Contact: Paul Carey-Kent, (01962) 84 7525, e-mail: [email protected]

1 Background

1.1 In January 2006, Cabinet agreed to submit an Expression of Interest to the Government for support for a private finance initiative (PFI) proposal to replace street lighting columns in Hampshire. This Committee considered the report to Cabinet at its meeting on 25 January 2006 and asked for further information on the long term impact of a PFI scheme and any financial alternatives as a means of funding street lighting renewal.

1.2 This report identifies the possible funding strategies and the advantages and disadvantages of a PFI solution, using the street lighting project as an example.

2 Funding for street lighting renewals

2.1 The estimated capital cost of street lighting renewal in Hampshire is £92m over five years. This is a significant sum in the context of the County Council's total capital programme which averages £130m per annum over the four years from 2006/07. The Environment service's capital programme averages £40m per annum. This covers integrated transport schemes funded from Government support under the Local Transport Plan (LTP) and structural maintenance funded from the LTP and the County Council's own local capital resources. It would not be feasible to divert sufficient resources from programmes of that level to make a significant impact on a street lighting renewal programme of over £90m.

2.2 Possible funding mechanisms for capital schemes, apart from PFI, include:

· Government borrowing approvals and capital grants - it is unlikely that the Government will make available any support for street lighting renewal other than via a PFI solution

· capital receipts from the disposal of County Council land and buildings - expected future capital receipts are fully allocated to funding the existing capital programme. The level of capital receipts will be reviewed during summer 2006 but it is unlikely that a significant increase in capital receipts will be identified. First call on any additional resources will be to finance the small shortfall of capital funding resources in the existing capital programme approved by Cabinet in February 2006

· contributions from developers and other external bodies - unlikely to be a significant source for street lighting renewal

· contributions from the County Council's revenue budget - in the context of the pressure to contain the council tax, increased revenue contributions to capital of up to £92m would require a level of cuts in revenue services that is not feasible

· reserves - the capital reserve is already fully utilised to fund the existing capital programme. Other reserves are earmarked for specific purposes or are required as apart of the County Council's overall medium term financial strategy

· additional prudential borrowing - this option is considered in the following section.

3 Prudential borrowing

3.1 Prior to April 2004, the County Council could only borrow for capital purposes if the Government had issued a borrowing approval. This was relaxed by the Local Government Act 2003 which introduced a `prudential' regime for borrowing. The County Council is now able to borrow for capital purposes provided it complies with the Prudential Code for Capital Finance in Local Authorities, published by the Chartered Institute for Public Finance and Accountancy (CIPFA).

3.2 The debt charges (principal repayments and interest costs) on this prudential borrowing have to be financed by the County Council from its own resources No additional revenue grants are available from the Government towards the debt charges on prudential borrowing, which is also sometimes known as `unsupported' borrowing. The Government still issues borrowing allocations for schemes and programmes it wishes to support and these provide revenue grant towards the resultant debt charges, if the impact of the Government's grant damping mechanism is ignored.

3.3 Cabinet agreed a framework for the use of prudential borrowing in November 2003 which limited it to:

· borrowing for which loan charges are financed by virement from the executive member's revenue budget, including invest-to-save schemes that will generate revenue savings or additional revenue income

· `bridging' finance that will be repaid by eventual capital receipts, capital grants or contributions

· capital investment by business units

· limited borrowing for corporate priorities.

3.4 If Cabinet were to agree that prudential borrowing should be used to fund street lighting renewal, then either the executive member for Environment would be required to make savings in Environment's revenue budget to fund the debt charges likely to be around £5.8m per year, or additional funding would have to be provided to the Environment department. If that increase were funded from Council Tax, it would add 1.4% to the level of Council Tax (for 2006/07, clearly that would have made capping an issue). This is unlikely to be feasible given the scale of investment required.

4 Comparison of PFI and prudential borrowing

4.1 If the County Council is successful in obtaining the Government's approval for a PFI scheme for street lighting renewal, it would receive an annual revenue grant from the Government towards the capital costs of the scheme. Once the new street lighting provision is operational, the PFI provider will levy an annual charge on the County Council for providing the street lighting service. This `unitary' charge is payable over the term of the contract, say 25 years, provided the service is delivered to specification. It is usually variable only in accordance with an agreed annual indexation. It would cover all operational running costs as well as an element for the PFI service provider to recover the capital cost of the street lighting renewal and the interest costs on the loans raised to finance the scheme, together with a return on equity employed.

4.2 The Government's annual revenue PFI grant is based on a `PFI credit' calculated from the capital cost element within the unitary charge. The grant takes the form of an annuity sum over the term of the PFI contract, in this case 25 years say, calculated using an interest rate set by the Government. For PFI schemes for which grant is first payable in 2006/07, the rate is 6.0%.

4.3 The PFI service provider would use debt and equity finance to fund the capital cost of the scheme in the ratio of, say, 90% debt and 10% equity. In the application to the Government for the street lighting renewal scheme, it has been assumed that the rate payable by the PFI service provider would be 6.5% based on the London Inter Bank Offered Rate (LIBOR) plus 1%. The PFI equity funder would expect a return of, say, 15%. On a 90%:10% basis, this equates to an overall cost of capital of 7.35%.

4.4 The County Council is able to borrow at much lower interest rates, via the Public Works Loans Board. Rates change daily but, as at 8 March 2006, the County Council could borrow £92m over 25 years, repayable on the maturity of the loan, at 4.2% - provided the County Treasurer was able to confirm that such borrowing complied with the Prudential Code.

4.5 Simply in terms of interest rates, there is clearly a financial advantage to using prudential borrowing and avoiding a PFI arrangement - the difference between 4.2% and 7.35%. But using prudential borrowing would mean foregoing the PFI grant, which is equivalent to 6.0%. This swings the financial advantages heavily in favour of using the PFI route, provided the scheme wins Government approval. Simplifying the calculations and ignoring cashflow patterns, it is broadly the difference between paying 4.2% per annum for prudential borrowing and a net 1.35% via PFI procurement (7.35% less 6.0%). In simple annuity terms over 25 years, financing the capital element of traditional procurement would cost £5.8m per annum compared with a net cost of £0.9m per annum for the PFI route (£7.4m less grant of £6.5m).

5 Other advantages and disadvantages of PFI procurement

5.1 There are other considerations, however. Operational and energy costs of street lighting could be more or less expensive under a traditional or PFI procurement. However, the consultants advising on the PFI proposal, PricewaterhouseCoopers, suggest that this is not likely to be a significant factor either way. On energy costs, the large scale of the contract should enable the PFI provider to negotiate very competitive terms. The County Council could also, if it wished, retain the right to negotiate the energy contract under a PFI procurement.

5.2 The consultants have assumed that the PFI provider would be able to achieve economies of scale of about 2% on procuring the capital cost which would not be available to the County Council under a traditional procurement arrangement.

5.3 One disadvantage of PFI could be a loss of flexibility and control for the County Council over the period of the contract, eg 25 years, on issues such as future service and maintenance levels for street lighting. However, there would be a `change' clause in the contract that could be invoked by the County Council - at a price - if, for example, increasing energy costs meant that the extent of street lighting provision had to be radically reconsidered.

5.4 The County Council has yet to enter into any PFI contracts but there could be a cumulative impact on a local authority's ability to manage its budget if an increasing number of PFI arrangements are contracted. The County Council is unlikely to benefit for some years from the Government's Building Schools for the Future programme to renovate secondary schools, but that programme is mainly allocated through PFI procurement.

5.5 The three main advantages of PFI procurement are:

· accessing grant support from the Government that would not otherwise be available

· the certainty that street lighting will be renewed and maintained to a high standard for the period of the contract (after which the street lights would revert to the County Council for nil consideration). As the reverse of the argument about loss of flexibility, it guarantees that street lighting will not be seen as an easy source of resources to be diverted to other short term priorities.

· transferring some of risks of procurement and service provision from the County Council to the PFI provider, including the possibility of cost over-runs.

5.6 It is difficult to quantify these advantages and disadvantages, particularly the loss of flexibility and control over future service levels and the budget strategy. But if the County Council is satisfied that this can be managed in the context of the overall level of long term contractual commitments, it is unlikely that the remaining advantages and disadvantages would outweigh the significant benefit to be gained from accessing the Government's PFI grant.

Recommendations

1 That the committee notes the various issues relating to PFI, and comments as appropriate.

Section 100 D - Local Government Act 1972 - background papers

The following documents disclose facts or matters on which this report, or an important part of it, is based and has been relied upon to a material extent in the preparation of this report.

NB the list excludes:

1. Published works.

2. Documents which disclose exempt or confidential information as defined in the Act.

None

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