Local authority financial sustainability and the section 114 regime Contents

5Local authority commercial investment

Commercial investment and borrowing for yield

56.In recent years, local councils have made increasing use of cheap borrowing from the Public Works Loan Board (PWLB) to invest in commercial property with a view to generating revenue. In its report, Local authority investment in commercial property, the NAO estimated that local councils spent £6.6 billion on commercial acquisitions between 2016 and 2019, a fourteenfold increase on the preceding three years, and that as much as £6 billion might have been financed through borrowing. It also found that the practice was concentrated in a small but growing number of authorities and that nearly all identified yield as an important motivation.108 It warned that such income was “uncertain over the long term” and that authorities could become “significantly dependent on commercial property income to support services.”109

57.The rules governing the purposes for which local councils may borrow for commercial investment are set out in CIPFA’s prudential code. Councils can borrow for commercial investment to meet a service or regeneration need. As Rob Whiteman, CEO of CIPFA, told us, “local authorities are public institutions that borrow to support services and regenerate their local economies” and this can involve “some appropriate use of borrowing for commercial purposes”. Councils can be “innovative and creative” and “invest in local regeneration and transport infrastructure”, but as revenue budgets tightened, some councils started to “reinterpret the rules” and borrow in advance of need. In CIPFA’s view, this practice, known as “borrowing for yield”, does contravene the code.110

58.The Government agrees that borrowing primarily for yield is an inappropriate use of the PWLB and in November 2020 revised its lending terms. Its stated aim was “to develop a proportionate and equitable way to prevent local authorities from using PWLB loans to buy commercial assets primarily for yield, without impeding their ability to pursue service delivery, housing, and regeneration under the prudential regime as they do now.” According to the new lending terms, finance directors must now confirm that “there is no intention to buy investment assets primarily for yield at any point in the next three years.”111 At the same time, though, in evidence to our inquiry, the Minister was clear that the Government still thought commercial investment could be “appropriate and necessary when it is done well.”112

59.Despite the recent criticisms of local government commercial investment, much of the evidence to our inquiry emphasised the benefits. Dan Bates, an accountant and local government finance specialist, cautioned against “assuming that all commercial property investment is necessarily bad” and thought that while the Government and CIPFA “have expressed concerns with this income stream”, with “high-profile cases of bad investments” being used “to justify this stance”, insufficient consideration was being given to “good investments and their contribution to local authority funding.”113

60.Many local councils now consider commercial investment an important and legitimate part of the local government financial system and object to the whole sector being judged according to the behaviour of a small minority.114 London Councils argued that “commercial property investment by local government is balanced and subject to significant internal and external scrutiny” and that any “steps to curb perceived excessive risk taking in the sector must be developed in close consultation with the sector so as to avoid dampening much needed investment in local areas”.115 The DCN strongly defended commercial investment, arguing that, having been “encouraged to be innovative and self-sufficient”, councils “developed new income streams to replace lost funding” and “maintain vital core services and project jobs without increasing the burden on the taxpayer”.116

61.We were also told that commercial investment was not a cause of local government financial instability. London Councils said that commercial investment decisions, whilst sometimes a factor, were “never the sole reason” for financial failure.117 According to researchers from Nottingham Business School, risky commercial investments “exacerbate and intensify” the structural funding issues but are not “fundamental causes of these problems”. They said that while borrowing for yield was a significant problem in a minority of councils, it could not be said to be undermining the local government financial system overall and that even where councils had done it, it was not the primary cause of their financial difficulties.118 This conclusion is supported by our examination of the circumstances at Croydon Council (see Annex).

62.The evidence to our inquiry indicated that only a small minority of councils were behaving irresponsibly. As Rob Whiteman told us, “the vast majority of councils have not borrowed for yield” and “have followed the prudential code as it has always existed.” Richard Watts agreed that a “small number of councils” were “doing a lot of this so-called commercial borrowing” but that most councils were “not going anywhere near it.”119 The Society of County Treasurers said it was “not typical” of the sector.120 Local and central government agreed on this point. The Minister talked of “a minority of councils that have been taking excessive risks with taxpayers’ money and becoming overly indebted in pursuit of commercial income.121

Oversight and the role of central government

Data

63.Under the prudential framework, which governs local government borrowing and investment, the Department has overall policy responsibility for monitoring the commercial activities of local councils. It has been heavily criticised in recent years, however, for failing to take the problem seriously. In particular, the NAO and the PAC have repeatedly highlighted the inadequacy of the Department’s data gathering.122 Last year, the PAC said the Department had “effectively been flying blind” and that it needed to “get a grip on this in the future.”123 In response to questioning, the Minister told us the Department was “undertaking a review to make sure we have the data that we need”. He continued: “We have to be able to understand the trends and drivers of this type of risk and investment in councils, and the associated longer-term effects on financial stability for councils. We want to improve that data.”124

Councils encouraged to be more self-sufficient

64.Despite the Government’s criticisms of some councils’ commercial investments, we were told that former Ministers, particularly in the Coalition Government, had actually encouraged them to be more commercial in response to funding cuts.125 As noted earlier, making local government self-sufficient was the explicit policy of previous Governments.126 The Society of County Treasurers told us: “Over the last decade councils have been actively encouraged by Government to seek out commercial ventures to supplement shortfalls in funding.”127 According to Richard Watts, from the LGA, “between 2010 and 2015–16, the view of the Secretary of State was that councils should seek to replace lost grant with income from commercial borrowing” and that the Government considered this “a legitimate way for councils to substitute the grant they have lost because of the programme of spending reductions.”128 When asked whether previous Governments had encouraged councils to be more commercial, the Minister could only reply: “I would not comment on the language that Ministers before me and the Secretary of State have used about commercial investment.”129

Reform of the PWLB’s lending terms

65.Many submissions welcomed the reforms to the PWLB’s lending terms.130 Richard Watts thought they had “landed us about in the right place” and that the sector should “allow those to bed in before seeing whether they need further reform.”131 Pete Carpenter, from Peterborough City Council, argued that councils had been encouraged to invest in commercial property by the recent low PWLB interest rate and welcomed “the reclassification of what PWLB finance can be used to fund”.132 Rob Whiteman listed reform of the PWLB as one of the prerequisites of clamping down on irresponsible borrowing, although CIPFA’s written submission called for “a period of stability to enable local authorities to support economic regeneration post-covid”, adding that “additional uncertainty” would “hamper longer term planning.”133

66.In contrast, accountant and local government finance expert Dan Bates told us that policies such as withdrawing access to the PWLB from councils that invest in commercial property “should be based on a fuller analysis of the facts rather than isolated examples of poor investments.”134 London Councils said it was concerned by the “indirect tightening of central control over local authorities’ capital programmes” and that it did not “consider PWLB lending terms to be the right mechanism for adjusting the operation of authorities’ statutory powers.”135 The DCN called the changes to the PWLB lending terms “disproportionate” and described commercial investment as “a wider investment in the economic wellbeing of the area”.136 Somewhere in the middle, Core Cities UK thought the new interest should be halved for prudent schemes within a local authority’s area to incentivise responsible investment.137

Prudential framework

67.Apart from the lending terms of the PWLB, MHCLG has overall policy responsibility for the framework of principles governing local authority borrowing and investment, known as the prudential framework, but has been criticised in recent years for the quality of its oversight. In its report, Local authority investment in commercial property, the PAC said the Department appeared “blind to the level of exposure of the local government sector to sectoral commercial risks” and called on it to “be more active in its oversight of the prudential framework”.138 In response, the Government set out a series of reviews and initiatives designed to “ensure that the Department remains effective in its role as stewards of the local government capital system”.139

68.An underlying principle of the prudential framework is that local authorities are best placed to make borrowing and spending decisions in their areas.140 The evidence we received supported the autonomy that the Department’s approach enabled. CIPFA described the prudential framework as “key to local authority decision making” and said it gave councils the “freedom to invest in areas such as regeneration and housing”. It argued that if councils were “to play a central role in rebuilding post-covid communities during the next five years, it must remain active and have the flexibility to make local decisions.”141 London Councils supported MHCLG’s approach to oversight, as it provided councils with the autonomy they needed, and argued “against any changes in response to perceived risks of commercial investment by the department”.142

Prudential code

69.CIPFA’s prudential code, which forms one part of the prudential framework, sets out the rules governing capital investment by local councils and its purpose is to ensure that capital investment plans are affordable, prudent and sustainable. Among other things, the code sets out how much an authority may borrow and for what purposes. Currently, however, authorities need only have regard to the code. According to Rob Whiteman, compliance should be made a statutory duty. “If it was the law or regulation”, he told us, “the onus would not only be on the section 114 to sign this off from an accounting perspective”; the “leader, the chief executive and the cabinet” would also “all have a corporate responsibility to follow these regulations”.143

70.Commercial investment appears to pose no clear threat to local government financial resilience overall, and where it has contributed to financial instability, the councils concerned must bear ultimate responsibility. We also welcome the Government’s reforms to the PWLB’s lending terms, which are a useful clarification of the purposes for which PWLB loans can be used. In understanding local authorities’ use of commercial investment, we must acknowledge that previous Governments encouraged councils to be more commercial.

71.Furthermore, whilst we welcome the Minister’s commitment to gathering the best quality data to better understand councils’ exposure to commercial investment, we think this should have been done by now. We are also concerned about the lack of a statutory requirement on local councils to comply with the prudential code.

72.We recommend that the Government legislate to make compliance with the prudential code by local authorities a statutory duty. The Government should also make good on its commitment to improving the data it collects on local authority commercial investment.

108 National Audit Office, Local authority investment in commercial property, (13 February 2020), pp. 7–8

113 Mr Dan Bates (Director at OnTor Limited (Private Limited Company)) (FSS0009)

114 Society of County Treasurers (FSS0003)

115 London Councils (FSS0014)

116 District Councils Network (FSS0013)

117 London Councils (FSS0014)

118 Professor Peter Murphy (Professor of Public Policy and Management at Nottingham Business School); Dr Peter Eckersley (Senior Research Fellow at Nottingham Business School); Katarzyna Lakoma (Research Associate at Nottingham Business School); Bernard Kofi Dom (Associate Lecturer at Nottingham Business School) (FSS0001)

120 Society of County Treasurers (FSS0003)

122 Public Accounts Committee, Twenty-Sixth Report of Session 2016–17, Financial sustainability of local authorities, HC 708; Public Accounts Committee, Eleventh Report of the 2019–21 Session, Local authority investment in commercial property, HC312; National Audit Office, Local authority investment in commercial property, (13 February 2020)

123 Public Accounts Committee, Eleventh Report of the 2019–21 Session, Local authority investment in commercial property, p. 16

125 Professor Peter Murphy (Professor of Public Policy and Management at Nottingham Business School); Dr Peter Eckersley (Senior Research Fellow at Nottingham Business School); Katarzyna Lakoma (Research Associate at Nottingham Business School); Bernard Kofi Dom (Associate Lecturer at Nottingham Business School) (FSS0001); District Councils Network (FSS0013)

126 Department for Communities and Local Government, Self-sufficient local government: 100% business rates retention, (July 2016)

127 Society of County Treasurers (FSS0003)

130 Society of County Treasurers (FSS0003); Mr Pete Carpenter (Corporate Director Resources at Peterborough City Council) (FSS0010); Chartered Institute of Public Finance and Accountancy (CIPFA) (FSS0012); Richard Watts, Q15; Rob Whiteman, Q21

132 Mr Pete Carpenter (Corporate Director Resources at Peterborough City Council) (FSS0010)

133 Q21; Chartered Institute of Public Finance and Accountancy (CIPFA) (FSS0012)

134 Mr Dan Bates (Director at OnTor Limited (Private Limited Company)) (FSS0009)

135 London Councils (FSS0014)

136 District Councils Network (FSS0013)

137 Core Cities UK (SRF0023)

138 Public Accounts Committee, Eleventh Report of Session 2019–21, Local authority investment in commercial property, HC 312, para 1

141 Chartered Institute of Public Finance and Accountancy (CIPFA) (FSS0012)

142 London Councils (FSS0014)




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