultation with the Länder.

The individual credit profile captures governance factors under the ‘quality of governance and financial management’, where NRW is assessed as ‘stronger’, reflecting its: i) track record of fiscal consolidation and credible commitment to fiscal sustainability; ii) strong debt and liquidity management; iii) management of contingent liability risks related to unfunded pension liabilities via its pension fund; and iv) ability to formulate and implement long-term economic and fiscal strategies.

Social considerations are included in Scope’s assessment of NRW’s ‘economic sustainability’. The labour market remains robust. However, projections show that the working age population will shrink in the coming years which will intensify labour supply challenges. Overall, NRW’s economic outlook and growth potential is assessed as broadly in line with the German average, also given NRW’s importance in terms of economic output and population.

Additional environmental and social factors can be material for sub-sovereign creditworthiness beyond what is already captured in other sections of the methodology. In the case of NRW, no additional adjustments to the individual credit profile apply for social and environmental factors and resilience.

Regarding exposure to transition and physical risks, Scope sees NRW as broadly in line with the nationwide average, also given NRW’s size. The state is somewhat more exposed to transition risks, which is however mitigated by the federal institutional framework and significant federal transfers in support of NRW’s transition. This stems from the fact that the state’s economic structure is relatively more reliant on energy-intensive industry and faces costs related to the phase-out of coal until 2030. A full exit from electricity production from coal will significantly reduce carbon emissions and support the state’s emissions reduction path. The central government is supporting the region’s coal exit via significant grants.

Physical climate risks are also broadly in line with the nationwide average. The supportiveness of the federal framework was also at display when the Ahrtal experienced flooding in 2021, with a EUR 30bn recovery fund set up by the federal government and all Länder to share the financial burden. Another physical climate risk relates to droughts and low water-levels of the Rhein river, which runs through NRW and is an important transportation channel, especially for heavy industrial goods. Low water levels experienced in recent years slowed down goods transport and led to rising prices.

The Land is addressing climate change challenges and is striving to become the first carbon neutral industrial region in Europe by 2045. To promote climate protection and to adapt to the effects of climate change, the government has passed a climate law in 2021 and a climate protection package with 68 concrete measures in 2023, with the key commitment to become carbon neutral until 2045, which is in line with current the nationwide goal.

Rating Committee
The main points discussed by the rating committee were: i) institutional framework; ii) debt burden, liquidity profile and contingent liabilities; iii) debt management strategy; iv) budgetary performance and flexibility; v) regional socio-economic and demographic developments; vi) peer comparison; and vii) environmental and social factors.

Methodology
The methodology used for these Credit Ratings and/or Outlooks (Sub-sovereigns Rating Methodology, 11 October 2023) is available on https://scoperatings.com/governance-and-policies/rating-governance/methodologies.
Information on the meaning of each Credit Rating category, including definitions of default, recoveries, Outlooks and Under Review, can be viewed in ‘Rating Definitions – Credit Ratings, Ancillary and Other Services’, published on https://www.scoperatings.com/governance-and-policies/rating-governance/definitions-and-scales. Historical default rates of the entities rated by Scope Ratings can be viewed in the Credit Rating performance report at https://scoperatings.com/governance-and-policies/regulatory/eu-regulation. Also refer to the central platform (CEREP) of the European Securities and Markets Authority (ESMA): http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml. A comprehensive clarification of Scope Ratings’ definitions of default and Credit Rating notations can be found at https://www.scoperatings.com/governance-and-policies/rating-governance/definitions-and-scales. Guidance and information on how environmental, social or governance factors (ESG factors) are incorporated into the Credit Rating can be found in the respective sections of the methodologies or guidance documents provided on https://scoperatings.com/governance-and-policies/rating-governance/methodologies.
The Outlook indicates the most likely direction of the Credit Ratings if the Credit Ratings were to change within the next 12 to 18 months.

Solicitation, key sources and quality of information
The Rated Entity and/or its Related Third Parties participated in the Credit Rating process.
The following substantially material sources of information were used to prepare the Credit Ratings: public domain and the Rated Entity.
Scope Ratings considers the quality of information available to Scope Ratings on the Rated Entity or instrument to be satisfactory. The information and data supporting these Credit Ratings originate from sources Scope Ratings considers to be reliable and accurate. Scope Ratings does not, however, independently verify the reliability and accuracy of the information and data.
Prior to the issuance of the Credit Rating action, the Rated Entity was given the opportunity to review the Credit Ratings and Outlooks and the principal grounds on which the Credit Ratings and Outlooks are based. Following that review, the Credit Ratings and Outlooks were not amended before being issued.

Regulatory disclosures
These Credit Ratings and Outlooks are issued by Scope Ratings GmbH, Lennéstraße 5, D-10785 Berlin, Tel +49 30 27891-0. The Credit Ratings and Outlooks are UK-endorsed.
Lead analyst: Julian Zimmermann, Associate Director
Person responsible for approval of the Credit Ratings: Alvise Lennkh-Yunus, Managing Director
The Credit Ratings/Outlooks were first released by Scope Ratings on 9 November 2018.
As a "sovereign rating" (as defined in EU CRA Regulation 1060/2009 "EU CRA Regulation"), the ratings on NRW are subject to certain publication restrictions set out in Art 8a of the EU CRA Regulation, including publication in accordance with a pre-established calendar (see "Publication Calendar 2024 Sovereign, Sub-Sovereign and Supranational Ratings" published on 19 February 2024 on www.scoperatings.com). Under the EU CRA Regulation, deviations from the announced calendar are allowed only in limited circumstances and must be accompanied by a detailed explanation of the reasons for the deviation. In this case the deviation from Scope’s published calendar was due to the first-time publication of the ratings.

Potential conflicts
See www.scoperatings.com under Governance & Policies/Regulatory for a list of potential conflicts of interest disclosures related to the issuance of Credit Ratings.

Conditions of use / exclusion of liability
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