Major Factors

Recent Developments

The U.K. local authority sector continues to experience significant economic shock resulting from the COVID-19 pandemic, with notable adverse effects on revenue and costs. Observed financial performance had started to rebound in 2017 and 2018, following almost a decade of revenue and spending cuts in response to the financial crisis of 2008. However, this recovery has been stunted, with estimated performance for 2019 and beyond seeing a significant worsening due to an accumulation of unforeseen revenue and cost pressures.

The U.K. government has supported the sector with £4.3 billion of pandemic grant funding to date, and further promises of support for lost income. However, we anticipate funding gaps will still materialize, and will need to be met through the use of reserves and further cost reductions. We also anticipate some longer-term behavioral changes in the public that could have the potential to further affect operating balances.

The pandemic has exacerbated pressure on social care services, and a forecast £4 billion sector-wide funding gap poses significant policy and fiscal concerns for both central and local government bodies.

In addition, the U.K. public sector as a whole has been preparing for the constitutional change arising from the U.K.'s exit from the EU. While we do not anticipate immediate and significant structural disruption to the local government sector, we see that recent events, including divergences in COVID-19 pandemic responses, and disagreements over post-Brexit internal markets and the level of U.K. central control, have brought the stability of the union between the U.K.'s separate nations into the spotlight. We also see a risk of this permeating into other aspects of devolved governance, potentially affecting U.K. local authorities in the medium- to long-term. In addition, we think local economies will likely feel the effect of Brexit, and this will have an indirect impact on local government revenue and expenditure.

Sector-wide debt has grown to 91% of revenue as a result of increased Public Works Loans Board (PWLB) borrowing to fund expanding capital programs, and the refinancing of pricey historic debt. Borrowing to support the acquisition of commercial real estate investments has drawn negative attention from the media and U.K. government, and is the subject of an ongoing consultation into the practice. The U.K. government raised standard PWLB borrowing rates by 100 basis points (bps) in October 2019, as a short-term measure to curtail the activity, which has led authorities to seek finance from other sources. Housing Revenue Account (HRA) rates on loans from the PWLB were introduced at 100 bps below the standard rate in March 2020, to promote further investment in social housing.

Predictability

Frequency and extent of reforms

The U.K. local authority system is well established and well defined, with strong foundations codified in statute and regulation. It features a broad range of operational freedoms, but remains closely tied to the central government through funding, policy, and regulatory mechanisms.

In our view, U.K. local authorities are capable of influencing the outcome of major reforms, and would most likely work with the central government and trade bodies in the design and implementation of any future changes to the financial framework.

Local authorities have responsibility for the provision of a wide array of services, including housing, education, public health, social care, transport, and environmental services. Within the multi-tier system, each type of authority has slightly differing accountabilities to the local public, and differing cost and revenue bases as a result. Across the tiers, authorities generally enjoy an equal relationship with the central government, and are equivalent in ranking.

Local authorities operate a democratic structure, with elected council members, and apolitical employed officers to deliver on policy mandates. Across the U.K., there are 343 local authorities in England, 32 in Scotland, 22 in Wales, and 11 in Northern Ireland. As part of the devolution arrangements for Scotland, Wales, and Northern Ireland, the responsibility for local government resides with the respective devolved administrations. While funding and policy is devolved, the overall framework for local authorities' administration remains generally consistent across the U.K.

Chart 1

In the period since our previous assessment carried out in August 2018, there has been minimal systemic reform for U.K. local authorities. The number of new devolution agreements, deals that transfer additional powers and revenue-raising abilities to specific local authorities, has also reduced. The U.K. government is currently drafting a devolution white paper, which is expected to set out the next stage in policy and procedure for future devolution deals and encourage further consolidation of entities. Due to the pandemic, its release has been delayed until 2021.

We have seen increases in the level of retained business rates--a local tax on commercial properties--with some authorities now retaining 100% of collections. However, council tax, a similar tax raised against residential properties, has remained broadly unaffected by any reforms since our last assessment. In contrast, we have observed a reducing trend in government grant income from 2009/2010 to 2019/2020 of close to £16 billion, or 60% from previous levels. But despite its severity, we do not see this period of grant reduction as having fundamentally changed the underlying predictability of the system. Under successive U.K. government budgets and spending reviews, grant cuts have been announced in advance, allowing authorities to adjust their budgets and strategies accordingly before the reductions take effect.

Central government funding announcements generally have a three-to five-year outlook, which provides a level of certainty over medium-term revenue. However, these are subject to annual revisions. Local authorities operate on annual budgetary cycles, which are more accurate reflections of their medium-term financial strategies (MTFS) that have a three- to five-year outlook for operating and capital budgets. Authorities are exposed to demand-led pressures (for example, social care, homelessness, and public health) and as such there is an accepted level of volatility in medium- to long-term budgets for these services.

Three key structural reforms are on the horizon for the sector:

• The Fair Funding Review concerns the methodology by which government grants are allocated to local authorities, with the aim of simplifying the process and better aligning the allocations to support equalization. The review is due to conclude in 2021, and we think it unlikely that any changes will be implemented within this assessment horizon. However, we will continue to monitor the review's progress and the potential impact of changes on the operating revenue and budgetary performance of rated entities.
• In July 2020, the U.K. government issued a consultation paper on the future of the business rates framework. The consultation considers the framework's effectiveness as a tax in a digital marketplace, and takes into account the COVID-19 pandemic's impact on commercial property utilization. The longer-term outcome of this exercise could be significant changes to how rates are levied.
• The PWLB consultation is looking at the central government lending facility's controls to prevent borrowing solely for commercial investments without any policy objectives. We are likely to see additional measures put in place to manage utilization of borrowed funds, and potentially beneficial and punitive rate adjustments.

Proposed reforms generally involve extensive consultation and communication, with gradual implementation over a number of years, and often include transitional arrangements to mitigate any short term adverse impacts on Authorities.

The impending exit from the EU on 31 December 2020 creates uncertainty in the Local Authority landscape in the short to medium term, but is unlikely to create structural stresses in the system.

Ability of local and regional governments (LRGs) to influence or oppose reform

U.K. local authorities enjoy the general power to act autonomously on almost all matters without central government consent. However, the central government still controls a significant proportion of local authority revenue via government grants. The last decade of austerity has demonstrated that central government has been able to pass on large spending reductions relatively easily.

While authorities cannot directly block reform, there is a history of consultation with the central government on policy and funding matters. Furthermore, the noted trend in devolution of power outward from central government is creating greater autonomy within local authorities, and therefore greater control over local matters. In addition, the industry has a strong political lobby through a number of trade bodies, including the Chartered Institute of Public Finance and Accountancy (CIPFA), the Local Government Association (LGA), and other regional groups.

Revenue And Expenditure Balance

Overall adequacy of revenue to cover expenditure needs

We expect the COVID-19 pandemic will suppress local authority revenue over the next two years, and government support is unlikely to offset losses entirely. As a result, we see operating deficits emerging (before transfers from reserves), which will put strain on the sector's finite reserves, and potentially lead to further cost reduction measures in individual authorities. Our longer-term view sees a gradual recovery to a sectorwide operating surplus, albeit outside the horizon of this report.

Our most recent industry-wide financial assessment identified an estimated 2019 operating deficit of -1.3% (as a percentage of total revenue), and a deficit after capital accounts of -1.0%. Our forecasts expect a significantly more distressed 2020, and a prolonged recovery period throughout 2021, with operating balances hitting a low of -4.4% of revenue. Our analysis takes a cash-based view of U.K. local authorities' financial performance, which does not factor in the use of reserves to offset any operating deficits. Therefore, it is possible for our analysis to show entities in deficit that do not actually breach the balanced budget requirement due to the differences in calculation basis.

We anticipate lower revenue from discretionary fees and charges, as lockdowns significantly disrupt local economies, while tax revenue will be strained due to the potential for increased voids, discounts, and business failures. Expenditure pressure will be exacerbated in a number of areas, but most notably in social care, education, and environmental services. Central government support will likely mitigate a proportion of lost income and additional costs--for example, with grants covering business-rate discounts offered to affected sectors--but we do not expect this to offset the full effect of the pandemic on authorities' budgetary performance. We expect borrowing requirements to increase at a slower rate than previously forecast, as capital programs may be suspended or mothballed to preserve resources in the short to medium term.

Chart 2

Expenditure

Since our last assessment, local authorities have continued to see growing cost pressure on key areas of service provision, including adult social care and housing. Aging populations, increased life expectancy, and more complex care needs combine and continue to weigh on budgets. We think that by 2024, there could be a £4 billion funding gap due to social care pressures. Authorities have employed a number of measures to manage the funding gap, including cost savings, amending eligibility for support, and drawing on finite reserves to balance operating deficits. However, there remains no clear solution at either local or central government levels for the long-term funding of social care services. As such, it is a significant risk to ongoing budgetary performance in the sector.

The economic shock arising from the COVID-19 pandemic has created a number of additional and unforeseen cost pressures in social care, homelessness, and environmental services. The U.K. government has currently pledged £4.3 billion of grant support to offset the additional costs of COVID-19, which will offset a proportion of the estimated £12.7 billion additional costs. Yet over our assessment horizon, we anticipate continued longer-term pressure arising from other areas, including housing and homelessness, as well as the costs of recovery from the COVID-19 pandemic. The critical cost pressure created by the pandemic is exacerbated by a decade of austerity, during which authorities delivered significant cost saving and efficiency measures to discretionary spending in order to balance their budgets, and in doing so eroded their flexibility to manage costs. We expect greater calls on reserves to manage these imbalances. Local authorities' reserves sat at £25.8 billion in 2018 (latest available information), equal to roughly 15% of total operating revenue for the sector. However, these reserves are finite, and sustained depletion is likely to affect our view on the financial management and budgetary performance of rated entities, and the sector as a whole.

Chart 3

Revenue

The greatest share of a local authority's revenue (41%) still comes from government grants and contributions, reflecting authorities' "delivery arm" responsibilities, on behalf of the central government, for a large array of statutory and nonstatutory policy areas. We expect that government grant income will continue to contribute a significant proportion of authorities' total revenue over the short to medium term. While COVID-19-related stress has led to increased direct funding from the central government, the effect of Brexit and potential fiscal tightening may lead to suppressed levels of government funding in the future.

Council tax is a stable, property-based tax that is charged on residential properties within an authority's boundary. Across the U.K., we have seen income from council tax (as a proportion of total revenue) increase by 19% since 2016, with an average increase of 3.8% each year. Authorities are limited by the extent to which council tax can be raised. Increases over 2% a year (or 4% including an additional 2% adult social care precept) require a public referendum, the cost of which can be prohibitive for authorities. Therefore, increases are generally maintained below the threshold.

Business rates (also referred to as national nondomestic rates) are similar to council tax, but charged on commercial properties. In recent years, we have seen greater retention of business rates by authorities, to support ongoing investment in the local area and to boost local economic activity. The tax represents 12% of total revenue. Since the last assessment, authorities have been able to retain up to 50% of business rates; plans to increase this to 75% have been delayed. In some devolution agreements, 100% of business rates collected can be retained.

Authorities have the ability to raise additional income through fees and charges for some of the services provided to businesses and the public. These include car parking, registrars, leisure centers, waste management, and planning and building control. As a whole, this revenue stream is under considerable strain due to the pandemic, since lockdowns have led to significantly reduced demand for discretionary services. The U.K. government estimates lost income across all U.K. local authorities for the full year to be £6.5 billion in 2020. In response, it has agreed to fund 75% of lost income (over an initial 5% threshold) for authorities in 2020. We expect this to help mitigate some of the effects, yet it remains uncertain whether we will see long-term behavioral change in the public, leading to a sustained drop in activity and permanently lower revenue from associated fees and charges.

Since our last assessment, the sector has continued to engage in commercial investments undertaken solely to generate a revenue stream. Supported by cheap borrowing from the PWLB, a small number of authorities have entered into investments in assets including shopping centers and business parks, sometimes outside their own boundaries, using the rental income to service the debt and contribute to operating expenditure. A recent National Audit Office (NAO) report on the practice noted that £6.6 billion of PWLB borrowing had been used to fund commercial property investments in the three years from 2016 to 2018. With the COVID-19 pandemic creating distress in the commercial real estate market, we see an increased likelihood that these revenue streams, and subsequently the debt service that they fund, will come under pressure.

Chart 4

We expect less pressure on capital balances than operating balances in local authorities, since capital investment is likely to be funded through increases in grant funding, additional PWLB borrowing, and receipts from the sale of surplus assets. Given operating pressures, we do not anticipate authorities relying on revenue sources or reserves to fund capital investment. Furthermore, we do not anticipate borrowing to increase markedly, because capital programs may be suspended or mothballed to protect budgets and cash balances.

The U.K. government's policy initiative to "level up" the country by improving local transport and community and technological infrastructure could lead to an increase in the level of capital grants and contributions available to local authorities, in order to deliver on the agenda over the next two to three years.

Debt

Debt has grown steadily over the past five years and represents a significant proportion of total revenue. This could become a greater concern if the trend were to continue; however, the existence of strict borrowing controls within authorities should mitigate this risk. Competitive credit markets, dominated by the PWLB, maintain low debt service costs, and wider economic trends indicate this is unlikely to change within this assessment's horizon.

At the end of financial year 2019 (estimated data), local authorities had debt stock of £126.9 billion, equal to 91% of total revenue for the year. This has been increasing on both an absolute and relative basis over the previous five years, starting at £94.4 billion (69%) in 2015. Across the devolved administrations, borrowing levels vary significantly between authorities from about 15% of total revenue, up to about 245% of net revenue on an individual entity basis.

Chart 5

Roughly 74% of the outstanding debt held by authorities is with the PWLB. The aforementioned consultation over PWLB controls has suggested that authorities that continue to engage in commercial investments could be effectively shut out of the PWLB market for a year, which would call into question the strength of that authority's access to external liquidity, albeit for a limited one-year period. There are a number of alternative sources of finance available to local authorities, including municipal bonds, intra-authority lending, and traditional bank loans. Therefore, we do not believe that there will be any significant issues preventing an authority from accessing credit in the event of a PWLB shutout.

Across the U.K., we do not anticipate authorities' debt will increase markedly, since entities cannot borrow to fund operating deficits--unlike the U.K. government and other sovereign issuers. In addition, authorities may seek to curtail discretionary capital investment in order to preserve budgets and cash.

Fiscal Policy Framework

All U.K. local authorities are required to balance their budget annually, and cannot run operating deficits unless met by reserves. This statutory requirement means that, on an accruals basis and after statutory adjustments such as removing the effect of depreciation, we do not see operating balance deficits in U.K. local authorities after transfers from reserves are taken into account. We see the existence of the statutory requirement for a balanced budget, and the associated Section 114 step-in provisions for the central government, as very strong credit positives for the sector.

The annual financial management process is heavily prescribed. Authorities must present balanced budgets to Full Council which must be approved through a majority vote; and then monitored and reported on monthly. Authorities must also prepare financial statements in accordance with statute and regulations set out by the central government and CIPFA, to ensure comparability and transparency. Further monitoring and reporting by the central government is performed to track spend, and there is an integrated financial and performance framework against which authorities report back to the central government on their ability to deliver value for money.

Authorities are required to have annual audits of their financial statements, carried out by independent auditors. Accounts are submitted by deadlines set by the central government. There is also a requirement for authorities to operate an internal audit function that performs annual reviews over financial, governance, and policy processes and controls. CIPFA has developed the Prudential Borrowing framework as a mechanism to ensure authorities' debt levels and capital investment plans are affordable, prudent, and sustainable, and treasury management decisions are taken in accordance with good professional practice.

Statute requires that authorities appoint a Section 151 (s151) officer to take legal responsibility for the financial affairs of the organization. The s151 officer is usually the Finance Director or CFO of the local authority. There is collective and individual legal accountability for statutory officers and elected members, ensuring strict observance and adherence to the long-established framework. A legal failsafe exists in the form of a "Section 114 notice" (referring to s114 of the Local Government Finance Act 1988) that requires the s151 officer to make a public pronouncement, and thus inform the central government, at the earliest opportunity of the likelihood that they will not be able to meet the balanced budget requirement for the current year, or future years. In such cases, authorities are required to suspend all expenditure (excluding social care and statutory services) and issue a revised budget. This would likely be done in conjunction with the central government and external auditors. The central government can exercise step-in powers to temporarily control the financial activities of the authority, or ultimately execute a reorganization of the authority, effectively closing it down. In the short term, local authorities' access to the PWLB, or other local authorities' or commercial sources of finance, ensures exceptional access to liquidity in times of stress.

The most recent example of a s114 notice was in Northamptonshire County Council in 2018, when the finance director issued two notices in the space of a year on the grounds of the council not expecting to deliver a balanced budget. The council has since agreed to a restructure which will see a new organization formed, and the old one dissolved. This is expected to occur in 2021.

We regard the local authority system as well monitored and regulated, both internally and externally, through the central government and independent audit. It benefits from various levers (both self-controlled, and in the hands of the central government) to redress imbalances or financial shocks; and the frequency of reporting, externally and internally, helps to mitigate the effect of unforeseen financial issues that would impair an authority's creditworthiness.

Extraordinary Support

Due to the relatively centralized nature of the system--either through the U.K. government, or the devolved nations--there is a high level of monitoring and oversight of activities, and a strong record of support in times of financial stress.

The COVID-19 pandemic has led to central government support to local authorities equal to £4.3 billion. Furthermore, the Bellwin Scheme exists to provide extraordinary support from the central government in the event of immediate and unforeseen costs arising from large-scale emergencies and disasters.

Transparency and Accountability

Transparency and institutionalization of budgetary process

The transparency and accountability of the U.K. local authority sector is strong, with many requirements codified in statute.

Across all U.K. local authorities, the roles and responsibilities of elected members and senior officers are clearly defined and made public via authorities' websites. Minutes and records, as well as financial publications (such as budgets, MTFS, and annual accounts) and key statistical information, are also made public. All local authorities are also subject to the requirements of the Freedom of Information Act 2000 (Scotland has a separate but equivalent Act enshrined from 2002), further increasing transparency and accountability. Furthermore, statute requires that authorities publish all items of third-party expenditure over £500 each month.

Disclosure and accounting standards

The sector employs U.K.-wide accounting standards under the Chartered Institute of Public Finance and Accountancy (CIPFA). These are well-established, accruals-based standards, and use International Financial Reporting Standards (IFRS) as a framework. CIPFA updates the guidance for the preparation of accounts on an annual basis.

Annual accounts are comprehensive but can be difficult to interpret. Unique to the local authority sector when compared with other parts of the U.K. public sector, the guidance for preparation and interpretation of annual accounts is not freely available to the public, thus impairing the transparency of accounting compared with other rated U.K. public sector asset classes. In addition, compared with U.K. corporates, financial reporting is less timely, with accounts usually published within three to six months of the financial year-end, and minimal interim financial information available during the course of the financial year.

Control levels and reliability of information

Authorities are required to have accounts audited by independent auditors in accordance with the applicable legislation, and the accounts are made available for public scrutiny, as well as Full Council scrutiny from elected members who are ultimately accountable. Many authorities also operate finance and audit committees that provide further scrutiny of an authority's financial stewardship and performance.

Trend

We have maintained our view of a weakening trend for the institutional framework because, despite initial signs of recovery, the onset of the COVID-19 pandemic has led to local authorities' financial positions becoming more distressed due to rising costs and falling income. The residual effects of the previous decade of austerity, plus limited cost-control flexibility and tightly controlled revenue-raising powers (underpinned by continued reliance on government grant income), exacerbate matters and further constrain authorities' ability to deliver a balanced budget alongside increasing public service demands.

Additional uncertainty exists around the outcome of a number of key reforms that could affect authorities' debt and funding. The long-term effects of the pandemic on public behavior, local economies, and authorities' revenue streams add to the structural and financial stress in the system. In addition, the uncertainty around the effects of Brexit on the sector, and some local authorities' close ties to the U.K. sovereign, could see them affected by any sovereign rating actions taken as a result of the U.K.'s exit from the EU.

We could revise down our institutional framework assessment if there is a sustained recession in the U.K. that leads to downward pressure on grant funding through spending cuts, and additional pressure on local taxes. This could be further exacerbated by increased underfunding in areas such as social care, education, and environmental services. In addition, any permanent, recurrent costs (or lost income) arising from COVID-19 may add further strain to an authorities' finances. The unsuccessful implementation of key reforms or any instances of systemic failure leading to s114 notices being issued could also lead us to revise downwards.

We could reinstate a stable assessment if we see the implementation of a long-term financial plan for local authorities' financial sustainability, which includes sufficient funding to address specific service pressures and secure the future debt obligations. Furthermore, the resolution of key reforms providing clarity of funding to authorities, and not creating an imbalanced distribution system, as well as a fast recovery of operating balances that return to, or improve upon, pre-COVID levels, could also lead to a stable assessment.

Related Criteria

• Methodology for Rating Local And Regional Governments Outside Of The U.S., July 15, 2019

Related Research

• Institutional Framework Assessments For Non-U.S. Local And Regional Governments, Sept. 21, 2017