Prudential potential

Local authorities have always operated commercial services. From postcards at the art gallery to trade refuse collection, success is not an excellent grading on an inspector’s certification, but rather the ability to provide a better combination of price and quality than anyone else. While local authorities’ powers to trade were extended by the Local Government Act 2003, it has been the arrival of prudential borrowing that has given new impetus to such trading activities.

The new trading powers widened both the range of commercial activities that local authorities can undertake and the range of potential customers for whom they can work. But such commercial ventures would have remained very limited if restricted to the disposal of spare capacity and surplus assets. The advent of prudential borrowing has given local authorities the ability to raise the investment capital for such ventures and opened the door for much wider commercial activity, and it is this open door at which enterprising local authorities are now pushing.

Does this represent a threat to the private sector? And if so, is it an unfair threat?
In fact, local authorities can enjoy a genuine competitive advantage over the private sector. They may have:

  • Better knowledge of the market for a particular service, especially where potential customers are existing clients.
  • Technical skills and products designed for the particular service.
  • Local brand recognition and, hopefully, a reputation for reliable service delivery.
  • The benefit of volume purchasing.
  • Close control of costs, bred from year-on-year savings.
  • Measurable service quality and sophisticated quality assurance systems, as a product of the ‘best value’ programme.
  • The ability to accept a lower required rate of return or a longer-term view where the service also contributes to the authority’s public service objectives

But, equally, local authority enterprises can suffer from commercial disadvantages. These can include:

  • Higher employee costs and less flexibility of employment.
  • A service provision focus rather than a commercial focus.
  • A lack of commercial management skills and experience.
  • Legalistic decision-making processes and structures.
  • A tangled and opaque statutory foundation.
  • An inability or unwillingness to introduce performance-related incentives.

The Local Government Act 2003 sought to put such new local authority commercial enterprises on an equal footing to private sector competitors, hence:

  • All new commercial activities that are carried out under the new powers must be undertaken through a company.
  • That trading company is subject to Corporation Tax and VAT, unlike its parent local authority.
  • The parent local authority may only supply goods and services to the trading company at full cost, thus preventing subsidy to the trading company.
  • Fiduciary duty and the rules on state aid mean that the trading company’s direct borrowing comes at commercial rates.

The real change, though, has been the introduction of prudential borrowing.

Historically, each local authority has had a strict upper limit on its power to borrow. That limit has been made up of an allowance set by central government, partly as a minimal, across-the-authority provision and partly as project-specific approvals for defined new schools, roads and so on. To that total, each authority could add the proceeds from asset sales (except in respect of housing, where 75 per cent of right-to-buy sale proceeds were clawed back by central government, despite the desperate need for local authority capital expenditure to improve council houses to the decent homes standard). This meant that local authorities had insufficient borrowing capacity (except by using the device of PFI, where the borrowing is kept off the authority’s balance sheet) that was barely sufficient to maintain and renew essential infrastructure, let alone to finance commercial enterprises.

Now the Prudential Code has swept away such specific controls (although central government retains the right to reimpose such controls generally or upon individual local authorities if necessary) and local authorities may borrow as and when they wish, provided that they can afford the costs of servicing and repaying the debt.

Local authorities’ ability to fund such borrowing depends on their ability to raise income. Central government’s annual reduction of grants, on the assumption of further efficiency savings and the effective capping of Council Tax levels in the provision of local services, leave authorities scraping around for revenue to meet increasing service pressures. So prudential borrowing is unlikely to unlock a nationwide flood of investment in refurbishing crumbling local infrastructure, simply because investment in reconstructing a road or replacing a leaking school roof rarely produces the additional income needed to meet the costs of servicing the new debt.

It is that need for a new income stream to fund the cost of new borrowing which makes new commercial enterprises particularly attractive and alters fundamentally the relationship between a local authority and its potential commercial partners. If participation in a joint venture company with the private sector was historically necessary to secure capital funding outside the straightjacket of central government control of local authority borrowing, that is no longer the case. Where the commercial venture promises a real profit, it is the local authority that can now provide the equity and loan capital, and incidentally make a profit from borrowing cheap on its own account and lending at full commercial rates to the company.

So the private sector partner should now be demonstrating how, as partners in such commercial ventures, they can help local authorities to overcome the commercial disadvantages as listed. This can be achieved by:

  • Providing alternative employment structures offering opportunities for real performance-related incentives, for risk and reward and personal development, without diluting unduly the perceived benefits of public sector employment.
  • Providing commercial management skills and experience.
  • Supporting legal structures which take such commercial ventures outside the legalistic decision-making processes and structures of local authorities.
  • Reconciling the legitimate pursuit of profit with the accountability required of local authorities and the attainment of broad public benefit objectives.

If potential commercial partners can focus on making the most of their differences, the new impetus behind local authority trading activities can be an opportunity rather than a threat.

Peter Keith-Lucas is a local government partner with Bevan Brittan