Rating action

Scope Ratings GmbH (Scope) has today affirmed the Land of Baden-Württemberg’s (Baden-Württemberg) 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, resulting in a strong alignment of the German Länder’s ratings with the federal government’s AAA-rating. Key elements of the framework include: i) a robust revenue equalisation mechanism; ii) wide-ranging participation of the Länder in national legislation, including veto rights; iii) equal involvement of the Länder in 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 this 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 related to such an emergency, which was also commonly used by Länder governments since 2020, thus also impacting budgetary practices of the Länder.

The ruling did not affect Baden-Württemberg’s current budgetary and financial planning. An external evaluation commissioned by the Land found that, in retrospect, the transfer of the emergency loans to subsequent years in Baden-Württemberg also did not fully comply with debt brake regulations. However, all funds were used exclusively for pandemic-related spending, with no re-purposing of loans. Funds were also fully used up by the end of 2022, and the financial years had already been concluded by the time of the Constitutional Court’s ruling.

Baden- Württemberg’s strong individual credit profile with the following credit strengths: i) solid budgetary performance and management with recurring operating surpluses and a strong commitment to the Land’s debt brake, ii) conservative debt and liquidity management, with excellent capital market access and moderate debt, iii) large, wealthy and diversified economy, and iv) above-average revenue flexibility.

Baden-Württemberg’s conservative budgetary management, resulting in solid budgetary performance. Between 2016 and 2019, operating margins averaged 12.5% of operating revenue. These were supported by an accommodative monetary and economic backdrop, allowing for consolidation efforts before the implementation of the debt brake at state level in 2020. Operating surpluses also allowed the Land to cover interest payments and capital expenditure without additional borrowing.

In 2020, the Covid-19 pandemic led to a temporary budgetary deterioration due to revenue losses and additional expenditure, as well as higher borrowing under the debt brake emergency clause. At the same time, significant central government transfers cushioned the direct impact on Länder budgets. Budgetary performance recovered strongly in 2021/22, allowing Baden-Württemberg to redeem EUR 942m of extraordinary pandemic borrowings early, reducing the initially committed repayment period by almost three years.

In 2023, budgetary performance deteriorated, with tax revenue underperforming compared to budgeted levels by around EUR 600m, leading to a decline in operating revenue of 2.9% YoY. However, as some planned expenditure was not incurred during the year, an accounting surplus of EUR 2.3bn was ultimately recorded for 2023, of which EUR 1.8bn could be used to ease the consolidation pressure in the 2025/26 draft budget. Similarly, a surplus of EUR 4.7bn was recorded in 2022, also easing pressures in the draft budget.

Positive effects from the 2022 census will lead to additional revenue allocations for Baden-Württemberg over the next years. In combination with the accounting surpluses from prior years, this created some additional headroom for the 2025/26 draft budget which faces rising spending pressures. However, some consolidation measures are still required to close the structural funding gap. These measures include a reduction in the previously planned allocations to the pension reserve and an extension of the repayment period of pandemic-related redemptions back to the originally committed 25 years. Despite the pressures, Scope expects remaining budgetary reserves, together with some consolidation measures, to allow Baden-Württemberg to adhere to its commitment to the debt brake in coming years. The use of deferred credit authorisations will create some room for new, though mostly earmarked, credit market debt. In aggregate, Scope expects credit market debt and deferred credit authorisations to remain stable over the next years.

Overall, the state’s commitment to fiscal consolidation, conservative budget management and low debt service costs will help mitigate budgetary risks and enable the state to implement its long-term fiscal consolidation strategy.

Baden-Württemberg’s excellent debt management limits maturity, foreign-currency and interest-rate risks, while securing favourable funding conditions. The weighted average maturity of debt is 11.7 years. Derivatives are used to hedge foreign-exchange and interest-rate risk, and exposure to these risks is minimal.

Unlike most other Länder, Baden-Württemberg has accumulated significant deferred credit authorisations in recent years as a result of the debt brake’s cyclical component. Actual debt issuance in the Land only occurs when funds are required, which explains the substantial amounts of deferred debt being carried forward compared with other Länder. Scope expects the Land to gradually convert deferred debt into credit market debt over the next years given rising spending pressures.

Further, the Land has broadened its capital market presence by issuing green benchmark bonds. The first issuance occurred in 2021 with a volume of EUR 300m and the Land has issued a green bond every year since then. The 2024 bond is expected to be priced in October with an issuance volume of EUR 650m. Scope views the green bond issuance as credit positive, as it widened the Land’s investor base. As a financially stronger Land with a smooth debt profile, Baden-Württemberg has excellent capital market access.

The state’s liquidity management is 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. A further source of liquidity is also provided by commercial cash transactions between the German Länder, which lend excess liquidity to each other. As a consequence, the risk of liquidity shortages is negligible.

Finally, the large, wealthy and diversified economy supports the rating. Baden-Württemberg’s economic profile is strong compared to peers, with a higher GDP per capita than the German average. It is the third largest Land in Germany in terms of geography, population and economic output, contributing almost 15% of national GDP in 2023. The Land’s strong long-term economic performance is reflected in the fact that Baden-Württemberg has been the only continuous contributor to the federal equalisation system since its introduction.

Baden-Württemberg's economy is highly diversified, with key strengths in the manufacturing, pharmaceutical and automotive sectors. As the top export region among the German Bundesländer, it consistently records the highest export volumes, reflecting its strong international trade links. Additionally, the state boasts the second-lowest unemployment rate in Germany, underpinned by the strength of its Mittelstand – a network of small and medium-sized enterprises that provide resilience. According to the European Commission’s Innovation Scoreboard, Baden-Württemberg stands out as a leading region for research and innovation, within Germany and across Europe, further enhancing its competitive position in high-value industries.

The main rating challenge is limited expenditure flexibility due to elevated spending pressures in the near-term and a high pension burden weighing on long-term flexibility.

Baden-Württemberg’s flexibility to adjust expenditure is moderate, as minimum legislative requirements and the socially sensitive nature of several expenditure items limit the ability to cut spending. Inflexible spending items comprise personnel (37% of operating expenditure in 2023) and transfers (around 56%), including to municipalities. Scope expects personnel expenditure to rise from EUR 20.5bn in 2023 to EUR 25.7bn in 2026, an average increase of around 6% per year.

In line with other Länder, Baden-Württemberg has unfunded pension liabilities related to its civil servants. With the ‘Versorgungsrücklage’ and the ‘Versorgungsfonds’ the Land set up two special funds to partially cover its future pension obligations. The ‘Versorgungsrücklage’ was established in 1998 and amounted to EUR 4.5bn at end-2023, while the ‘Versorgungsfonds’ was launched in 2007 and had total assets of EUR 6.9bn. Hence, total reserves related to future pension obligations stood at around EUR 11.4bn at end-2023 and are expected to increase to around EUR 18bn by end-2027. These assets stand against pension provisions that amounted to EUR 172bn at end-2022, resulting in a funding ratio of 6.6%. In a sign of budgetary pressures, the 2025/26 draft budget includes a reduction in the previously planned allocations to the pension reserve of around EUR 1bn.

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 a notably weaker individual credit profile;
    
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 Baden-Württemberg of 80 out of 100.

The mapping of this score to the range defined by the Institutional Framework assessment results in an indicative rating for Baden-Württemberg 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 Baden-Württemberg’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 Baden-Württemberg’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 Baden-Württemberg 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 regular annual transfers to the fund to support long-term sustainability; and iv) ability to formulate and implement long-term economic and fiscal strategies.

Social considerations are included in Scope’s assessment of Baden-Württemberg’s ‘economic sustainability’. Baden-Württemberg maintains a robust economy characterised by diverse industries in manufacturing, pharmaceuticals and the automotive sectors. The region's economic sustainability is underpinned by robust business dynamics and demographic trends, which will support the Land’s status as a contributor to the financial equalisation system.

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 Baden-Württemberg, no additional adjustments to the individual credit profile apply for social and environmental factors & resilience.

Climate protection has been regulated through a separate law in Baden-Württemberg since 2013. The Land was the second federal state with such a climate protection law, after North Rhine-Westphalia, and last updated and further developed it in 2023. The state aims to be carbon neutral by 2040, i.e. five years earlier than the federal state, with intermediate goals in line with other states of a 65% reduction vis-à-vis the 1990 level by 2030. In addition, the regional administration is expected to become climate neutral by 2030. In line with other German states, the Land is exposed to transition risks over coming years on its path to carbon neutrality by 2040.
 
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 Outlooks (Sub-Sovereigns Rating Methodology, 11 October 2024) 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: Eiko Sievert, Senior Director
Person responsible for approval of the Credit Ratings: Jakob Suwalski, Senior Director
The Credit Ratings/Outlooks were first released by Scope Ratings on 9 November 2018. The Credit Ratings/Outlooks were last updated on 13 December 2019.
 
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, as well as a list of Ancillary Services and certain non-Credit Rating Agency services provided to Rated Entities and/or Related Third Parties.

Conditions of use/exclusion of liability
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