A case for self help?

With central government funds in short supply, Alan Aisbett looks at how local authorities will be able to finance infrastructure and regeneration going forwards.

Centralised Grant Distribution

For the last 15 or so years local authorities have undertaken major capital investment financed by diverse central government programmes. These programmes have now largely been turned off. The Coalition Government's policies now emphasise Localism reflected in the requirement for local growth. There is also an evident shift from social to economic infrastructure. Local authorities (perhaps through Local Enterprise Partnerships) are expected to provide the underlying infrastructure needed to facilitate private sector growth and economic regeneration.

How can local authorities achieve this in these times of austerity? Or put another way where are the sources of Localist finance and is the main tool in the Localist finance toolbox self-help?

Movement to Localist Finance

Any Localist finance model must necessarily be built around local authority revenues and assets. Thus far the availability of local authority revenues has been heavily constrained with an average 53% of local authority income derived from central government grants. With the balance from Council Tax required to maintain local services, and is effectively capped, there has been little by way of revenues available to fund infrastructure (in any event Council Tax with its low base in housing gives little opportunity to harness significant revenue growth). However, with the shift to Localism policies this is starting to change.

The most significant change is the devolution to local authorities of revenues hitherto controlled by central government. This relates to revenues in both local authority statutory accounts, the General Rate Fund (business rates) and the Housing Revenue Account (social housing rents). Since the 1980s both business rates and rents have been the subject of central pooling and re-distribution as formula grant (in the case of business rates) and housing subsidy (in the case of rents). The proposition in relation to both of these sources of revenue is local retention albeit on different terms.

Business Rates

Starting with business rates the Government has recently published a consultation paper[1] on business rate retention. The document looks at the retention of business rates as a whole and suggests incentives in the proposed regime for local authorities to encourage growth as the business rates from such will be retained by local authorities. The emphasis is on business rate retention as a whole rather than the establishment of ring fenced business rate tax streams to finance borrowing for infrastructure (Tax Increment Finance). Although the revenue stream comprising the general growth in business rates can be used to raise finance the nature of what is being done is more generic than specific and is capable of funding other models of delivery such as private finance contracts and investment funds.

How will business rate retention work? The first hurdle the government will need to overcome is the balancing of its desired outcome of incentivising local authorities to encourage growth with the need for ongoing protection for those local authorities with high needs and low tax bases. To overcome this hurdle the Government is proposing to establish a baseline (roughly at the level of 2012-13 grant). Those local authorities whose business rate income is higher than the baseline will pay the difference to Central Government in the form of a "tariff" and those authorities who are less will receive a "top up" from central government.

However, in ensuing years the "tariffs" and "top ups" will remain fixed so that an increasing proportion of business rate growth will be retained by the local authority. The new system won't be quite as straightforward as this as the Government is also proposing levies (to address disproportionately high tax bases), adjustments (to address differing growths in rateable values) and a re-set mechanism (to address where resources are too divergent from need). Authorities will also be permitted to pool their business rates.

The Consultation Paper sets out two options for raising finance from the incremental growth in business rates. The first is to operate wholly within the new regime taking into account "net" business rates after "tariffs", "top ups", adjustments and re-sets. The income stream will be less certain but the risk spread across the local authority. The revenue stream could be used to fund borrowing or a private finance contract or an infrastructure investment fund. The second (which will be in addition to the first) will involve the growth in business rates in a given development area being ring fenced from levy, adjustments and re-setting. As a consequence there will be more certainty of cashflows but the potential impact on the "balancing" mechanism will mean greater Government control over use.

Council Housing Finance

A similar approach is being taken by the Government in relation to the devolution of Council housing finance. From April 2012 local authorities will be free to retain rents from their dwellings and thereby surpluses on their Housing Revenue Accounts in return for a "one off" allocation of debt to achieve equalisation for those authorities with a low rent but high cost base. The allocation of debt will be by reference to a valuation of the stock (the Net Present Value of notional rents less notional costs). Local authorities with a higher value than notional debt under the current system will borrow to pay central government the difference and authorities with a lower value than notional debt under the current system will be paid a dowry by the Government.

Once the settlement is agreed the local authority will be free to use any surplus to fund capital investment.  However, for reasons of deficit reduction there will be a cap on borrowing although it remains to be seen whether other transactions will be permitted such as private finance contracts.

Institutional Finance

Changes proposed for both business rates and Council housing finance will give opportunities to raise finance from revenues (although in the case of Council housing the cap on borrowing will limit raising direct finance to the initial debt). Thus far the favoured source of funding for local authorities has been the Public Works Loan Board. However, the increase in PWLB interest rates has opened the way for local authorities to use the capital markets to fund housing (through rents) and infrastructure (through business rates). With a potential market for municipal bonds (the GLA has just issued a bond to finance Crossrail from a business rate supplement), local authorities need to consider aggregation through a vehicle (a Local Authority Finance Corporation) to achieve economies of scale in debt funding and potentially also investment funding (the latter using different sources of cash and other assets – see last paragraph below).

Assets

One of the public sector's most valuable resources is its asset base, estimated to be worth around £370 billion. With the reduction in government grant funding the asset base could be the most important ingredient for stimulating capital investment.

Private finance can be raised against public sector assets using different PPP structures. Although there are several structures which can be used these tend to be variations through a contract or corporate entity. The principle underpinning whichever structure is used is capturing the underlying increase in the value of assets for capital investment.

The corporate entity or joint venture model has proved to be the most popular structure. It is a more collaborative model than a contract structure with the public sector body transferring its assets into a joint venture vehicle (probably a Limited Liability Partnership or Limited Partnership for reasons of tax efficiency) in return for shares with the private sector matching the value of the assets with cash equity. This so called Local Asset Backed Vehicle (LABV) can then raise debt finance to fund infrastructure (either on an "as provided" or "serviced" basis) with the proceeds of sale from the assets being used to repay debt and returns. The public sector will take a deferred consideration for its assets being paid from profit.

LABVs can have different risk profiles, with some being investment and others development vehicles. There may also be different procurement strategies with some going through a full EU procurement for investor and supply chain and others selecting a joint venture partner and then undertaking an EU procurement for the supply chain. Often seen as a regeneration or housing finance vehicle (eg in Newcastle Scotswood project) it can also be an investment vehicle for industrial and commercial property (Aylesbury) and for accommodation (Croydon). The concept which started with Regional Development Agencies is now a popular part of local government infrastructure procurement and now moving into the NHS (Calderdale and Huddersfield NHS Trust).

The asset model has more recently evolved into a "fund" model being a hybrid of the asset and revenue models (as explained previously). The "fund" model is largely a creature of the deficit reduction age and involves the public sector (often more than one body) pooling available finance often with assets for investment in individual infrastructure projects. The fund is likely to be a tax efficient vehicle (either LLP or LP) which will invest in accordance with a pre-agreed investment strategy. The investments are "evergreen" with returns reinvested. Originating in the EU "Jessica" (Joint European Support for Sustainable Investment in City Areas) programme it is now a source of infrastructure finance which several local authorities are looking at.

Alan Aisbett is a partner at Pinsent Masons. He can be contacted on 0121 626 5742 or by email at This email address is being protected from spambots. You need JavaScript enabled to view it..

[1] Communities and Local Government.  Local Government Resource Review: Proposals for Business Rate Retention