How can local authorities manage pressure on their assets?

Not many days go by without the news headlines reporting the financial pressure facing local authorities, and recent economic conditions suggest that this situation is unlikely to improve any time soon. Although inflation is decreasing, the rate of this decline is relatively slow, and many councils are still struggling with high-cost bases.

Our latest analysis finds that the current outlook for local councils in England is alarming, with 40% of councils at risk of financial failure over the next five years. And our recent report on ‘Preventing Failure in Local Government’ highlights common issues for councils on the brink of financial collapse.

Between 1988 and 2017, only five councils issued a Section 114 notice – essentially announcing that expenditure will exceed income in a given financial year. Since 2018, nine councils have issued Section 114 notices, and two councils have issued multiple notices in 2018 and 2020. 

Capital programmes are suffering due to spiralling construction and financing costs after a period of sustained low inflation and low borrowing rates. Some of these financial pressures were contributed to by losses suffered by existing assets, investments, and projects previously entered into by local authorities. In the widely publicised cases of Nottingham City Council’s Robin Hood Energy Limited (energy provider) and Croydon Council’s Brick by Brick Limited (housing developer), the root causes for failure included external market forces, improper governance arrangements, lack of industry expertise, and poor oversight and due diligence by the authorities themselves.

What should local authorities do?

With continued pressure and focus on delivering the frontline services, there's a risk that local authorities might be distracted from their oversight of the existing investments, assets, or projects, especially those invested years ago. It's critical that authorities regularly review their investments from a financial and governance perspective. This should include an assessment of how these investments, assets, or projects may impact on the council-wide budgets in the short- and medium-term. A three-step approach can help structure this task in a manageable way. 

Three-step approach

Assess baseline

For all publicly funded investments, commercial ventures and projects, authorities have a duty to ensure value for money. They should, therefore, assess the current baseline financial positions of the investments and have a clear understanding of the internal and external factors driving the financial and operational performances. Authorities should diagnose any funding issues and risks from these investments, assets, or projects, and consider any non-financial issues, such as suitability of the management team (or the board of directors), the governance structure, and the level of internal controls. 

From our experience, the common risks include:

• income pressures; with inability to pass on cost increase to the end-user, eg, affordable housing
• significant exposure to interest rate-risk, especially those assets entirely or partially financed by debt
• cost pressure; with employees expecting pay rises to mitigate the cost of living crisis
• skill shortages; without the right blend of competencies and experience to navigate the economic challenges
• wrong operating model for the current economic situation

Appraise options

The baseline assessment should help authorities identify future options for managing the issues found. In our work with local authorities, we've seen challenges facing investments, particularly those funded by debt a few years ago with soaring borrowing costs.

For investments, assets, or projects heavily funded by debt, it might be necessary for the authorities to revisit the funding structure and consider whether it's still financially sustainable. A restructure might be required to stabilise the financial position, with options including extending the term of the debt or refinancing to an interest-only debt. It may even be necessary to sell existing council-owned investments for cash to reduce the level of debt, although such sale should be assessed in entirety, given a corresponding reduction in commercial income or revenue. 

For trading subsidiaries wholly owned by the councils that have been solely funded by themselves via debt, it might be sensible to consider options that help the subsidiary continue to trade as a going concern. The options may include revising the debt repayment profile or undertaking a debt restructure, such as a ‘debt for equity’ swap, or a partial disinvestment to generate cash / release capital.

Other options include new investments or raising extra equity or debt from third parties, which, however, would dilute the authorities’ ownership. In a worst-case scenario, there's also an option of exit, with the authorities liquidating the trading subsidiaries and bringing the services back into their full control.

Naturally, to appraise the impact of any of the options, authorities should evaluate them in a business case covering all aspects, based on the Treasury’s five-case model. There would be financial, economic, and tax implications that need to be fully considered ahead of any final decision.

Take actions

Authorities should seek expert advice on the options and allocate sufficient time to properly assess and debate each option with the appropriate stakeholders. The leadership team, such as the Chief Executive Officer, Section 151 Officer, and Monitoring Officer, should be allowed to present the facts of the business case to the Members. In turn, Members (who are democratically appointed by the local residents), have the right to scrutinise and reject options which may result in a deterioration of services to constituents.

Deciding the best way forward may be tough, but it's critical that an option is chosen which ensures the council’s financial security, rather than an ‘easy’ option that provides temporary relief. It's also key that any action taken is transformational and pragmatic.

With the challenging economic headwinds and the main day-to-day focus on frontline services, it can be easy for authorities to overlook existing investments or assets which may have underlying financial concerns yet to emerge. Following the pressures on funding and cost, any level of financial return from investments remains vital for most local authorities to support the delivery of public services. Therefore, councils must not delay in undertaking regular assessments of these investments, so that they can identify the best options and take appropriate actions as required.

For more insight and guidance, get in touch with Brian Ng or Aman Harees.