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���������ֳ� - Warsaw - 01 Mar 2024: ���������ֳ� has affirmed the City of Tallinn's Long-Term Foreign and Local-Currency Issuer Default Ratings (IDRs) at 'A+'. The Outlooks are Stable. A full list of rating actions is below.

The affirmation reflects ���������ֳ�'s expectation that the city's financial standing will remain robust over the rating horizon until 2028, despite a prolonged weaker macroeconomic environment and the expected debt increase. The Stable Outlook reflects our expectations that despite the deterioration in Tallinn's debt ratios, its Standalone Credit Profile (SCP) will remain 'aa-', which results in the city's ratings being capped by Estonia's ratings (A+/Stable), as the Estonian framework does not allow for rating a local government (LG) above the sovereign.

KEY RATING DRIVERS

Risk Profile: 'Midrange'

The risk profile combines three factors assessed at Midrange (revenue robustness, expenditure adjustability and liabilities and liquidity flexibility), two assessed at Stronger (expenditure sustainability and liabilities and liquidity robustness) and one at Weaker (revenue adjustability).

Revenue Robustness: 'Midrange'

The city's revenue sources are generally stable and moderately reliant on the economic cycle as they are dominated by personal income tax (PIT; average 65% of operating revenue in 2019-2023). PIT revenue grew by 10% in 2023 as high inflation led to pressure for salary increases and the weakened labour market conditions and heightened unemployment did not affect Tallinn as strongly as other Estonian LGs. From 2025 we expect the national economy to return to growth (by 3.0%-3.6% annually), which combined with a stabilisation of the unemployment could lead to higher PIT revenue for Tallinn's budget.

Transfers from the Estonian state are the second-largest revenue source for Tallinn. We expect they will account for 16% of operating revenue over the rating horizon. Their share will go down from the exceptionally high 19% average of operating revenue in 2020-2022, when the city received current transfers from the state to offset revenue losses and cover costs resulting from the pandemic.

Revenue Adjustability: 'Weaker'

Tallinn has limited scope for additional taxation as PIT rates are set by the national government. The income tax allocation rate from the state budget to LGs has been stable at 11.96% since 2020. No further rate increases are envisaged by the state. However, the distribution rates from the state budget to the local budget are under discussion. Local taxes (predominantly land tax) account for less than 5% of the city's operating revenue and are not flexible, but from 2025 the city will receive at least EUR2.4 million a year more based on the recent land revaluation.

Current transfers are mostly made up of provisions for operating expenses (teachers' salaries, social care and the maintenance of local roads) and are less flexible. Estonian LGs can receive funds from the equalisation fund but Tallinn is not a beneficiary due to its high revenue. The Weaker assessment of revenue adjustability is based on our assumption that Tallinn could raise additional revenue in case of an expected decline of revenue, but that coverage would be significantly below 50% of the losses.

Expenditure Sustainability: 'Stronger'

Tallinn's main policy is to keep operating expense growth consistently below operating revenue growth. This was jeopardised in 2023 due to worsening macroeconomic conditions, the energy crisis imposing much higher energy costs and high inflation (average of 9.2% in 2023). The city's operating balance fell to a low EUR54 million (preliminary data), which we treat as a one-off and expect that it rebounds over the rating horizon. The overall budgetary result shows a deficit of EUR74 million that was driven solely by the city's investment activities.

Tallinn's responsibilities are non-cyclical, and include education, transport and roads, social care and utilities. Capex is linked to the availability of EU grants and the city has a proven record of postponing investments if funding is not secured. Tallinn plans a blend of investments such as the redevelopment of school and kindergarten buildings, social and health infrastructure. In 2024, the largest investment is in streets and roads (31% of budgeted investment activities), education (19%) and culture (11%). The construction of a new hospital (EUR320 million in 2026-2027) was abandoned in the absence of state treasury capital grants.

Expenditure Adjustability: 'Midrange'

Tallinn operates under a legal framework with balanced budget rules, under which LG's budgets are approved by the central government and are not allowed to run deficits. The city has a moderate share of inflexible costs, as about 70%-90% are committed expenditure. Staff costs accounted for 34% of operating expenditure (average in 2019-2023) and the city is still under pressure for wage increases as the National Bank estimates of 6.6% average salary growth in 2024.

Economic conditions should improve and inflation ease from 2025, lowering opex pressure. In 2024-2028, we project lower capex than in our previous forecast (12% of total expenditure versus 17%) due to the abandonment of the new hospital construction. Capex is more flexible than current expenditure and can be revised upward upon accessibility of non-returnable EU capital grants.

Liabilities & Liquidity Robustness: 'Stronger'

Tallinn operates under a strong national debt management framework and has a strong individual credit policy. Debt is raised only to secure investment finance and no other forms of liabilities are being concluded. The share of loans from the European Investment Bank (EIB; AAA/Stable) increased to 98% at end-2023 from 84% at end-2022 and 79% at end-2021. Tallinn has still EUR20 million available from EIB and a EUR100 million loan agreement signed with Nordic Investment Bank, which covers capex financing needs for the medium term.

The EIB loans have amortising debt structures and final maturities up to 2043, ensuring a smooth and not too burdensome debt service for the city. All of the debt is euro-denominated and most of it has floating rates, which exposes the city to the risk of increasing interest rates. The city has limited off-balance-sheet risks, consisting mainly of debt of municipal companies such as the transportation company or the two hospitals. The municipal companies' debt amounted to EUR50.3 million at end-2023, down from EUR65.7 million the year before. It included EUR49.4 million of loans granted from the city's budget, down from EUR65.5 million in 2022 due to repayments.

Liabilities & Liquidity Flexibility: 'Midrange'

Tallinn's cash position has continuously been strong and the city is not reliant on external borrowing. The city's liquidity policy foresees a minimum cash position of EUR50 million at any time that would allow to service an average amount of liabilities falling due within two weeks. Tallinn has no committed liquidity credit lines but is considering obtaining one due to the uncertainty about PIT reform impact on the city's budget. Our revised rating case, with lower operating balances projected, forecasts a weakening of the synthetic debt service coverage ratio (SDSCR). We expect it will average 2.6x in the rating horizon, much less than the 11x average in 2019-2023.

Debt Sustainability: 'aaa category'

We expect that Tallinn's debt payback ratio (net adjusted debt to operating balance) will deteriorate due to weakened operating performance, but remain strong and below five years, which corresponds to a 'aaa' assessment. The SDSCR (operating balance to synthetic debt amortisation, including short-term maturities) will decrease to 2.6x, down from the average 3.6x forecast in our previous scenario, but still corresponding to a 'aa' score. The fiscal debt burden (net adjusted debt to operating revenue) will increase and be close to 40% by 2027, from 22% in 2023 (on preliminary basis), which also corresponds to a 'aaa' assessment. All the metrics justify a 'aaa' debt sustainability.

Tallinn's financial position has been temporarily negatively affected by the weakening of the economy due to the pandemic, the outbreak of the Russian-Ukrainian war in 2022 and by the following energy crisis. We assume that in the medium term the city can prove its resilience to sharp shocks, despite its vulnerability resulting from its small size compared with other European capital cities. We assume that Tallinn can maintain a sound financial profile with its debt sustainability score remaining in the 'aaa' category. This will be supported by the reduced investment portfolio, which will lower the need for debt and the supportive changes to the land tax legislation. The largest threat to the city's budget stems from PIT tax reform, which is still at a preliminary stage.

Tax reform discussed by the Estonian parliament foresees a new allocation of PIT to mitigate financial inequalities among LGs, increasing their share of PIT on pensions to 2.5% from 1.88%, while reducing their portion from PIT on salaries to 11.89% from 12.06%. However, the reform also considers compensating LGs with dividends that were previously allocated to the state. These changes have not been incorporated into our rating scenario due to the current uncertainty surrounding the legislative process.

Derivation Summary

We assess Tallinn's SCP at 'aa-', reflecting the combination of a 'Midrange' risk profile and debt sustainability metrics assessed in the 'aaa' category under our rating case. The IDRs are not affected by any asymmetric risk or extraordinary support from the central government of Estonia. The city's ratings are capped by the ratings of Estonia. The Estonian framework does not allow for rating a LG above the sovereign.

Short-Term Ratings

Tallinn's Short-Term IDR is assed at 'F1+', the higher option for 'A+' Long Term IDRs.

Key Assumptions

Risk Profile: 'Midrange'

Revenue Robustness: 'Midrange'

Revenue Adjustability: 'Weaker'

Expenditure Sustainability: 'Stronger'

Expenditure Adjustability: 'Midrange'

Liabilities and Liquidity Robustness: 'Stronger'

Liabilities and Liquidity Flexibility: 'Midrange'

Debt sustainability: 'aaa'

Support (Budget Loans): 'N/A'

Support (Ad Hoc): 'N/A'

Asymmetric Risk: 'N/A'

Rating Cap (LT IDR): 'A+'

Rating Cap (LT LC IDR) 'A+'

Rating Floor: 'N/A'

Quantitative assumptions - Issuer Specific

���������ֳ�'s rating case is a "through-the-cycle" scenario, which incorporates a combination of revenue, cost and financial risk stresses. It is based on 2019-2023 figures and 2024-2028 projected ratios. The key assumptions for the scenario include:

- Operating revenue growth of 4.0% annually, including tax revenue growth of 5.2% due to inflationary increase in wages (National Bank of Estonia: 6.6% in 2024);

- Operating expenditure growth of 3.3% annually due to the expectation that the pressure will ease from 2025;

- Net capex of EUR116 million annually, down because of the new hospital construction being abandoned;

- Apparent cost of new debt 3.9% per year, new debt long-term (up to 20 years maturity) and smoothly amortising; the cost includes a risk premium for unexpected interest rate increases as the city' debt stock is based on floating interest rates.

Liquidity and Debt Structure

Tallinn's direct debt was EUR245 million at end-2023, up from EUR217 million the year before, due to the EUR50 million drawdown of the EIB loan. Adjusted debt includes concession obligations paid by the city (end-2023: EUR43 million). Those are old liabilities, which the city has partially renegotiated. As a result, interest payments were reclassified by the city from interest costs to other operating expenditure in 2022 and the final payments were readjusted to reflect the current higher interest rates.

Issuer Profile

Tallinn is the capital of Estonia, with 461,258 inhabitants as at end-January 2024 (end-2022: 458,398). The city is service-oriented and its wealthy economy results in high tax revenue. The unemployment rate moves in line with the national rate, which deteriorated in 2023 due to the prolonged recession (Estonia, 2023 estimates: 6.7% compared with 5.6% in 2022). Tallinn will be European Capital of Sport in 2025.

Rating Sensitivities

Factors that Could, Individually or Collectively, Lead to Negative Rating Action/Downgrade

Negative rating action on Estonia would be reflected in Tallinn's ratings.

A deterioration of the payback ratio to above 7x on a sustained basis in our rating-case scenario could lead to a downgrade.

Factors that Could, Individually or Collectively, Lead to Positive Rating Action/Upgrade

Positive rating action on Estonia's IDRs as Tallinn's IDRs are currently constrained by the sovereign ratings.

ESG Considerations

The highest level of ESG credit relevance is a score of '3', unless otherwise disclosed in this section. A score of '3' means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or the way in which they are being managed by the entity. ���������ֳ�'s ESG Relevance Scores are not inputs in the rating process; they are an observation on the relevance and materiality of ESG factors in the rating decision. For more information on ���������ֳ�'s ESG Relevance Scores, visit /topics/esg/products#esg-relevance-scores.

Discussion Note

There was an appropriate quorum at the committee and the members confirmed that they were free from recusal. It was agreed that the data was sufficiently robust relative to its materiality. During the committee no material issues were raised that were not in the original committee package. The main rating factors under the relevant criteria were discussed by the committee members. The rating decision as discussed in this rating action commentary reflects the committee discussion.

Public Ratings with Credit Linkage to other ratings

Tallinn's ratings are capped by Estonia's sovereign ratings.

References for Substantially Material Source Cited as Key Driver Rating

The principal sources of information used in the analysis are described in the Applicable Criteria.

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