Local authority investment in commercial property Contents

Conclusions and recommendations

1.The Department has been complacent while £7.6 billion of taxpayers’ money (including the extra £1bn spent in the first half of 2019–20) has been poured into risky commercial property investments. In 2016 this Committee reported that the Department appeared complacent in relation to local authorities increasingly acting as commercial landlords. Since then, investments have ballooned 14-fold, demonstrating that the Department remains just as complacent as it was four years ago. The Department has taken modest steps to improve data and strengthen its guidance after realising that there is an issue with the borrowing and investment behaviour in parts of the sector. However, these actions have not been sufficiently timely or robust and have not proved effective. The Department’s limited response seems to reflect the fact that it is keen to preserve the local freedoms provided by the prudential framework. As part of this the Department downplays the true nature and scale of the issue. The Department referred to “a handful” of councils where they have concerns, and also argued that investing solely for yield is “relatively scarce” and that it is only disproportionate borrowing where they have concerns despite the fact that borrowing for yield at any scale is at odds with the Department’s own guidance. However, the NAO’s report shows that 179 authorities purchased commercial property in the three years to 2018–19. Activity was concentrated within this group, with 49 authorities (14%) accounting for 80% of spend, but this is nonetheless a sizeable group of authorities. Some 105 local authorities spent over £10 million on commercial property in the three years to 2018–19, compared to 13 authorities in the preceding three years. The NAO’s report demonstrates the significance of acquiring property for yield rather than service provision: £2.5 billion of spend in the three years to 2018–19 was on property out of authorities’ own areas with 64 authorities incurring this form of spend. The NAO’s report identifies that up to £6 billion of spending on commercial property in the three years to 2018–19 was financed by borrowing. We recognise the prudential framework provides valuable borrowing and investment freedoms and understand the sector’s determination to protect them and the Department’s reluctance to intervene. Nonetheless, a balance has to be struck between protecting the framework and challenging behaviour that does not conform to its principles.

Recommendation: The Department must be more active in its oversight of the prudential framework and strike a better balance between supporting localism and ensuring that local authorities act within the frameworks that underpin local freedoms. To do this the Department should:

2.The Department’s failure to ensure that authorities adhere to the spirit of the framework has led to some authorities taking on extreme levels of debt which is both risky and sends a mixed message to the sector. Amongst the group of district councils that have been most active in acquiring commercial property the median level of external borrowing as a share of spending power (government grant plus council tax) increased from 3% to 756% from 2015–16 to 2018–19. By the end of 2018–19, Spelthorne Borough Council had borrowed £1.1 billion against annual core spending power of £11 million, a ratio of almost 100 to 1. This debt has to be serviced by rental income, and the current difficult economic conditions due to the COVID-19 pandemic demonstrate that these income streams cannot be taken for granted. Guidance from both the Department and CIPFA is clear that authorities should not borrow solely to invest for profit. In CIPFA’s view this activity has traditionally been viewed as unlawful. Nonetheless, the prudential framework, even with the revised investment guidance, has failed to constrain the extreme levels of risk taking by some authorities. The behaviour of these authorities not only means that they are highly exposed to risk, but it also alters the terms of the debate; the outlier authorities are viewed as behaving poorly, while other authorities borrowing for yield at relatively lower levels are now not necessarily seen as an issue. Extreme behaviour needs to be curtailed not only for the risk it represents for those specific cases, but also for the mixed messages it sends across the sector, normalising behaviour that may be relatively less risky but nonetheless is still not within the spirit of the framework.

3.Where a local authority uses prudential borrowing, it must set aside money each year to repay the debt. This is known as Minimum Revenue Provision (MRP). It means that borrowing is reflected in current spending and the costs of borrowing do not fall wholly on future council tax payers. The Department’s MRP guidance is clear that prudence requires making MRP in relation to debt associated with commercial property purchases. Local authorities must have regard to the Department’s guidance but ultimately make their own decisions about prudent MRP. The NAO found some instances where local authorities were still not making MRP on their commercial property acquisitions. Richard Watts, Chair of the Local Government Association Resources Board told us that not applying MRP “strays very close to breaching” the requirements on authorities.

Recommendation: For its future oversight of the prudential framework the Department needs to develop, and rapidly deploy, interventions that target extreme risk taking. These should be used as part of a wider package of measures to limit non-compliance with the framework, regardless of scale.

Recommendation: The Department should undertake a review of the MRP guidance and consider whether its statutory basis should be strengthened and how to require local authorities to improve the clarity and transparency in relation to commercial property purchases.

4.The actions taken by the Department to address risky and non-compliant behaviour have been too little and too late. The Department has recently changed aspects of the investment guidance in response to rapid growth in spending on commercial property and in levels of borrowing. Work began on these changes following the publication of this Committee’s November 2016 report, but the guidance changes were not operational until 2018–19. Even when they were operational, the Department was anticipating only gradual movement in the “right direction”. The NAO estimates that authorities spent £2.6 billion in 2017–18 when the guidance changes were being developed, and £2.2 billion in the first year of their operation, and a further £1bn in the first half of 2019–2020. When the pattern of public expenditure is changing at this speed, interventions need to be implemented more quickly and be operational from the outset. A framework that can only be revised at a significantly slower rate than the changes in the behaviour it is supposed to manage is not effective. The Department recognises that the guidance changes have not had the desired effect and have told us that “further action” is needed. HM Treasury is consulting on prohibiting loans purely for yield and investments outside an Authorities area. The consultation also proposes that authorities have to provide more detail, including on potential commercial investment, on their borrowing and investment activities in their annual returns to the Public Works Loan Board (PWLB). In October 2019 HM Treasury announced a one percentage point increase in the cost of new PWLB loans, which the NAO consider may influence some authorities’ decisions on future commercial property acquisition. HM Treasury’s decision to bring the PWLB back in house will also enable departments to access more accurate and timely information about loans.

5.Taken together these changes represent a significant ‘hard’ intervention and demonstrate that the ‘soft’ approach of guidance changes has failed. In order to support the framework going forward, and to help design future effective interventions and minimise the need for hard interventions, the Department needs to establish why its recent guidance changes have been insufficient.

Recommendation: The Department should take steps to ensure that future interventions are more timely and effective, and subject to rigorous post-implementation review to ensure lessons are learnt.

6.The prudential framework has been impaired by the emergence of new forms of behaviour in the sector, and now requires fundamental review. The Department says that authorities have “managed, as it were, to escape” from the affordability constraint that is critical to the prudential framework. We are particularly concerned to hear that this undermines the Department’s statutory backstop powers to intervene in relation to borrowing by individual councils. In addition, there are a range of innovative financial practices such as income strips and renewable energy schemes, including ‘solar bonds’, that the government needs to understand better. Written evidence and sector witnesses offered a range of explanations for the change of behaviour, including financial pressure on local services, government encouragement for commercial behaviour and a lack of clarity. These are not legitimate excuses for non-compliance and the Department recognises the need to tackle new behaviours.

Recommendation: Working with CIPFA and sector stakeholder bodies, the Department should undertake a thorough review of the prudential framework, that addresses the issues we have identified. The Department should publicly report within the next 12 months. This review should incorporate the recommendations relating to challenging behaviour in the sector, designing effective interventions and improving the data held by the Department set out elsewhere in this report.

7.The Department does not have access to the data it needs to carry out its oversight responsibilities properly. In this Committee’s 2016 report we recommended that the Department improve the data it holds on local authority commercial investment activity. The Department did take steps to improve the data it has access to, but these changes have not added much clarity, and the new data the Department acquired is already outdated. The Department needs to improve the data it has access to on local authority investment activity and the associated risks, so it can assess the exposure to risk of local government investment in individual sectors. It also needs better data to ensure framework compliance.

8.We welcome the Department’s statement that it will undertake a ‘serious’ data review in relation to local authority commercial investment. It is important that the review considers data not only on commercial property acquisition, but on new forms of commercial activity such as investment in renewable energy schemes, the use of innovative financial arrangements such as income strips, and the use of arms-length trading companies. The review should also examine the extent to which data can be used to assess framework compliance, particularly in relation to borrowing for yield. Given the way authorities’ capital programmes are financed, we recognise the complexities of identifying this activity definitively. But the Department should nonetheless look for possible measures to give some sense of the potential scale and direction of travel of this activity which can then trigger further investigation if required.

Recommendation: The Department should write to the Committee by September 2020 setting out its approach and timescale for improving its data on council commercial activity, and how this relates to its broader review of the prudential framework. The Department should also set out how it intends to use its improved data following the data reviews to strengthen framework compliance. The data review should address the concerns we have raised relating to data on new forms of commercial activity, and on the use of data to assess framework compliance.

9.Changes to external audit might improve its ability to provide assurance related to local authority commercial investment activity but it will not be a silver bullet. There are concerns in the sector about the capacity of local audit. The Department’s Post Implementation Review of its recent guidance changes concluded that audit “should not be viewed as a strategy for mitigating risk within the system” as it is unlikely to inform decision making when authorities are developing their commercial strategies. The Department points to the Redmond review of external audit as covering issues relating to commercial investment; the Department will consider what changes should be made to the local audit framework once it has received the report of the Redmond review. We welcome the realistic view about the role of external audit presented by departmental witnesses: focusing on the assurance that audit provides about local governance and not seeing it as a substitute for scrutiny in real time. The Centre for Public Scrutiny emphasised that local governance needs to be bolstered rather than external bodies second-guessing council decision making, which risks muddying accountability. We anticipate that the outcome of the audit review will represent at best one aspect of the action that need to be taken to address local governance issues in relation to commercial investment, and will therefore need to be accompanied by a broader package of measures beyond local audit improvements.

Recommendation: As part of its review of the prudential framework, the Department should consider a wider package of changes, rather than relying primarily on (post-Redmond) external audit to address failings in the local governance of commercial investment activities.

Recommendation: The Department should write to the Committee within three months of the publication of the Redmond Review setting out its response to the review, including not only how the Department intends to strengthen local audit but also how this will support improved governance of commercial investment activity.

10.Local governance arrangements are not robust enough with some authorities’ commercial investments not being properly transparent or subject to adequate scrutiny and challenge. In May 2019 this Committee expressed concern about weak arrangements for the management of risk in local authorities’ commercial investment. We have recently needed to make clear to central government that commercial sensitivity is not an adequate excuse for concealing risk and uncertainty. Accordingly, we were disturbed to receive written evidence as part of this inquiry which highlighted limited reporting to members, decision-making by very small groups, and a reliance on commercial sensitivity to excuse this kind of behaviour. The Centre for Public Scrutiny told us that, in some councils, member governance has not caught up with commercial activity and a change in culture is required. Some local capital strategies still do not contain the level of transparency encouraged by the Department.

Recommendation: The Department should:

Published: 13 July 2020