S&P Global Ratings assigns credit ratings to local and regional governments (LRGs) based on its qualitative and quantitative analysis of a range of financial, economic, managerial, and institutional factors. Our analytical framework for rating LRGs is articulated around six major components, resulting from our methodology:

• The institutional framework;
• Economy;
• Financial management;
• Budgetary performance;
• Liquidity; and
• Debt burden.

Our assessment of the institutional framework is an important component of the rating. The institutional and legislative environment in which an LRG operates provides an important context in which to evaluate the LRG's individual credit profile. Therefore, we combine our assessment of the institutional framework and the five other factors listed above to determine an indicative credit level for an individual LRG. We then adjust this level for certain overriding factors to provide the final rating for the respective LRG (see "Methodology For Rating Local And Regional Governments Outside Of The U.S." published July 15, 2019).

LRG Characteristics By Rating Category

We project the credit quality of Canadian LRGs will experience more volatility this year, compared with our expectations in 2022. This could result in more upgrades, as our ratings on three provinces and two cities have a positive outlook, and only one rating on a province has a negative outlook.

We generally expect most Canadian LRGs will remain well positioned to weather the current clouded economic outlook because they entered the year in a position of strength. The more resource-dependent provinces continue to experience volatility, rebounding to healthy after-capital surpluses as higher energy prices supported a return to economic growth. This follows outsize deficits prior to 2022. Overall, we project elevated inflation will continue to support high revenue collection, with expenditures slowly catching up. In addition, our provincial base-case forecasts already incorporate the impact of higher wage settlements and elevated input costs for large capital outlays over the next three years. At the same time, growth in most provinces will be broadly in line with that of Canada, which we expect will fall modestly next year before picking up in the medium term. For Canadian municipalities, we expect that higher-than-typical tax increases will likely continue in the next two years in response to the impact of elevated inflation on both operating and capital costs.

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Canadian provinces will continue posting operating surpluses, with deficits after capital accounts, on average, over 2021-2025. We expect consolidation efforts will strengthen and the tax-supported debt burden will moderately increase because of high investment spending in health care and infrastructure planned through 2025.

An outlier is the Province of British Columbia, which we downgraded to 'AA' from 'AA+' in April 2023, on record operating and investment spending. The rating outlook is negative, as the province's commitment to fiscal consolidation continues to waver, as reflected by large after-capital deficits, increasing debt, and very low internal liquidity (see "Province of British Columbia Downgraded To 'AA' From 'AA+' On Record Spending; Outlook Negative," published April 18, 2023, on RatingsDirect.

However, we believe that a focus on debt sustainability in combination with moderate economic growth in the next two years could result in a stronger financial performance and lower debt burden than currently projected for the provinces of Ontario and New Brunswick.

In our view, Canadian provinces operate in a very predictable and well-balanced institutional framework. Provinces have almost full revenue and expenditure autonomy for the powers and responsibilities granted to them under the constitution. Still, political considerations and tax competitiveness constrain the ability to increase revenues against a faster pace of spending for key responsibilities, such as health care and education. This results in relatively high budgetary deficits and debt levels compared with those of international peers.

The institutional framework for Canadian municipalities was strengthened in June 2022 to extremely predictable and supportive due to their track record of sound fiscal performance through multiple crises, and strong intergovernmental support they receive during periods of severe economic stress. Following the upward revision of the institutional framework, we raised the ratings on 21 Canadian municipalities and affirmed the ratings on 13 LRGs.

In our view, Canadian municipalities operate under stronger revenue and expenditure balance than provinces via comprehensive, prudent, and transparent statutes established by individual provinces. Canadian municipalities generally produce operating revenues sufficient to fully cover operating expenditures and to fund a portion of capital investment or build cash reserves, thereby somewhat mitigating new debt issuance.

We believe that most of our ratings on Canadian LRGs remain resilient to periods of stress. Both our five-year average medians for balance after capital accounts as a percentage of total revenue and tax-supported debt as a percentage of consolidated revenues were largely unchanged within their respective rating categories and are trending downward (charts 1 and 2).

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'AAA'

We rate 14 Canadian municipalities in the 'AAA' category. These LRGs operate in an extremely predictable and supportive institutional framework, and they compare favorably with international peers. They have very strong economies, reflected in high incomes, as well as sound financial management and well-documented medium- to long- term financial planning. They also have manageable contingent liabilities that, if they materialize, would not weaken the LRGs' financial position, in our view. All LRGs in this category have exceptional internal liquidity and satisfactory access to external liquidity to fund any unexpected short-term financial needs.

Other common characteristics among LRGs at this level include:

• They exhibit strong to very strong budgetary performance by international standards, with median operating surpluses as a percentage of operating revenues averaging 16.3% over 2021-2025. Most 'AAA' rated LRGs also show after-capital surpluses during the same period.
• Their debt burdens are relatively low. We project median tax-supported debt will increase to 35.4% as a percentage of consolidated operating revenues, on average, in 2021-2025. At the same time, all LRGs have relatively low and stable median interest expense compared with that of international peers, at about 1.3% of operating revenues, with a few below 1.0% of operating revenues. They also have the lowest ratio compared with LRGs in other rating categories in Canada.

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'AA'

We rate 25 Canadian LRGs in the 'AA' category. Most LRGs in this category are municipalities that operate under an extremely predictable and supportive institutional framework. We also rate four provinces in the 'AA' category. These provinces have very strong economies, excluding Nova Scotia, which has a comparatively lower level of local GDP per capita and socioeconomic challenges. This is similar in the municipal sector, as some entities have to contend with low incomes, limited growth prospects, or demographic difficulties. Financial management practices in this rating category are sound, although the average degree of fiscal planning and transparency is often less robust than that of 'AAA' category issuers.

Key economic and financial risk indicators for the 'AA' rated LRGs are:

• Income levels of these LRGs are high.
• Budgetary performance is strong, with sound median operating surpluses, albeit lower than that of 'AAA' entities, and with minor deficits after capital spending. We expect the median operating surplus will reach about 13.5% of operating revenue in 2021-2025, while posting a deficit of 2.1% as a proportion of total revenue.
• Debt levels are moderate to high. Tax-supported debt as a percentage of consolidated operating revenues is higher than that of 'AAA' rated peers and we project it will increase, with median levels at 83.4% for 2021-2025. The same applies to median interest, which, while it is still low, we project will reach about 3.0% of operating revenue on average during the same period.

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'A'

We rate the remaining six Canadian provinces in the 'A' rating category. As with all the provinces in Canada, entities in this rating category operate in a very predictable and well-balanced institutional framework. Typically, financial management is satisfactory, although commitment to prudent fiscal policies has varied over the years. Most of the individual credit profiles are weaker than those of the 'AA' rated LRGs. This is mainly because of relatively weaker budgetary performances (particularly on the operating side); lower budgetary flexibility; significantly higher debt burdens and interest payments; and notably, weaker liquidity.

The 'A' rated LRGs exhibit the following common characteristics:

• Budgetary performance is notably weaker than that of 'AA' rated peers. We estimate median operating surplus as a percentage of operating revenues will reach about 5.3% in 2021-2025. At the same time, we expect these entities will have a median after-capital deficit as a percentage of total revenue of 2.2% in 2021-2025, an improvement from our previous forecast. We consider the budgetary performance assessments for the Province of Newfoundland and Labrador and the Province of Alberta to be weaker than their metrics would suggest because of their large exposure to volatile commodity prices.
• Indebtedness is high in both the Canadian and international context. We estimate median tax-supported debt as a percentage of consolidated operating revenue will reach about 206.7% in 2021-2025. Compared with our previous forecast, the projected median debt burden is somewhat lower, based on a stronger recovery last year and fiscal consolidation efforts. During the same period, we project median interest expense as a percentage of operating revenue will be 6.8%, which is considerably higher than that of 'AA' and 'AAA' rated Canadian peers.

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