1.On the basis of a report by the Comptroller and Auditor General, we took evidence from the Ministry of Housing, Communities & Local Government (the Department) and HM Treasury. We also took evidence from witnesses representing the Local Government Association (LGA), the Chartered Institute of Public Finance and Accountancy (CIPFA), South Hams District Council and chartered surveyors working in the public sector.
2.Local authorities can acquire commercial property to support objectives such as regeneration and place-making. They can finance these activities by borrowing and are able to generate a commercial yield as a by-product of this investment. Authorities can also acquire commercial property primarily for yield, but this should be funded through capital receipts or revenue resources from their general fund. According to CIPFA, borrowing solely to invest for yield has traditionally presumed to be unlawful. The Department has responsibility for the framework of powers and duties, and a set of statutory codes and guidance within which local borrowing and investment decisions are made.
3.In the context of a period of sustained funding reductions, some local authorities have adopted a new approach to the acquisition of commercial property. The scale of activity has increased with an estimated spend of £6.6 billion on commercial property in the three years to 2018–19; over 14 times more than in the preceding three years. Up to 91% of this spending was financed by borrowing, and the pursuit of yield to offset funding reductions was a predominant factor underlying these investments. Spending was concentrated in a minority of authorities; 49 councils (14%) accounted for 80% of the spend. As with all investments, these acquisitions involve risk, particularly where they are financed by borrowing. Some authorities now have levels of external borrowing that are many multiples of their spending power (government funding and council tax). Much of this debt is long-term, and authorities are reliant on steady rental income to service the debt.
4.In this Committee’s 2016 report we said the Department appeared complacent regarding the acquisition of commercial property by some authorities. The Department did take some steps following the report to address authorities’ behaviour, principally by revising the investment guidance for authorities. However, the Department told us that these changes have not had “all the effect” that was needed. HM Treasury is now proposing to alter Public Works Loan Board (PWLB) lending terms to put an end to the ‘borrowing for yield’ model pursued by some authorities.
5.A key factor underlying the Department’s failure to manage this activity has been its continued complacency in relation to the true nature and scale of the issue. In its responses to us the Department referred to “a relatively small number”, “a very small number”, and “a handful” of councils where they have concerns. The Department also argues 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. Some sector bodies made the same arguments in their evidence. The Local Government Association, for instance, argued in a variety of ways that borrowing for yield was minimal and that rules should not be set based on “a handful of small and quite extreme examples of council practice.”.
6.The evidence does not support this position. 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: 38% (£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; and authorities recorded spend of £4.1 billion across 2016–17 and 2017–18 in the Whole of Government Accounts on investment properties, which are held for rental income, capital appreciation or both. 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. External borrowing levels for some authorities that have been most active in acquiring commercial property are now many multiples of their spending power. We also received written evidence from a number from stakeholder bodies and authorities which were frank that they or some of their members were investing in commercial property, including out of area, in response to financial challenges since 2010–11.
7.The Department was clear that it does not want to implement changes to the prudential framework which could potentially compromise local authorities’ capacity and freedom to invest in activities such as regeneration. In our view, it is this reticence to intervene in the system that has underpinned the Department’s complacency regarding the scale of authorities’ commercial property investment activities, its unwillingness to comment publicly or confront behaviour not in line with the spirit of the framework, and its inability to fulfil its responsibilities by designing interventions that are urgent and robust enough. Ultimately, the Department’s failure to balance its support for local freedoms against its responsibility to ensure that the prudential framework functions as intended has in fact resulted in the situation where significant intervention in the form of the proposed PWLB changes is now likely.
8.We are not reassured that the Department is on the front foot in relation to the risks of new forms of commercial activity such investment in renewable energy or the use of innovative financial instruments. To hear from the Department only that these investments “might be caught in the grey area” relating to the proposed PWLB changes was alarming.
9.The Department has stated that the changes proposed to the PWLB’s lending terms will be a “game changer” and that they will “…ensure that the new behaviours we have seen in the past do not continue in the future”. While this sounds reassuring, it is taking place four years after the borrowing for yield model first began to spread across the sector and was brought to the Department’s attention. Ultimately these proposals are four years and many billions of pounds in borrowing and potentially risky investments too late.
10.The NAO first highlighted the emergence of this activity in June 2016, which was followed by this Committee’s report in November 2016. The Department began work in response to the report and issued new investment guidance which became operational on 1 April 2018. The Department also worked with CIPFA on changes to CIPFA’s codes. However, even when the new guidance was operational the Department was anticipating only gradual movement in the “right direction”. We recognise that introducing framework changes can be complex and time-consuming, but there has to be a quicker way of intervening when patterns of behaviour are changing so rapidly. In 2015–16 authorities spent £200 million on commercial property. In 2016–17, the year in which the NAO first highlighted this issue, authorities spent £1.8 billion, followed by £2.6 billion in 2017–18 and £2.2 billion in 2018–19. When spending behaviour is changing so rapidly it is not acceptable to pursue intervention models that take over 12 months to implement, and then even at that point are not expected to deliver significant change.
11.The Department has conceded that the new guidance has not had the effect that was needed and that further changes are required. This reflects the analysis in the NAO report which indicates that levels of spending on commercial property remained largely unchanged in the 18 months following the introduction of the new guidance. HM Treasury, working with the Department, are now proposing significant changes to the PWLB’s lending terms. These changes include the government asking local authorities to provide details annually of their borrowing and investment plans in order to access PWLB borrowing. The Department told us that these proposals will deliver significant behaviour change in the sector. However, in the context of the permissive nature of the prudential framework it has to be a matter of regret that the ‘soft’ approach of issuing new guidance has failed, and instead the Department and HM Treasury have had to resort to introducing new ‘hard’ parameters on authorities’ behaviour. In order to support future interventions and limit the need for further ‘hard’ interventions the Department must establish why the guidance changes it introduced were not sufficiently effective. The Department has conducted a post-implementation review of the impact of its guidance changes. However the review does not reflect the evidence given to the committee by the Department that further change to the framework in the form of the PWLB changes is needed, nor in fact does it contain any reference to the proposed PWLB changes despite being published after HM Treasury had begun consulting on them. We assume a fuller review setting out why it was felt that the guidance had not succeeded and therefore that further action was necessary will be undertaken in the next phase of review work the Department told the NAO it will undertake.
12.During the period of ineffective guidance, some authorities have taken on very high levels of debt, with accompanying risks. Amongst the group of district councils that have been most active in acquiring commercial property the median level of external debt 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.
13.The cost of servicing debt linked to commercial property investments is intended to be met from rental income or contingency reserves. We have been sent worrying written evidence about the potential impact of the COVID-19 pandemic on such rental income. Spelthorne Borough Council, which has a debt-funded commercial property portfolio worth approximately £1 billion, said that COVID-19 “poses the most extreme economic stress test for more than two centuries.”
14.The Department told us “a very small number of councils that have borrowed disproportionately … is what we are most concerned about in the Department; it is the Spelthornes of this world.” The Department went on to say, “We are not necessarily concerned about a council where they are undertaking a reasonable amount of commercial activity but their borrowing ratios look sensible and look proportionate with their income.” Some written evidence from within the sector argued that a measured approach to income generation through borrowing and commercial investment should be recognised as beneficial. However, statutory guidance and codes from the Department and CIPFA are clear that borrowing to invest solely for yield is not in accordance with the framework. Knowsley Council’s written evidence was clear that local authorities that have due regard to the principles and spirit of the framework “do not borrow purely to make a commercial yield”.
15.Where a local authority uses prudential borrowing, it must set aside money annually to repay the principal, so the costs do not fall wholly on future council tax payers. This is known as Minimum Revenue Provision (MRP). It is an important means by which the cost of borrowing is reflected in current spending. The Department told us it changed its MRP guidance to specify that MRP is needed for investment properties in order to address concerns about authorities not making prudent provision for commercial property. 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.
16.The prudential framework has been tested by new behaviours. These are not limited to the commercial property purchases and associated borrowing outlined above. Watford Council has acquired a 40-year lease on a local business park with an annual rent of £9.2 million (linked to RPI) along with the right to buy the property at the end of the lease for a nominal sum. Local authorities have also established trading companies, entered into joint ventures with private developers, made loans to other bodies on a commercial basis, and invested in renewable energy. Thurrock Council has borrowed to invest over £700 million in renewable energy through complex and indirect routes. Unfortunately there is a history of authorities entering into commercial arrangements that provide initial benefits but subsequently cause widespread concern: use of Lender Option, Borrower Option (LOBO) loans is the most recent example.
17.We were presented with a range of explanations for the change in behaviour. For example, the Local Government Association told us that activity has been driven by a need to offset lost income to protect local services and claimed the biggest thing government could do to alleviate this activity is to revisit local government funding. Other written evidence made similar points. The LGA also said that “Councils operating in an environment where Government Ministers encourage them to be “more commercial” have often done exactly that.” In written evidence, Mr Paul Brooks said that the legal position needs to be clarified while Arlingclose wrote that that official guidance is confusing and so it is understandable that some councils interpreted it as permitting such a wider range of property investment activity. However, ultimately the arguments presented here do not change or remove the obligations imposed by the framework.
18.The Department rightly still wishes councils to abide by the spirit as well as the letter of the framework, with the Permanent Secretary telling us “I would very strongly expect every council to follow it”. Affordability no longer acts as a binding constraint on local authority borrowing in the way that it did when the framework was created. Departmental officials advise Ministers about the use of reserve powers to cap borrowing by individual local authorities. However, the Department has not felt able to use this power because authorities “have managed, as it were, to escape out of that affordability test” on which the power depends. The government recognises the need to consider further changes to the prudential framework, including the need for a system that tackles the new behaviours of concern. CIPFA has some specific proposals for changes to the framework, including making the prudential code more strongly binding on councils corporately; currently they only have to ‘have regard’ to it.
1 C&AG’s Report, Local authority investment in commercial property, Session 2019–20, HC 45, 13 February 2020
2 C&AG’s Report, paras 1.2, 1.3, 1.13
3 C&AG’s Report, paras 2.5, 2.10, 2.15–2.17, 3.3, Figure 3
4 C&AG’s Report, Figures 15 and 19
5 HC Committee of Public Accounts, Financial sustainability of local authorities, Twenty-Sixth Report of Session 2016–17, HC 708, 18 November 2016, para 1
6 Q 103; C&AG’s Report, para 4.15
7 Q 103; C&AG’s Report, para 2.5 and Figure 3
8 Qq 120, 130
9 Ministry of Housing, Communities and Local Government, Post Implementation Review of Changes to the Local Authority Capital Finance Framework, April 2020, para 4.4 (Hereafter, the Department’s Post Implementation Review)
10 Q 130
11 Q 61
12 C&AG’s Report, para 2.10
13 C&AG’s Report, paras 2.17, 2.23 and 2.27
14 C&AG’s Report, para 3.13, 3.30
15 LAI0018, LAI0023, LAI0027, LAI0033 and LAI0040
16 Q 143
17 C&AG’s Report, para 4.17
18 Q 114
19 Qq 120, 143
20 Comptroller and Auditor General, Financial sustainability of local authorities: capital expenditure and resourcing, Session 2016–17, HC 234, June 2016, para 2.26
21 HC Committee of Public Accounts, Financial sustainability of local authorities, Twenty-Sixth Report of Session 2016–17, HC 708, 18 November 2016
22 Ministry of Housing, Communities & Local Government, Statutory Guidance on Local Government Investments, 3rd edition, February 2018
23 Chartered Institute of Public Finance and Accountancy, Prudential Code for Capital Finance in Local Authorities and Treasury Management in the Public Services: Code of Practice and Cross-Sectoral Guidance Notes, both December 2017
24 C&AG’s Report, para 4.21, Figure 3
25 Qq 103, 104
26 C&AG’s report, para 2.5 and Figure 3
27 Qq 109, 136
28 C&AG’s Report, para 4.21
29 C&AG’s Report, Figure 15
30 Ministry for Housing, Communities & Local Government, Core spending power: final local government finance settlement 2019 to 2020, January 2019. Spelthorne Borough Council, Capital Strategy 2020–25 – Appendix 5, Treasury Management, February 2020
31 C&AG’s Report, para 3.18
32 LAI002, LAI0019, LAI0033, LAI0035
33 Qq 130 and 131
34 LAI0018, LAI 0027
35 C&AG’s Report, para 4.19 and Figure 21
37 C&AG’s Report, para 1.8 and Figure 21; Q 105
38 C&AG’s Report para 4.27, and Figure 1
39 Q 38
40 C&AG’s Report, paras 2.8 and 2.9
41 C&AG’s Report, paras 28, 2.3
42 Jonathan Ford, Max Harlow and Gareth Davies, ‘Revealed: an Essex council’s £1bn borrowing spree to fund investment in solar power’, Financial Times, 22 May 2020
43 A review of objections made to auditors by members of the public between 2015 and 2019 found that 24 of the objections accepted for consideration related to LOBO loans; the audit fees for dealing with these 24 objections were over £400,000. . See also Comptroller & Auditor General, Financial sustainability of local authorities: capital expenditure and resourcing, Session 2016–17, HC 234, June 2016, paras 1.48 to 1.51. For earlier examples of activities giving rise to concern, see HC Communities and Local Government Committee, Local authority investments, Seventh Report of Session 2008–09, HC 164-I, 11 June 2009; LAI0001 and LAI0032.
44 Q 48; LAI0020
45 For example, LAI0018, LAI0023, LAI0027, LAI0029
46 Q 61
47 LAI0040, LAI0028
48 Qq 101, 109
49 Q 119; C&AG’s Report, para 4.29
50 C&AG’s Report, Figure 1
51 Q 120
52 Qq 112, 136, 143.
53 Q 35; C&AG’s Report, para 1.9 and Figure 1
Published: 13 July 2020