By Thomas Aubrey, Founder, Credit Capital Advisory and Affiliated Researcher, Bennett School of Public Policy
How can the Prime Minister finance his ambitions on regional infrastructure and council homes?
The Prime Minister has announced a raft of policy measures since he walked over the threshold of 10 Downing Street on July 20th. The cut in VAT for electricity, capped bus fares, and business rates discounts for businesses with a social function appear to be popular with the electorate. But it seems we will have to wait until the Autumn Budget for his big policy announcements on growth - including how they will be paid for - to be finalised.
Andy Burnham’s speeches have to date focused on building more council houses and rebalancing power away from Whitehall with the aim of boosting investment in regional infrastructure. Given the huge waiting list for social housing, which according to Shelter is now at 1.3m households, alongside the substandard levels of infrastructure investment across many city regions, this focus is welcome. Furthermore, the existing model of private housebuilders delivering housing independently of new infrastructure does not scale well. If Burnham is to be successful, any dramatic increase in council housing must be accompanied by large-scale infrastructure investment including new public transport systems connecting homes to jobs.
This infrastructure-led approach was recommended by the New Towns Taskforce and could indeed deliver the scale of investment and council housing that Burnham desires. But the Starmer government did not find any solutions to fund and finance these projects. The former Chancellor believed the private sector would build new towns based on large public subsidies using a public private partnership (PPP) approach. However, not only is there insufficient grant funding to subsidise the private sector, but by the Treasury’s own admission, this approach cannot deliver at the necessary scale. Furthermore, such a model would see housing delivered at a rate four times slower than a public-led model, and with significantly lower levels of social housing.
Burnham therefore needs to come up with an alternative plan to deliver large urban extensions with more council housing. Such a programme will likely cost tens of billions in investment and must be funded without damaging the public finances. There are at least four potential solutions to this challenge.
Four potential options
One approach is to borrow more by significantly increasing the amount of UK government bonds (‘gilts’) issued, in turn enabling departmental expenditure to provide the necessary grants. Jeremy Corbyn in 2016 proposed boosting borrowing and investment by £500bn. But this approach has numerous problems, as more gilts issuance - even for investment - will be poorly perceived by the bond market, increasing gilt yields and driving up the cost of borrowing. The UK is also experiencing a structural change with a fall in demand for gilts. Moreover, the UK government has a poor record of delivering projects due to governance failures which can clearly be seen in HS2. Finally, if Burnham is going to stick to the fiscal rules he has inherited - and he has said he will - then all other things being equal there is almost no ‘headroom’ left to allow for such borrowing.
The second is to continue with the Rachel Reeves plan and use the PPP approach to lend money via the National Housing Bank (NHB) to increase housebuilding. As noted above, this approach does not scale well and does not address the delivery of council housing. While it would be possible to extend NHB lending to local councils, once councils start delivering homes it would impact negatively on the existing fiscal rule, as the homes would not be recognised as a financial asset by the current measure of public sector net financial liabilities (PSNFL). Burnham could change the measure to public sector net worth (PSNW), which includes physical assets such as homes to offset against the money borrowed to build them. However, the bond market would react negatively to this approach as PSNW tells investors little about the government’s ability to service its debt and access the capital market.
The third option would be to exploit Burnham’s fiscal devolution plan where strategic authorities are to be provided with a share of local income tax revenues incentivising growth. While fiscal devolution is to be welcome, using this mechanism for large scale infrastructure investment is likely to be problematic in the medium-term. First, increasing local government borrowing will increase PSNFL (as above). Given the lack of fiscal headroom this will not enable projects to scale, even more so as some of them are likely to cross boundaries of more than one strategic authority. Moreover, issuing bonds against a share of income tax in this way would mean the borrowing would not be linked to project-specific finance, based on detailed costs and revenues. The cash flows arising from the infrastructure would be indirect, thereby increasing uncertainty for investors and subsequently increasing the cost of borrowing. In addition, this also creates governance concerns due to the lack of clear lines between the infrastructure project and business as usual which can result in significant scope creep for a large development. Even in Sweden, where generic local government debt is used for projects, this has led to governance concerns.
The fourth option is to return to the regional public corporation model that Britain pioneered in the 19th century which built large swathes of our infrastructure, and which over the last 50 years has been copied across Europe. The key to the success of these projects is to integrate housing, transport, utilities, green spaces and local amenities at scale and to use long term public corporation debt to finance the project. This solves for the ‘maturity mismatch problem’ where projects have high short-term costs but longer-term revenue streams.
How would a modern public corporation model work in practice?
Using section 190 of the 2023 Levelling Up and Regeneration Act, a development corporation can acquire land at close to use value (which excludes ‘hope value’ or the potential value flowing from a change in use), thereby enabling these projects to be financially viable. Once the infrastructure has been built and planning permission awarded, serviced land plots are then sold to developers, allowing the development corporation to capture the full increase in the uplift in land values. This model reduces risks for developers and hence will bring more SMEs into the market as planning risk has been removed. It also enables a far higher proportion of social rent homes to be delivered given the much higher level of planning gain captured than via other routes such as obligations under section 106 of the Town and Country Planning Act or the Community Infrastructure Levy.
When the revenue stream from the land value uplift is supplemented by other revenue streams - including social housing receipts, a portion of transport receipts, car parking receipts and business rates - the risk of the project falls considerably. Moreover, as the development corporation is self-funding the project, upfront plans are typically more detailed with care given to avoiding costly and unnecessary design components.
This public corporation debt is an asset class that is in demand by investors, yet the UK is one of the few advanced economies without a deep market. One reason behind this lack of issuance is that the UK is an outlier when it comes to international accounting standards because it includes self-funding public corporation debt within its fiscal rule. Hence, as above, this form of borrowing would count against the rule and eat into the Chancellor’s fiscal headroom. Other European economies use the framework developed by the pro-growth, fiscally conservative Bundesbank for the 1992 Maastricht Treaty - which treats self-funding public corporation debt as off-balance sheet. Germany, the Netherlands and Sweden all issue a significant amount of public corporation debt leading to much lower sovereign debt issuance and a lower cost of borrowing. The centralisation of the UK during the Thatcher era is one reason why the UK diverged from this model, hence devolution naturally raises the opportunity of pursuing this approach once more.
Indeed, a group of investors managing nearly £2 trillion of assets wrote a letter on this point to the former Chancellor seeking a consultation for the UK to align with international standards, but this ultimately did not go anywhere. The bond market believes that the status quo makes the UK a low growth economy, and one which does not offer an asset class widely demanded by investors.
The only option that works
If Andy Burnham wishes to see his political ambitions realised and deliver council housing and infrastructure at scale, there is only one realistic option that has a large evidence base: a renaissance of public corporation debt. If Burnham were to pursue this, he could immediately change the definition of public sector net debt (PSND) and exclude self-funded public corporations. This can be considered as ‘flexibility within the fiscal rules’. In 2008 self-funding public sector banks were removed from the definition so this approach already has precedent.
This does not mean that the Treasury should allow any project to proceed; it should move towards a risk-based framework for assessing which projects to support in this way. In reality, bond investors will only buy into projects that meet their risk return characteristics and hence they are the ultimate arbiters of the riskiness of projects.
Burnham’s Autumn Budget must therefore exclude self-funding public corporations from PSND, establish a Treasury risk-based framework, and pilot regional development corporations to deliver infrastructure-led council housing at scale. If he chooses another option, he is less likely to achieve his ambitions - with all the political and economic risk that implies.
Housing and infrastructure really do have to be considered together. Building homes is one thing; building places where people can get to work, schools and services is another. Housing targets become much more meaningful when we talk about the communities being created around them.
The exclusion of public corporation debt from the Excessive Debt Procedure is why, inter alia, European Government owned railway companies ran many of the UK rail franchises. These entities' economic signals clearly differ to those of General Government bodies because of their governance and financial focus. So the UK lumping them together is clearly odd. Clever debt minimisation structures for private entities are bankable especially through local authorities which have fewer borrowing restrictions but they probably can't deliver the necessary scale. I agree with you that the public corporation route is the way to go.