Consultation on Capital Risk Metrics implementation and mitigation measures in the Local Government Act 2003

Overview

This consultation seeks views on the capital risk metric calculations and implementation for use in the sector. It covers the following areas:

1. Metrics calculations
2. Threshold methodology
3. Process following risk identification and implementation plan

The Ministry of Housing, Communities and Local Government (“the Department”) has policy responsibility for the Prudential Framework (“the Framework”), under which local authorities borrow and invest, and stewardship responsibility for ensuring that it operates effectively. The Framework is intended to ensure that borrowing and investment decisions are prudent, sustainable and affordable, while giving authorities the freedom to determine their own capital strategies to meet local priorities. The Government monitors risks across the sector and keeps the Framework under review to ensure that it remains fit for purpose.

The Framework comprises of primary legislation, with which local authorities must comply, and statutory codes, which they are required to have regard to. It provides authorities with broad freedoms to borrow and invest without the need for specific Government consent, reflecting the principle that locally elected authorities are best placed to assess local needs, determine local priorities and manage their own finances. In exercising those powers, authorities must determine and keep under review an affordable borrowing limit, which must not be exceeded.

Since its introduction in 2004, the Framework has generally operated as intended. However, from around 2016 there was a marked increase in borrowing across the sector with total borrowing by English principal authorities rising from £60.4 billion to £83 billion by the end of 2019/20, an increase of more than £22 billion, compared with an increase of only £1.7 billion between 2011/12 and 2015/16. Much of the increase in borrowing has been driven by a small number of authorities taking on excessive debt to finance novel and risky investments, in some cases where the primary objective was to earn commercial income. Risks were allowed to build to levels that were inconsistent with the core principles of the Framework.

In recent years, a small but significant number of authorities have experienced severe financial failure because of historic decisions that left those authorities with unsustainable debt far in excess of the value of the assets it was used to finance. This has necessitated Government intervention and unprecedented levels of support to move back to sustainability.   Evidence from these failures demonstrates a range of problematic practices, including pursuit of novel or complex strategies outside the authority’s core expertise, disproportionate levels of debt (including for non-commercial activity), over-reliance on commercial income to support revenue budgets, and weaknesses in local governance, scrutiny and risk management.

The Government recognises the importance of local investment and borrowing in supporting housing supply, infrastructure and local growth, and the benefits of local decision making enabled by the Framework. Equally, for the Framework to be able to function effectively there must be effective safeguards to address legacy risks and prevent new risks accumulating in the system. Poor capital decisions have lasting and pervasive consequences, as debt incurred in earlier years may remain on authorities’ balance sheets for decades, and weaknesses in financing structures or investment assumptions can continue to create significant pressures long after the original decisions were taken.

The Government’s objective is to preserve the flexibility that responsible authorities need to invest in their areas, while ensuring that the system is sufficiently robust to detect, mitigate and, where necessary, intervene in relation to excessive risk, particularly where investments do not support local or national priorities such as housebuilding. In this way, the Framework can continue to provide authorities with the flexibility they need to invest in their areas, while protecting the long-term stability of the local Government finance system and avoid the need for more fundamental reform of the capital system.

To support this objective, the Government intends to take forward the statutory capital risk powers introduced by the Levelling-up and Regeneration Act 2023 (“the 2023 Act”). These provisions amended the 2003 Act to expand the Government’s powers to address excessive risk in local authority borrowing and investment, enabling the Secretary of State to issue directions to individual authorities where such risk is identified. The legislation requires any direction to be appropriate and proportionate to the level of financial risk. While the powers enable intervention, their use is discretionary and targeted.

The powers can only be exercised where a trigger event occurs. A trigger event arises where an authority is financially unsustainable, indicated by the issuance of a report under section 114(3) of the Local Government Finance Act 1988 ("section 114 notice"), or the need for Government support to avoid such a report, or where an authority breaches a risk threshold in relation to one of the four capital risk metrics specified in section 12B of the 2003 Act. For example, the first metric relates to whether an authority is excessively leveraged.

While the risk metrics themselves are set out in primary legislation, the method for calculating the relevant numerical thresholds must be specified in secondary legislation. The Government is committed to engaging with local authorities and the wider sector in developing those calculation methods and the associated regulations.

This consultation therefore seeks views from local authorities, sector bodies and other stakeholders on the proposed approach to calculating and applying the capital risk metrics. To support the proportionate, fair and consistent use of the powers in line with the legislative framework, the Government is also seeking views on the proposed framework for how the capital powers will operate in practice.

Why your views matter

We want to understand any unintended consequences, difficulties, and additional considerations regarding our suggested methodologies. Additionally, we have developed a series of responses to metrics being triggered alongside a potential timeframe for implementation. The response is intended to be proportionate to the level of risk identified, taking the necessary supportive measures to help steward away from financial failure.

The consultation will be used to collect views, and the evidence will be carefully considered in deriving the final metrics calculations that will underpin powers set out in the Local Government Act 2003, sections 12A to 12D. Alongside this consultation, the Government will collect evidence from the sector through other forms of engagement and stakeholders will be made aware of this in due course.