Long road ahead for leasing, by David Martin

8 Sep 05
The Prudential Code has not led to councils abandoning leasing for loans as predicted, but finance managers say it has freed them to borrow for major projects that will save money in the long term

09 September 2005

The Prudential Code has not led to councils abandoning leasing for loans as predicted, but finance managers say it has freed them to borrow for major projects that will save money in the long term

When it comes to asset management, local authorities are faced with one main question: do they borrow the money to invest, or do they use alternative funding options, such as leasing?

Following the introduction of the Prudential Code in April 2004, finance experts predicted a dramatic fall-off in leasing and a significant rise in borrowing to purchase assets. On the face of it, this assumption was not unreasonable, given that authorities can now borrow at very favourable rates from the government-backed Public Works Loan Board.

However, a survey shows that councils that have looked into the lease-versus-loan issue carefully have taken a more strategic view.

The survey, conducted for Siemens Financial Services in June this year, asked for local authority finance managers' views on the code and its effect on investment decisions. It covered more than 50 local authorities, including district, metropolitan, county and unitary councils.

Respondents consistently said the code had freed them to apply capital expenditure where it was most appropriate, but that there were still circumstances where leasing was the best option.

According to more than 80% of authorities questioned, capital expenditure was deemed appropriate for large 'spend to save' projects that had long-term substantial payback in efficiencies. Local authorities also cited the code's usefulness in enabling them to manage property portfolios more effectively: nine out of ten finance managers said this was one of its main benefits.

In particular, there was a widespread feeling that the code gives an authority greater freedom to devote capital expenditure to the acquisition of property, to obtain freehold over suitable properties and to avoid expensive rental agreements. The advantages of taking such an approach are exemplified by the London Borough of Ealing.

In its latest annual efficiency report, the code features prominently in the council's plans to meet its Gershon savings target. 'Key elements include… under the Prudential Code, swapping costly office lease rentals with lower debt financing costs through freehold acquisition,' Ealing says.

At the same time, the survey highlighted a marked reduction in the use of leasing agreements for fixtures and assets, such as street lighting, that have little residual value and are not returned at the end of the contract. The introduction of the code means that in these circumstances, leasing now offers little advantage over borrowing.

However, 80% of finance managers said they favoured leasing over capital expenditure where an asset's residual value was easily and reliably calculable, allowing for a straightforward operating lease to be negotiated.

Almost nine out of ten said the ability to dispose of assets in the secondary market at the end of the leasing contract term — and the resulting potential for councils to achieve cost savings — was a significant benefit.

At the same time, being able to negotiate a single financial agreement for the asset and its ongoing care was seen as enhancing local authorities' ability to plan their finances.

What also came through strongly in the research was finance managers' desire for stronger direction on which financing options were appropriate and in what circumstances. Survey respondents unanimously said they would appreciate a greater degree of guidance in the code on the finance options best suited to particular types of expenditure.

This is driven largely by a fear that misapplication of the code could lead to adverse audit judgements in the future. Each authority's finance team currently has to formulate its own business rules, leaving room for mistakes.

Local authorities are already taking into account all the funding options available and trying to ensure they make the right choice between leasing and loans.

But it would seem sensible that, as best practice in the new asset management environment develops, it is set out in a more explicit manner in the code for the benefit of local authorities' purchasing officers.

Overall, however, it is clear that councils feel the advent of the Prudential Code has given them valuable new freedoms to fund investment in their services in the most efficient and prudent way.

David Martin is head of public sector at Siemens Financial Services