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National financing authority for local government—Options assessment Dear Matty In accordance with Official Order 10008238 dated 30 October 2012 pursuant to the Deed between the Commonwealth as represented by the Department of Prime Minister and Cabinet and Ernst & Young dated 15 June 2010, we are pleased to present our report on options for aggregating the debt finance sought by the local government sector in Australia. This report has been prepared on your instructions solely for the purpose of providing advice on options for aggregating the debt finance sought by the local government sector in Australia, and should not be relied upon for any other purpose. Any use such third parties may choose to make of our report is entirely at their own risk and we shall have no responsibility in relation to any such use. Yours sincerely Darrin Grimsey Partner back to top Release noticeErnst & Young was engaged on the instructions of the Department of Regional Australia, Local Government, Arts and Sport ("Department") to undertake a review of options for aggregating local government debt in Australia ("Project"), in accordance with the official order placed on 30 October 2012. The results of Ernst & Young's work, including the assumptions and qualifications made in preparing the report, are set out in Ernst & Young's report dated 21 March 2013 ("Report"). You should read the Report in its entirety including the applicable scope of the work and any limitations. A reference to the Report includes any part of the Report. No further work has been undertaken by Ernst & Young since the date of the Report to update it. Unless otherwise agreed in writing with Ernst & Young, access to the Report is made only on the following basis and in either accessing the Report or obtaining a copy of the Report the recipient agrees to the following terms.
back to top Executive summaryLocal infrastructure is the backbone of our communities and our regions. Providing and maintaining this infrastructure is one of the most important responsibilities faced by Australian councils, but it also presents one of their largest challenges. Strong Foundations for Sustainable Local Infrastructure, the Ernst & Young report launched by the Australian Government in June 2012, suggested that there is a suboptimal use of debt finance within local government which is contributing to an under-provision of infrastructure by the sector. Building on recommendation 3 of the report, Ernst & Young has been engaged to develop this finding further. The objectives of this study are:
The case for actionNational local government financing vehicles operate effectively in a number of countries, and in some cases have been in existence for over a century. In other countries where they do not currently exist, notably France and the UK, planning is relatively advanced. Precedent alone does not justify change in Australia. Indeed, it is widely acknowledged that Australian councils already have good access to debt finance, in the form of bank credit or—in some jurisdictions—loans from treasury corporations or a collective vehicle. But the fact remains that councils in Australia are not taking advantage of the opportunities they have to use debt as a resource to contribute to the growing infrastructure task. They continue to think that borrowing is "bad", it is too expensive, and that it introduces significant financial risk that they are unable to manage. We do not underestimate the risks and costs that come with debt. Nor are we in the business of telling councils that they must borrow more. However, we do see a strong case for offering councils greater confidence in accessing finance at the best possible rates and the same opportunities that other governments enjoy in terms of tapping into a pool of institutional investment that is hungry for low-risk credit products. The incentives for intervention include:
RecommendationStrong Foundations for Sustainable Local Infrastructure suggested that a national collective financing vehicle for the local government sector could assist address the suboptimal use of debt in the sector by:
Importantly, a national collective vehicle must be designed so that it achieves these objectives with a minimal impact on the relationship between the local government sector and the Commonwealth, states and territories. It will be an "enabling" organisation, with a role of giving councils access to cost-effective debt, without forcing them to take it on where not appropriate or desired. Nothing about the organisation should take away from each and every council the responsibility for sound financial management and decision-making. There are a number of different models for collective financing vehicles overseas. We have evaluated a long-list of 11 options which satisfy the broad requirements set out above but are distinct by virtue of different permutations of factors of ownership, the providers of any credit enhancement and the nature of any credit enhancement. The evaluation criteria applied address the key success factors around purpose and function, impacts on other governments, market credibility and participation rates. The option which scored highest in the evaluation represents a tailored structure which we believe would be suitable to the unique Australian landscape: The preferred model is a collective financing vehicle established by a group of councils with the objective of issuing debt securities to the capital markets and on-lending the funds to members. It has the following features:
In identifying a preferred option, we acknowledge that the evaluation undertaken suggests that several models are closely ranked. This outcome largely reflects the broad similarities among the commercial characteristics and structure of the options. Some features and benefits are, as a result, found in all the options identified. These include the potential to provide financial benefits, for those entities which borrow, in the form of lower arrangement and servicing costs, and the potential to stimulate a higher rate of investment in priority projects which produce positive economic, social and/or environmental outcomes. However, the evaluation process suggests that marginal differences in the credit support structures and the proximity to councils could have a significant impact on stakeholders and processes. The following factors, when combined, were crucial in differentiating the preferred option from other options, and demonstrating a benefit when compared to the status quo:
International precedentsIn developing the case for a national financing authority in Australia, there are a number of lessons that can be learnt from international experience. In particular:
Throughout this report there is a strong focus on identifying and capturing the lessons from overseas. A comparative analysis of the international agencies is provided in Appendix D. Next stepsMoving to the next stage of development will need a concerted effort by all tiers of government. If there is appetite to take this initiative forward, we anticipate that the next steps should be:
We recognise that the establishment of a national financing authority for local government would be a considerable challenge. Firstly, a national financing authority will only succeed if a minimum number of councils are minded to join it. A critical mass would be required to give the authority the buying power in the market to raise funds and pass on capital to councils at low interest rates. Secondly, the idiosyncrasies of the Australian federal system, the different conditions and arrangements in different jurisdictions, and the multitude of stakeholders, mean that the path to reform has many obstacles. However, we urge the Australian Government to continue to work with jurisdictions and local government on this initiative. Providing the apparatus for councils to develop the same market presence and fund raising capacity as other governments could present a real opportunity for the sector to move to an optimal debt load and ultimately reduce the substantial backlog of priority infrastructure projects which create and sustain amenity in local communities. This objective is, we believe, consistent with the vision for strong and sustainable Australian councils which is shared by all tiers of government. back to top 1. The case for actionThis section provides context to the recommendation for a national financing authority by identifying and substantiating the case for action. In particular, it:
The analysis in this section is developed further in Appendix A. Debt and the infrastructure taskLocal infrastructure is the backbone of our communities and our regions. Underinvestment in this infrastructure results in constrained economic activity, reduced amenity for communities and declining social equity. But the costs of infrastructure are high and lumpy, and at a time when there are many competing demands on revenues, meeting these costs places significant pressure on council budgets. Leveraging core revenue sources to access debt is an option open to all councils as a means of contributing to the significant upfront costs common to most infrastructure projects, and can be the difference between a project going ahead or not. Borrowing is a common feature of private sector capital structures and does not mean that a council is acquiring things it cannot afford. Rather, in the context of sound financial management and project planning, the key benefits of debt are that it can:
Overlooking debt as a source of capital can prevent infrastructure investments from going ahead because councils often do not have adequate alternative resources to fund projects with lumpy cost profiles. The consequence of delay and non-investment is that the infrastructure gap gets bigger—or at the very least, it does not get smaller—and the local government sector's capacity to deliver economic, social and environmental benefits and contribute to national productivity, is significantly weakened. Debt in the context of local government fundingDebt is a source of finance, and it is important to understand that this is not the same as funding. Funding is how infrastructure is paid for. Finance describes the money that has to be raised upfront to deliver the infrastructure, and—unlike funding—it needs to be repaid. In other words, infrastructure must be funded, irrespective of how it gets financed. This means that while financing can support funding, it is ultimately a secondary consideration. Local infrastructure is (and will remain) funded by the community through taxation and user charges and revenues received from other tiers of government. Meeting the infrastructure task will always be dependent upon the quantum of this funding. Additional finance may make possible individual projects or programs when funding is constrained, but it is not the solution to the underlying issues of sustainable funding. But while financing will always be dependent upon funding, it can be crucial to the timely delivery of key community infrastructure projects. Debt finance enables councils to deliver infrastructure earlier than they otherwise would have been able and to spread the costs amongst future generations who will enjoy the benefit of the investments. The suboptimal use of debtIt is widely acknowledged that most Australian councils do have access to debt finance, either in the form of bank debt or services provided by the state/ territory government or an existing collective agency—and hence there is no demonstrable failure of the market to provide finance. But the fact remains that—as a general rule—Australian councils continue to adopt a cautious approach to borrowing. There remains a clear reluctance to borrow as an appropriate method of paying for infrastructure. Most councils prefer to use current year funding in the form of rates and grants receipts for this purpose, rather than utilise debt finance to match the incidence of the costs to the benefits, and ensure that current ratepayers are not shouldering a disproportionate burden. This is caused in part by an information asymmetry between councils as borrowers and the providers of finance that arises because councils often do not have the background and skills to make informed judgements about the risk of borrowing. The evidence of the reluctance to borrow supports the view that councils make an overly pessimistic assessment of the risks of using debt, despite possessing what lenders clearly consider to be sound credit fundamentals. Related to the information gap is the fact that the local government sector does not currently have the tools to tap into or create an interface with the institutional investment markets. Most Australian councils are relatively small entities and as such get less "attention" from capital markets than, say, state or territory governments or large corporations. And because they issue debt in a fragmented way and typically in relatively small quantities, the costs incurred are significantly greater than would be the case if there was the opportunity to work together. Aggregation as the key to unlocking the marketsA targeted policy intervention is required to facilitate the introduction of additional private capital into the local government sector and to enable the reluctance to borrow to be overcome. A coordinated effort by all tiers of government is necessary to spread awareness of the implications of unduly low levels of debt for councils' ability to invest in their assets. The central objective of action should be to assist the aggregation of the smaller borrowing needs of councils through a collective vehicle, which would develop a communal buying power and the required security to gain a strong credit rating. This in turn would enable councils to access lower cost borrowings, while also introducing operational efficiencies and administrative synergies to drive costs down. In current market conditions, there is likely to be a strong demand for low-risk government or quasi-government instruments, which a collective vehicle would be able to satisfy by issuing bonds into the capital markets, and on-lending the proceeds to participating councils. Providing access to debt in this way is not to say that every council should participate and should be seeking to increase its borrowings and financial gearing. Ultimately the capacity to raise debt will be a function of the capacity to fund debt servicing payments for the term of the loan, and to repay the principle once the term has expired. It must never be forgotten that the availability of finance will always be a secondary consideration to the availability and application of funding. Towards an Australian national financing authorityIf it is to fulfil this role and bring substantive benefits to the local government sector, there are some overarching principles, design features, or prerequisites, which are inherent in accessing wholesale finance markets and must be present in a national financing authority for Australian local government. These features (articulated below and in more detail in Appendix A), should be present in any option taken forward for further consideration.
back to top 2. A national financing authority for local governmentThis section summarises the evaluation of options undertaken and describes the key features of the preferred model. The detailed options evaluation is included in Appendix B. OptionsIn this study, we identify 11 options for a potential national financing authority for local government in Australia:
10 of the 11 options meet all the "core" functional requirements with respect to fund raising and lending to councils set out in Chapter 1. Each option is distinct by virtue of different permutations of factors relating to:
The final model (Option 8) is a "pass-through model", and as such does not meet all the "core" prerequisites previously identified. This option would involve the establishment of a vehicle to act as a financial intermediary or arranger of debt for participating councils requiring finance for specific projects or programs. It would react in response to demand and not have a regular presence in the bond market. The options are described in more detail in Appendix B, and—where relevant—appropriate precedents are referenced. Evaluation criteriaThe role of the evaluation criteria is to provide a basis for differentiating between the options. While many of the concepts and practical administration considerations are common across all the identified options, there are important structural and ultimately commercial differences. The following criteria are used in the evaluation of options for a national financing authority and are based upon the motives for action previously described. The criteria address the key success factors around purpose and function, impacts on other governments, market credibility and participation rates.
Preferred optionThe detailed evaluation of all models is in Appendix B. The evaluation suggests several models are closely ranked. This outcome largely reflects the broad similarities among the commercial characteristics and structure of the options. However, the evaluation process suggests that marginal differences in the credit support structures and the proxy to councils could have a significant impact on stakeholders and processes. The evaluation focuses on testing those impacts. The highest scoring option overall is 6c. This option consists of an entity established by a group of councils, with the membership required to contribute an upfront capital sum and enter into a mutual obligation in support of the entity. This obligation would be capped at a level broadly proportionate to members' borrowing or financial position and would be secured against their revenueraising powers. As with all options identified, the potential financial benefits, for those entities which borrow, include lower arrangement and servicing costs. The potential economic benefits include a higher rate of investment in priority projects which produce net economic, social and/or environmental benefits. With reference to the specific characteristics of Option 6c, the following factors (in combination) were crucial in differentiating it from other options:
Two key risks are identified with this option:
Preferred option—key featuresAlthough we have not developed a detailed specification for the authority, the following features and considerations are likely to be important.
back to top 3. Next steps and implementation considerationsThis section includes a discussion of the potential next steps with regards to developing the preferred option further and considering issues around implementation. Moving to the next stage of development will need a concerted effort by all tiers of government. In New Zealand, where it could be argued that the political landscape is easier to navigate on account of its two-tier system, three years were needed to progress the Local Government Funding Agency from a concept to reality. Broadly, the next steps for this initiative should be:
1) Policy consultationDeveloping the momentum for a national financing authority will be a function of the degree of consensus among federal, state and territory governments. This consensus primarily relates to accepting the case for action and the substance of the solution. For these reasons, it is suggested that policy authorities consider using a coordinating body such as a COAG Ministers' Forum to prepare a consensus policy position. It is anticipated that the main areas of discussion will be:
2) Further commercial and legal investigationThis study is preliminary in several areas, and has not had the benefit of close access to stakeholders. To progress the investigation of options, the assessment in this study should be validated in the context of updated information and discussion. In particular, the commercial structure of the preferred option(s) needs to be further developed so that it focuses on the role and function of the entity, the risk allocation between investors, intermediaries and borrowers, and the credit risk related to lending to the authority. These aspects are explored below.
The accounting treatment of participation by councils in a national financing authority will ultimately reflect the substance of the commercial arrangements attached to membership. Without knowing the precise nature of those commercial arrangements, it is too early to offer a view on the impacts for financial reporting by councils. However, some important considerations are addressed below.
back to top Appendix A—A national financing authority in contextLocal infrastructureIn Australia, all three tiers of government share responsibility for planning, delivering and maintaining public infrastructure. Local government is responsible for a stock of assets most recently valued at over $300bn, which it is required to maintain to a minimum quantity and quality to fulfil its legislative mandate to local communities.1 Council-provided infrastructure is the backbone of our communities and our regions. It provides access to welfare, education, transport, sport and recreation. It serves key environmental functions, such as waste collection and disposal, and enables services to be produced and consumed in the community by residents, workers and visitors. Providing and maintaining this infrastructure is one of the most important responsibilities faced by Australian councils. It also presents one of their largest challenges. Underinvestment in the right infrastructure results in constrained economic activity, reduced amenity for communities and declining social equity. But the costs of infrastructure are high and lumpy, and at a time when there are many competing demands on revenues, meeting these costs places significant pressure on council budgets. Together, the Commonwealth, states, territories and councils have a duty to ensure this challenge is addressed and that essential infrastructure is delivered. Strong Foundations for Sustainable Local InfrastructureIn June 2012, the Minister for Regional Australia, Regional Development & Local Government released Strong Foundations for Sustainable Local Infrastructure, a review undertaken by Ernst & Young that examines how local government plans, finances and delivers infrastructure investments.2 The 13 recommendations contained within the report are designed to provide a way forward for the local government sector to make the most of the tools and levers it already has, while at the same time to be open-minded to new ways of doing things. The focus is on ways in which councils can get more infrastructure from existing funding sources and the recommendations cover three broad areas:
The report was well-received throughout the sector and by key government stakeholders. Subsequent to the publication of the report, the Commonwealth has been active in assessing the merit and practicability of the recommendations. In doing so, it will require the cooperation of state and territory governments, local government peak bodies, councils and the private sector. Borrowing for local infrastructureCouncils, like any project sponsor, must consider all the associated costs of delivering their infrastructure priorities. This includes the upfront capital spend and all ongoing expenses related to repair, maintenance, renewal and financing. All these future costs should be taken into account when deciding whether or not to commit to any project. It is the capital for upfront expenditure, however, which generally presents the largest challenge. This is because infrastructure is by its nature capital-intensive and there is almost always the need to raise significant funds at the beginning of a project to pay for the construction and commissioning of the asset. There are many competing demands on councils' core revenue sources (primarily rates and grants). When core sources of funds are constrained in this way, access to cost-effective finance can be the difference between a project going ahead or not. One of the central findings of Strong Foundations for Sustainable Local Infrastructure was that there is significant capacity within the local government sector to optimise its level of borrowing for the purpose of capital spend on infrastructure. Although there is a readily accessible pool of finance available to some in the sector, there is a demonstrable preference not to use debt as an appropriate method of paying for infrastructure. This in turn is having a negative impact on the infrastructure gap. Provided that the ongoing costs of servicing debt are affordable, then the focus of project providers can be on the economic and social benefits of investing wisely in infrastructure. Borrowing is a common feature of private sector capital structures and does not mean that a council is acquiring things it cannot afford. In the context of sound financial management and project planning, the key benefits of debt are that it can:
The consequences of the suboptimal utilisation of debt financeOverlooking debt as a source of capital can prevent infrastructure investments from going ahead because councils often do not have adequate alternative sources of capital to fund projects with lumpy cost profiles. As a result, many councils prefer to wait until capital costs are funded (in large part by federal or state government grants), which can take years to secure. The consequence of delay and non-investment is that the infrastructure gap (also known as the infrastructure deficit or backlog) gets bigger—or at the very least, it does not get smaller. The infrastructure gap is essentially the difference between the required investment in infrastructure—on a forward looking basis—and the actual investment. It represents an acknowledgement that every council in Australia has identified priorities for its community which it is unable to fulfil. Numerous attempts have been made to monetise the gap at all levels: council, region, state and national. While each attempt to quantify the gap uses a different methodology and results in a different answer, there is no doubt that the gap does exist and that, on an aggregated basis, it is very large.
The following reports are just a selection of the many studies in recent years that have focussed on assessing the financial sustainability of the local government sector and the implications of a growing infrastructure gap. National: PricewaterhouseCoopers, National Financial Sustainability Study of Local Government, 2006 New South Wales: Local Government & Shires Association of NSW, Are Councils Sustainable?, 2006 (Allan Report) South Australia: Financial Sustainability Review Board, Rising to the Challenge: Towards Financially Sustainable Local Government in South Australia, 2005 Tasmania: Access Economics, Review of the Financial Sustainability of Local Government in Tasmania, 2007 Western Australia: Western Australian Local Government Association, The Journey: sustainability into the future, shaping the future of local government in Western Australia (Systemic Sustainability Study), 2008. This study does not attempt to quantify the infrastructure gap. This would be a significant undertaking, not least because the quality and standardisation of data and financial reporting across the sector is variable. Although a substantial amount of work is underway in most states and territories to improve the level of knowledge of infrastructure, many councils are starting from a low base and even those with more sophisticated systems and processes acknowledge material gaps in their understanding of the condition of their stock of infrastructure. By way of illustration, it is telling that the Australian Local Government Association (ALGA) has recently engaged consultants to run a pilot just to establish whether there is sufficient data and information to understand the state and condition of the class of asset—local roads—which is generally considered to be the best documented.3 Eliminating the infrastructure gap should not be the aim of a national financing authority—this will ultimately come down to the community's willingness to pay to do so and will rely on considerable effort by all tiers of government to support capacity building initiatives. A collective borrowing agency alone will not fill the gap, but could provide councils with the machinery to make significant inroads into it. Despite the uncertainty around the precise size and composition of the backlog, at a minimum there is enough evidence of its approximate size to justify action by government to assist councils to address it themselves. Without such an intervention, there remains a significant risk that capital investment over coming years will continue to fall well short of what is needed to meet the infrastructure needs of Australian communities.
There is limited consistency in how state and territory governments facilitate local government borrowing programs. This means that the actual cost of local government debt finance varies significantly between states on structural rather than practical grounds. Consultations with some of the financially stronger New South Wales councils highlighted that while availability of bank debt had not been an issue, recent pricing had been a significant deterrent in assessing a number of infrastructure enhancement opportunities. One example noted was based on upgrading a range of sporting facilities. The package of upgrades was forecast to generate additional council revenue in the medium-term, but the short-term debt costs were judged to be too high for council to accept the cash flow risks. It was noted that a reduction in debt costs of just 50 basis points would have provided the headroom for the upgrade to be implemented. The project did not qualify for interest payment assistance under the Local Infrastructure Renewal Scheme (LIRS). Barriers to optimising the use of debt finance for infrastructureStrong Foundations for Sustainable Infrastructure found that the flow of debt financing into the local government sector is constrained by:
The consultation undertaken revealed that the reluctance to borrow is often informed by a perception that the community regards a low debt position as a reflection of sound fiscal management. It does not appear to be widely understood that, in fact, a low debt position means that current ratepayers are meeting the full cost of infrastructure assets, while in reality much of the benefit will actually be gained by future generations. This is compounded by overly pessimistic views of financial risk and the probability of distress, which is not consistent with historical evidence of local government default. Debt will always have associated costs and risks. These costs include not just interest payments but transaction costs and complicated processes and due diligence requirements. They are costs and risks however, that can be mitigated through responsible financial planning and through taking advantage of the availability of secure and competitively priced debt products. They are costs and risks which must be weighed up against the upside of being able to deliver or bring forward key infrastructure priorities which might not otherwise have been possible. Decisions about whether to take out borrowing facilities will remain a question for individual councils based upon the relativity of the benefit of the project and the ability to meet the payments associated with it (see below). These decisions should be informed not by a cultural reluctance to borrow, but by a considered assessment of the costs and benefits of alternative financing solutions. How indebted is local government and what is the optimal debt load?Levels of indebtedness, regardless of the source of debt, are very uneven across the sector. As a general rule, however, Australian councils continue to adopt a cautious approach to borrowing for infrastructure. There remains a clear preference to use current year funding in the form of rates and grants receipts for this purpose, rather than utilise debt finance to match the incidence of the costs to the benefits, and ensure that current ratepayers are not shouldering a disproportionate burden. A number of local mayors write with pride in their annual reports that they have succeeded in reducing their levels of debt to zero. Queensland Treasury Corporation reports that 22 of 73 councils in the state have no outstanding debt at all. Indeed, many councils (a third of councils in South Australia, for example) have negative indebtedness—that is, their financial assets exceed their borrowings. The Tasmanian Auditor-General recently concluded that "in almost every case, councils' financial assets exceed total liabilities indicating they are in strong positions to meet short-term commitments and there is a capacity to borrow should the need arise."4 It may be that these councils are successfully managing their infrastructure backlog and have no need for additional expenditure; however this seems unlikely in light of the findings of a multitude of independent reports in almost every jurisdiction indicating that capital expenditure on existing assets is significantly less than what is required. Indeed, consultations with state governments carried out during this study have suggested that there are numerous cases of councils that are maintaining zero debt policies while at the same time having low infrastructure renewal ratios.
As part of the annual report on local governments in the state, the Victorian Auditor-General conducts an analysis of councils' indebtedness. The analysis looks at non-current liabilities (mainly comprised of borrowings) as a percentage of own-sourced revenue (as opposed to financial gearing where debt is generally compared to net assets): In 2011, the Auditor-General concluded that in relation to indebtedness, only 3% of councils are at high risk (defined as "potentially long-term concern over ability to repay debt levels from own-source revenue"), with 10% at medium risk ("some concern") and 87% at low risk ("no concern"): The most recent ABS data (from 2010—11) shows that, nationally, debt represents only 2.8% of net assets at the local government level, and that interest payments represent 1.4% of total council revenue.5 This suggests that there is greater capacity to service borrowings.
Optimising the use of debt is not to say that every council should be seeking to increase its borrowings and financial gearing. There is no right or wrong level of debt, and there is considerable debate about the definition of a sustainable level. Indeed, the Nationally Consistent Frameworks on local government financial sustainability, which were introduced in 2007 to provide a set of aspirational principles and best practice guidelines, recognised the limits of tightly-defined indicators which "individually and without associated explanations … can only ever tell part of the story".6 A future national collective lending vehicle would—as discussed in this report—be able to apply similar restrictions on members, if it were deemed appropriate. Do councils have the capacity to borrow more?The noticeable improvement in asset management techniques in recent years is providing councils (both elected members and officers) with a better appreciation of whole-of-life costs associated with infrastructure. It has been observed that this is leading to a greater awareness of the implications of unduly low levels of debt upon councils' ability to invest in their assets. A recent practice note issued as part of the Commonwealth's Local Government Reform Fund (2012) stated that "many councils have very low levels of net financial liabilities (debt and other liabilities less financial assets) relative to their revenue levels and the level of infrastructure assets they manage. A soundly based long-term financial plan can highlight the affordability and impact of additional borrowings (e.g. to address warranted but otherwise unachievable asset renewal). A modest increase in borrowings to fund priority needs would typically add materially very little to most councils' total operating costs. While organisations should not borrow unless necessary to satisfy their objectives, they should also not be averse to borrowing where this is warranted, to provide cost effective and affordable, desired levels of service."7 Within the limits of any restrictions which may be placed on councils' net borrowing, ultimately the capacity to raise debt will be a function of the capacity to fund debt servicing payments for the term of the loan, and to repay the principle once the term has expired. The availability of finance will always be a secondary consideration to the availability and application of funding. While some local infrastructure investments (such as airports, car parks and water assets) have the potential to be self-financing, the majority of local infrastructure does not have a business model that supports the generation of revenue. Debt servicing must therefore be met out of councils' core funding pools. As the source of funds over which councils have the most control, there is a clear nexus between the rating effort and the ability/willingness to raise finance for infrastructure. In many cases, rates increases may be required if additional debt is to be sourced. In this context, we note the view recently expressed by the Independent Local Government Review Panel in New South Wales that "keeping rates artificially low and failing to borrow when appropriate can be just as irresponsible as over spending".8 There are a small number of cases where councillors have proved that appropriate community engagement can help win support for clear and robustly developed infrastructure plans which are (partially) financed by borrowings. The City of Onkaparinga, an outer metropolitan council in South Australia, for example, has made strategic use of borrowing through its Major Projects Fund, whereby council resolved to raise rates by 1% per annum above previously determined rates increases, and to quarantine the additional income for the repayment of a debt facility to finance an infrastructure works program. The size of the facility is determined by the amount of revenue earned through the rates levy. The justification for increasing rates to fund debt servicing will ultimately be a subjective matter for councillors and the community based upon:
Aggregation and institutional investmentWhile debt finance in the form of conventional bank loans (or in some states and territories, treasury corporation loans) is readily available to councils in Australia, the local government sector has not been able to tap into or create an interface with the institutional investment market. Most Australian councils (outside of South East Queensland) are relatively small entities and as such get less "attention" from capital markets than, say, state governments or large corporations. Furthermore, because they issue debt in a fragmented way and typically in relatively small quantities, the costs incurred are significantly greater than would be the case if there was the opportunity to come together. The sector does not, for example, issue its own bonds. The minimum bond offer required to maximise the prospects of a liquid secondary market is generally considered to be around $100m. This is beyond the needs or capacity of the vast majority of Australian councils, and it is only through aggregation that a sufficient borrowing capacity can be achieved to justify going to market. Aggregating the smaller borrowing needs of participating councils is key to creating a communal buying power and a larger unit with the required security to gain a strong credit rating, thus enabling councils to gain access to lower cost borrowings, while also introducing operational efficiencies and administrative synergies to drive costs down. If the scale can be created, the evidence shows that there would be considerable appetite for local government bonds. Local government instruments would be seen as relatively low-risk investments, as councils enjoy steady and secure income streams in the form of rates and untied or general purpose government grants, which can be used to meet debt servicing obligations and to secure debt facilities. The establishment of robust liquidity buffers and credit enhancement arrangements—explored later in this study in relation to different models for a national financing authority—could further boost the standing of local government securities in the eyes of investors. In current market conditions, and in light of the introduction of APRA regulations implementing the Basel III recommendations around the quality of assets held by authorised deposit-taking institutions (ADIs), there is likely to be a strong demand for low-risk government or quasi-government instruments, which a national financing authority would be able to satisfy. The status quo is that the institutional investment market has the capability, but not the confidence or appetite for transaction costs, to invest; whereas councils have the pressing need for private funds, but not the means to access them. Aggregation can create the scale needed to incentivise institutional investors to spend on due diligence and ultimately make funds available which in turn can be on-lent to councils in the form of cost-efficient and stable debt products, hence enabling the sector to take advantage of its fundamentally sound attributes as a borrower. A collective vehicle is a tried and tested response to these circumstances to enable this relationship to form. A national financing authorityMaking inroads into the local infrastructure gap while simultaneously building financial sustainability will require a sustained effort on the part of all tiers of government. Strong Foundations for Sustainable Local Infrastructure suggested that centralising the provision of finance at an aggregated level might result in the creation of a critical mass which could be utilised by the sector to develop financial instruments to channel institutional investment into local government infrastructure, lower finance costs, and address the reluctance to borrow. The national financing authority as a concept would represent a targeted policy intervention designed to facilitate the introduction of private capital into the local government infrastructure sector, to lower financing and transaction costs for councils, and to complement Commonwealth and state/ territory policy objectives around financial sustainability and capacity building. A national financing authority—essential features and considerationsThere are numerous forms that a national financing authority might take and similarly there are many common elements which could be expected in all forms. Before proceeding to propose and evaluate models, it is important to lay out some overarching principles, design features, or prerequisites which are inherent in accessing wholesale finance markets and must be present to enable the authority to fulfil its role. It is anticipated that these features, which fall into the following categories, will be present in each option (with the exception of Option 8, which is a non-lending "pass-through" model).
1. PurposeThe purpose of the authority would be to pool the borrowing needs of participating local government bodies and draw in investment by issuing financial instruments. Participating members contemplating investment in their infrastructure priorities would benefit from low-interest rates and favourable terms, and could access a range of low-cost and flexible financial services. The authority would focus upon using the combined creditworthiness of participants (whether or not explicitly enhanced) to attract financing from institutional investors. Its purpose would be to channel that finance to participants; it is not intended to be a fund with a particular investment mandate (i.e. to ‘pick winners’), meaning investment decisions must remain with councils. A key principle underpinning the entity's purpose is that the risks of delivering specific infrastructure projects will remain with local government. As such, councils should be focussed on managing their levels of financial risk. The availability of new debt products should not dilute the responsibility or incentives for councils to mitigate these risks. Councils do this now through their internal management capability and robust treasury management processes and should continue to do so. 2. Ownership and governanceThere are a number of different ownership models which might be implemented, and this is a key differential between some of the options assessed in Appendix B. It is anticipated that the authority would be owned exclusively by government entities (federal, state/territory, local or a combination). This is largely consistent with precedent municipal financing agencies which exist overseas, although the relative stakeholding of different tiers varies considerably:
In each case, the proprietary structure of the entity is a function of the unique status held by local government vis-à-vis other tiers of government. This is no different for Australia, and is especially important given the federal or "three tier" structure of government. The national financing authority would need to comply with the legal obligations flowing on from the Corporations Act and related regulations. As an incorporated entity, there would be a board which would fulfil a crucial oversight function and demonstrate to the markets the competence and procedural rigour built into the authority's structures and processes. The governance structure will need to demonstrate a clear line of accountability to the participating local government entities. The board must be appropriately skilled, understand the owners and represent their interests. The board may also (depending on the final form) include representatives from the states and territories who have legislative responsibility for local government, and there may be some role for the Australian Government. As a government related entity, the national financing authority would also need to meet the competitive neutrality requirements of the National Competition Policy principles, and relevant state legislation.
The National Competition Policy (NCP) came into effect on 11 April 1995. It represents a commitment by all Australian governments to a consistent national approach to fostering greater competition in the Australian economy. The NCP is underpinned by the Competition Principles Agreement (CPA), which outlines the commitments by the states and territories to introduce and apply competitive neutrality policy and principles to local governments and government agencies. Government owned businesses may enjoy a net competitive advantage by virtue of their exemption from various forms of taxation, regulatory requirements and other costs faced by their private sector counterparts. Such differences can distort competition and undermine market efficiency. The objective of competitive neutrality policy is to remove any net competitive advantage enjoyed by significant government business enterprises resulting from their public sector ownership. The following key points outline how competitive neutrality might relate to NFA under CPA policy and principles:
The Local Government Finance Authority of South Australia, for example, pays a fee in return for the state government guarantee, equivalent of approximately 20 basis points of its base average liabilities. It also makes payments equivalent to company income tax. The liability is calculated on an accounting profits basis and the amounts are paid into an account established with the State Treasurer which are then made available for local government development purposes as recommended by the Local Government Association of South Australia and agreed to by the Minister for Local Government. In issuing financial products and instruments, the national financing authority would be required to comply with the regulatory requirements of the Australian Securities and Investments Commission (ASIC), the Australian Prudential Regulatory Authority (APRA) and potentially the Reserve Bank of Australia (RBA). Depending on the corporate form and relationship with participating councils, the reporting obligations in state and territory local government acts may also be relevant. Member councils might be required to report their relationship with the entity in their annual financial statements, including:
Transparency of reporting and compliance with law and regulation will be an essential component of establishing confidence in the entity. 3. Membership and participationTo receive any services from the national financing authority, a council would need to become a member. Membership would not represent an obligation to use the authority exclusively, and members would retain the right to source services—and finance—from other entities including banks (subject to any restrictions imposed by state or territory legislation). Membership should be voluntary. Any council could choose to apply to be a member, and equally, could choose to leave the authority. Ultimately, individual councils need to make their own evaluation of the overall benefits of membership. There are likely to be criteria that would need to be met prior to joining the national financing authority, such as being an incorporated local government entity and not being subject to insolvency-related legal proceedings. Membership may also be extended to include, for example, wholly owned subsidiaries of local government entities, or other public sector bodies, although for the purpose of this study we have assumed that it will be limited to councils. It is anticipated that there would probably be a role for state and territory governments in developing and reviewing any such criteria, in recognition of the need to retain their oversight of local government within each jurisdiction. Additional criteria relating to the financial health of an entity might be considered. In Sweden, for example, the existing members of Kommuninvest have the power to set criteria for joining the agency, which are designed to ensure that every new member has an acceptable creditworthiness. The creditworthiness of members is surveyed every year with the possibility to expel members if the criteria are no longer met. Membership criteria of this type may be appropriate for models where the creditworthiness of the authority is likely to be affected by the composition of its membership, such as if security over liabilities is to be provided by all members including those that are in a financial position that is weaker than others. Regardless of any membership parameters, it is anticipated that participating councils will be required to meet certain criteria and covenants prior to receiving approval to borrow from the national financing authority. The purpose of lending criteria is to provide ratings agencies and investors confidence in the authority's creditworthiness and to provide comfort to other members. In the South Australian model, for example, all councils in the state automatically became members of the Local Government Finance Authority when it was established, however each borrowing application is assessed individually based upon defined criteria and can be refused. As membership of the national financing authority would be voluntary, the number of participating entities would be expected to fluctuate over time as individual councils consider their own case for membership. The stability of the organisation will be a function of the level of "skin in the game" taken on by members, and the incentives provided to continue participation. Precedent authorities overseas have been founded by an initial group of members and expanded over time. The New Zealand Local Government Funding Agency was initially supported by nine councils and now has 30 members (out of a total of 78). Kommuninvest in Sweden started life with ten participating municipalities in 1986; there are now 272 municipalities and county councils, with more joining each year. Figure 1: Kommuninvest—number of members and total lending 2002—2011 (Annual Report 2011) The level of participation in the national financing authority is important because its ability to achieve its objectives—and its capacity to generate benefits—will depend upon achieving a critical mass to provide an attractive proposition for inward investors. For example, in the assessment of a collective entity, credit rating agencies look at the proportion of the agency's loan book exposed to a single borrower—the broader the council participation, the lower the concentration risk. The size (in revenue terms), as well as the number, of members will be an important factor in building the authority's creditworthiness. The optimal size—or the ‘tipping’ point at which membership is sufficient—is that which drives strong competition for the entity's securities and moves pricing to a point comparable with similar and equivalently-rated products. While it is hard to say precisely how many councils would be required to achieve this critical mass for an Australian national financing authority, it is likely that the authority would need the support of, at the minimum, a small number of large municipalities or a large number of medium sized ones. This is not to say that all (or even most) Australian councils would need to join the national financing authority for it to succeed in providing competitively priced debt to its members. In Sweden, for example, the three largest municipalities (Stockholm, Gothenburg and Malmo) are not members, but Kommuninvest has still been able to function extremely well for a number of years. Inasmuch as the ability of the authority to develop marketable investment products will be a function of the borrowing needs of its members, it is important that councils not only join the authority, but also use its services. Again, this does not mean that participating councils will need to source all of their debt from the authority (lending by Kommuninvest only represents 65% of its members' total borrowings, for example). The genesis of the entity, however, would be greatly facilitated with some degree of commitment by members. In New Zealand, for example, of the nine original sponsoring councils, eight committed to sourcing 80% of their financing needs through the Local Government Funding Agency, with the residual sourcing 30% for three years. There is evidence to show that this commitment was taken into account by the ratings agencies in allocating a preliminary domestic currency credit rating of AA+.
Moral hazard refers to situations where there are incentives for individuals or entities to change behaviour when they perceive the consequences of taking risks will be borne by others. If a collective vehicle were established to facilitate access to debt, and any council could become a member, this may invite risk-taking behaviour by less creditworthy councils who perceive they can transfer the consequences of unaffordable borrowing to the providers of credit enhancement for a collective vehicle. We contend that the risks of creating moral hazard should not be over-stated. In all the models proposed in this study, councils—and their rate payers—occupy the ‘first loss’ position. Individual councils remain liable for repaying their borrowings until the point of bankruptcy. The incidence of this level of financial distress or bankruptcy within a local government is very rare. This raises two important points:
It is also important to recognise the critical role of borrowing criteria. A core function of the national financing authority would be to apply criteria to ensure prudent lending, and this function includes assessing the capacity to repay debt amounts sought from it. Those councils that cannot currently access the amount of finance sought (or any at all) from either the private market or public sector lenders as a result of an unacceptable default risk would not be treated any differently by the collective vehicle proposed. This approach is consistent with moving the sector to a long-term sustainable financial position. 4. Intergovernmental considerationsAlthough municipal financing agencies in other countries provide important lessons and precedents, an Australian authority would need to be consistent with Australia's unique structure of government and sensitive to the concerns and needs of multiple stakeholders. These stakeholders will rightly need to be persuaded of the need to intervene, understand the benefits and the risks, including implementation considerations, outturn set up costs and longer-term impacts. It is widely acknowledged that Australian councils do have access to debt finance, either in the form of bank debt or products provided by state or territory governments, and hence there is no demonstrable failure of the market to provide finance. However, there is arguably an information asymmetry between councils as borrowers and the providers of finance that arises because councils often do not have the background and skill to make informed judgements about the risk of borrowing. As discussed earlier, the evidence of debt avoidance supports the view that councils make an overly pessimistic assessment of the risks of using debt, despite possessing what lenders clearly consider to be sound credit fundamentals. Ultimately the motives for supporting the objectives of a collective entity are consistent with the policy intent of the Commonwealth and jurisdictions to promote a self-sustaining local government sector that is capable of leveraging its "own-source" revenues to deliver the community's infrastructure requirements, while reducing its reliance on other tiers of government. A national financing authority could create the conditions to help councils invest their own revenues in much-needed infrastructure projects and accelerate their journey toward financial sustainability. It would give further momentum to initiatives to promote capacity building, financial self-sufficiency and consistency of standards in local government. These initiatives reflect the objectives of the Commonwealth and all jurisdictions to help the sector grow and prosper. The national financing authority envisaged in this study would not in any way diminish the quality of governance in the sector nor the level of oversight of state and territory governments. On the contrary, the authority should further strengthen the quality of financial control in the sector while retaining the ultimate regulatory control of state and territory governments. As observed in Appendix B, some models could lead to a higher level of scrutiny of local government borrowing requests than currently occurs. 5. FunctionsConsistent with its purpose, the national financing authority would have four primary functions: lending to local government, fund raising, supporting liquidity and credit quality, and providing advisory services.
In order to borrow funds from the Queensland Treasury Corporation (QTC), councils must provide:
The New Zealand Local Government Funding Agency provides a recent example of a collective local government vehicle delivering on its core function of procuring finance for its members. In its first ten months of operation, the agency has gone to the market on eight separate occasions, offering securities with maturities ranging from April 2015 to March 2019. In total, the volume offered has been NZ$1,460m. The total bid volume was NZ$6,247, meaning that issuances had an average cover ratio of 4.3 times. The credit quality of Local Government Funding Agency bonds has emerged much more quickly than was expected. The Local Government Funding Agency aims to reduce its margin over New Zealand Government bonds (NZGBs) to 50 basis points. As the graph below shows, progress in meeting this target has been extremely strong—from a margin over NZGBs of 113 basis points at the inaugural tender, the 2015 issue has narrowed to around 56 over NZGBs (as at 5 December 2012). The graph below shows that while the LGFA bonds do not provide as good value as national government bonds (NZGBs), they consistently track at a premium to those issued by a single council, even the largest council in the country, Auckland. Achieving good results in the market enables the agency to pass on competitive prices to member councils. After the sixth tender in August 2012, the Chief Executive, Philip Combe, estimated that "AA rated councils are now saving approximately 30 basis points and unrated councils approximately 40 basis points in interest cost by borrowing from the Local Government Funding Agency".
In September and December 2011, Standard & Poor's and Fitch both assigned the New Zealand Local Government Funding Agency a preliminary domestic currency rating of AA+ and the outlook on these ratings is stable. This rating is the same as the New Zealand Government, and the Local Government Funding Agency is the only entity in New Zealand other than the government to achieve such a strong rating. According to Standard & Poor's, the strong rating was assigned because of the authority's strengths:
Standard & Poor's stated that "the ratings on New Zealand's Local Government Funding Agency (LGFA) reflect our view of the entity's "extremely high" likelihood of extraordinary support from the New Zealand Government, arising from the LGFA's "integral" links to the New Zealand Government, combined with its "very important" role under our government related entity (GRE) criteria. The ratings on LGFA also reflect the organisation's strong stand-alone credit profile, arising from its sole role of providing debt finance to the New Zealand local and regional government (LRG) sector, the sound aggregate credit quality of that sector, and LGFA's prudent liquidity policies. These strengths are moderated by the organisation's wholesale funding profile and our expectation that risk-weighted capitalisation will progressively decline from initially strong levels as lending increases against a backdrop of a small capital base."
6. Profitability and operating costsThe national financing authority would be created for the benefit of the community. Its role would be to minimise finance costs for the local government sector and not to make accounting profits. It could be designated as a not for profit entity. It is anticipated that a portion of any future surplus would be retained in the organisation to build its capital base and subsidise auxiliary services (such as advisory services). Depending on the model, any additional surplus could be returned to shareholders. The Local Government Finance Authority of South Australia provides a useful precedent. It allocates surplus funds to members in the form of a bonus payment. Since its introduction in 1985, $28m has been distributed, with a further $1.74m to be paid in respect of the year ended 30 June 2012. The bonus payment is apportioned based upon average deposit and loan levels held with the authority during the course of the financial year. In the absence of the motive of profit, the national financing authority must still be incentivised to keep its cost base as low as possible in order to pass on the largest possible savings to its members. Pooled financing should lead to processing and issuing costs that are considerably lower than if the individual councils were to borrow from the capital markets on their own. Other operating costs should be kept to a minimum. To this end, they could be benchmarked against comparable entities and performance indicators could be incorporated into annual reporting and management remuneration.
One of the key objectives of the Local Government Funding Agency is maintaining operational efficiency. In its first annual report, the agency reports that overheads were contained to NZ$1.4m in the first seven months of operation. This represents annualised overheads of NZ$2.4 m, which is well within the performance target of NZ$3m set out in Statement of Intent 2011/12. Start-up costs were able to be kept to a minimum via an outsourcing agreement with the New Zealand Debt Management Office. At the end of 2011/12 financial year end the agency had a staff of four. In its first seven months of operation, the agency recorded a loss of NZ$4.2m. Excluding pre-establishment expenses (NZ$3.8m), its operating loss was NZ$400,000. The entity should have the capacity to provide a physical presence in each jurisdiction in which members are located. It may, for example, have a head office and branch structure. An on-the-ground presence is considered essential for adequately servicing members, particularly delivering the credit assessment and advisory roles. The entity would employ suitably skilled and experienced personnel. In doing so, there may be opportunities for other bodies to provide support (at least initially) to the authority. Appropriate providers of support might be state governments, treasury corporations including the Australian Office of Financial Management (AOFM), and other public sector financing agencies such as the Export Finance & Insurance Corporation. In New Zealand, the bulk of the Local Government Funding Agency's operational activities are outsourced to the New Zealand Debt Management Office (DMO), which is responsible for central government funding. As well as expertise in capital markets and liquidity management, the DMO execute the Local Government Funding Agency's funding and investing functions. back to top Appendix B Options and evaluationOptions11 options for a potential national financing authority for local government in Australia are evaluated in this section. 10 of the 11 options meet all the "core" functional requirements set out above with respect to fund raising and lending to councils. They are distinct by virtue of different permutations of factors of ownership, the providers of any credit enhancement and the nature of any credit enhancement. The final model (Option 8) is a "pass-through model", and as such does not meet all the "core" prerequisites previously identified. This option would involve the establishment of a vehicle to act as a financial intermediary or arranger of debt for participating councils requiring finance for specific projects or programs. It would react in response to demand and not have a regular presence in the bond market.
The options are described in more detail in the evaluation section below, and—where relevant—appropriate precedents are referenced. The descriptions below are relatively high level, the main intention being to outline the differentiating factors between the options for the purpose of the application of the evaluation criteria. Comparison of options
Evaluation criteriaWhile many of the concepts and practical administration considerations are common across all the identified options, there are important structural and ultimately commercial differences. The role of the evaluation criteria is to provide a basis for differentiating between the options. The following evaluation criteria are used in the evaluation of options for a national financing authority. The criteria address the key success factors around purpose and function, impacts on other governments, market credibility and participation rates.
The evaluation criteria play an important role and it is critical that they are appropriate. The criteria identified are considered appropriate because they:
The criteria have been drafted on the basis that this study aims to identify the model which is best for local government, while acknowledging that maintaining and increasing the stock of local government infrastructure is the underlying problem. Consequently, the criteria may not represent the specific priorities of the Commonwealth or state and territory governments or any other stakeholder group, nor are they intended to represent the views of the local government sector. In the next stage of planning for a national financing authority, it is recommended that the criteria are further tested with key stakeholders. Scoring mechanismThe table below contains a scale for rating each model against the evaluation criteria. As noted above, the options are evaluated on the extent to which they could satisfy each criterion.
Options evaluationAppendix A articulates some of the features and considerations that are considered to be core prerequisites to enable the national financing authority to serve its purpose. The features outlined in Appendix A would apply to each option except for Option 8. Option 1
DescriptionThis option would involve the establishment by the Commonwealth of a collective financing vehicle for local government with the objective of issuing debt securities to the capital markets and on-lending the funds to members. The differentiating factors are:
KBN Kommunalbanken (KBN) was established by an Act of Parliament in 1926 as a state administrative body with the purpose of providing low-cost finance to the Norwegian local government sector. It is wholly owned by the Royal Ministry of Local Government and Regional Development on behalf of the Kingdom of Norway. The agency benefits from a maintenance obligation from the central government, which underlines its owner's commitment to KBN as a government agency and the importance it places on KBN as Norway's main provider of low-cost finance to the local government sector. Export Finance and Insurance Corporation (Australia)The Export Finance and Insurance Corporation (EFIC) was established in 1991 under the Export Finance and Insurance Corporation Act 1991 (Cth) as a statutory corporation wholly owned by the Commonwealth of Australia. EFIC's role is to facilitate the inward flow of investment for the purpose of facilitating the export trade of Australian goods and services. It does this by mitigating private sector risk by acting as guarantor over financing arrangements between third party lenders and exporters, or by direct lending where a bank is unwilling to do so. EFIC is one of only two entities that are explicitly guaranteed by the Commonwealth of Australia, the other being the Reserve Bank of Australia. Green Investment Bank (UK)The Green Investment Bank was established in 2012 to accelerate private sector investment in green infrastructure assets. It will work to a "double bottom line" of i) achieving significant green impact and ii) making financial returns, and will operate independently and at arm's length from government. It will receive initial capitalisation of GBP 3bn by the government until 2015, at which point the agency's borrowing powers will become effective. Evaluation
Option 2
This option would involve the establishment by the states and territories of a collective financing vehicle for local government with the objective of issuing debt securities to the capital markets and on-lending the funds to members. The differentiating factors are:
The Local Government Finance Authority (LGFA) of South Australia was established in 1984 as a statutory authority, under the Local Government Finance Authority Act. All local authorities in the state are automatically members of the LGFA, but use of the authority for investment and loans is entirely voluntary. In accordance with the act, all the liabilities of the authority (including monies accepted on deposit from the local authorities) are guaranteed by the Treasurer of South Australia. Queensland Investment Corporation (Australia)Queensland Investment Corporation (QIC) was established in 1991 by the Queensland Government to manage its long-term investments. QIC Limited is a government-owned corporation (GOC) constituted under the Queensland Investment Corporation Act 1991 (Qld) (QIC Act). QIC is regulated by state government legislation pertaining to GOCs. Under the act establishing QIC, the Treasurer of Queensland is empowered to guarantee the payment of any moneys payable by, or the discharge of any liability of, the corporation. Evaluation
Option 3
DescriptionThis option would involve the establishment by a group of councils of a collective financing vehicle with the objective of issuing debt securities to the capital markets and on-lending the funds to members. The differentiating factors are:
Evaluation
Option 4
DescriptionThis option would involve the establishment by a group of councils of a collective financing vehicle with the objective of issuing debt securities to the capital markets and on-lending the funds to members. The differentiating factors are:
Evaluation
Option 5
DescriptionThis option would involve the establishment by a group of councils of a collective financing vehicle with the objective of issuing debt securities to the capital markets and on-lending the funds to members. The differentiating factors are:
The Local Government Funding Agency (LGFA) was established by the Local Government Borrowing Act 2011 and was incorporated on 1 December 2011. The LGFA is owned by a group of councils and the New Zealand Government. It is a Council Controlled Organisation (CCO) operating under the Local Government Act 2002. The LGFA's primary purpose is to provide more efficient finance costs and diversified financing sources (including foreign currency) for New Zealand local authorities. The New Zealand Government's Debt Management Office (DMO) executes funding and investing functions (on instructions from LGFA) and has provided an initial NZ$500m liquidity facility (to rise to NZ$1bn). Evaluation
Option 6a
DescriptionThis option would involve the establishment by a group of councils of a collective financing vehicle with the objective of issuing debt securities to the capital markets and on-lending the funds to members. The differentiating factors are:
Evaluation
Option 6b
DescriptionThis option would involve the establishment by a group of councils of a collective financing vehicle with the objective of issuing debt securities to the capital markets and on-lending the funds to members. The differentiating factors are:
The Municipal Finance Authority of British Columbia (MFA) was created in 1970 to contribute to the financial well-being of local governments throughout British Columbia. Long-term debt requirements of local governments (5 to 30 years) must be borrowed through the MFA. All borrowings must be within each municipality's individual borrowing power, which stipulates that only 25% of sustainable revenue may be allocated to debt servicing costs (principal and interest). Long-term financing needs are met through placing of debentures in capital markets—normally 10 year bonds to accommodate average borrowing terms requested by clients and the preferences of investors. Short-term funding needs have been fulfilled through a $500m Commercial Paper Program. Local governments within each regional district are joint and severally liable for each others' long-term debt borrowings through the MFA. When a municipality passes a borrowing bylaw and presents it to its regional district for the purpose of issuing security, all municipalities in the region must vote on their acceptance of the borrowing. Approval of the bylaw binds each municipality with joint and several obligations. Evaluation
Option 6c
DescriptionThis option would involve the establishment by a group of councils of a collective financing vehicle with the objective of issuing debt securities to the capital markets and on-lending the funds to members. The differentiating factors are:
Evaluation
Option 7a
DescriptionThis option would involve the establishment by a group of councils of a collective financing vehicle with the objective of issuing debt securities to the capital markets and on-lending the funds to members. The differentiating factors are:
Municipality Finance Plc (MuniFin), established in 2001, is incorporated as a financing institution under the Finnish Act on Credit Institutions and is supervised by the Finnish Financial Supervision. It is 53% owned by municipalities, 16% by the government, and 31% by the local government pensions fund. MuniFin enjoys a guarantee provided by the Municipal Guarantee Board (MGB). 328 Finnish municipalities are members of MGB (over 99% of the population) and its only function is to guarantee MuniFin's debt obligations. The member municipalities are jointly liable on a pro rata basis for MGB's commitments. If one member fails to meet its obligations, then all other members must make up the shortfall. Kommuninvest (Sweden)Kommuninvest was founded by nine municipalities and a county council in 1986, and now has close to 300 municipalities and county council members, more than 85% of the total. Its objective is to provide competitive loans and other financial services for its members. All members of the Kommuninvest Cooperative Society signs a joint and several guarantee covering all commitments of the agency. KommuneKredit (Denmark)KommuneKredit was established in 1899 by a special Act as an association (membership organisation) under Danish law, with the objective of securing cost-efficient financing for local government clients. Membership is voluntary, but currently all Danish municipalities are members. Members of KommuneKredit are directly, jointly and severally liable for all of KommuneKredit's obligations. Evaluation
Option 7b
DescriptionThis option would involve the establishment by a group of councils of a collective financing vehicle with the objective of issuing debt securities to the capital markets and on-lending the funds to members. The differentiating factors are:
Evaluation
Option 8
DescriptionThis option would involve the establishment by the Commonwealth and/or states/territories of a vehicle with the objective of procuring finance for councils or groups of councils. The differentiating factors are:
The Housing Finance Corporation (THFC) is an independent, specialist, not-for-profit organisation that makes loans to Registered Social Landlords, which are organisations, such as Housing Associations, that provide affordable housing to tenants throughout the United Kingdom. THFC funds itself through the issue of bonds to private investors and by borrowing from banks. It therefore acts as an aggregating financial intermediary, so diversifying risk for those who make funds available to THFC and reducing the cost and standardising the loan terms for those RSLs that borrow from us. Evaluation
Evaluation summaryBased upon the evaluation above, the scores of each option can be summarised as follows.
The evaluation suggests several models are closely ranked. This outcome largely reflects the broad similarities among the commercial characteristics and structure of the options. However, the evaluation process suggests that marginal differences in the credit support structures and the proxy to councils could have a significant impact on stakeholders and processes. The evaluation focussed on testing those impacts. Option 6c scores the highest and it is recommended for further investigation. back to top Appendix C—Financial modellingFinancial benefits of establishing a national financing authorityResultsEstimates of the size of the financial benefits of establishing a national financing authority are provided in the tables below. It is important to note that the estimates are indicative only. They have been generated through a high level modelling exercise and reflect a set of assumptions about current and future use and pricing of debt across the local government sector. Estimates of savings have been made on a jurisdiction by jurisdiction basis because each has different incumbent arrangements for local government borrowing, and consequently represents a different baseline. Table 1 below shows an estimate of the interest costs which could be avoided by councils, as a proportion of their current costs, through a national financing authority. That is, in each jurisdiction, councils using the authority could reduce the interest paid on every dollar of debt by between 7%—17%. Some jurisdictions, particularly Queensland, could benefit to a larger extent, which is a function of the difference between the assumptions about their current costs of debt finance and an estimate of debt pricing achieved by a national financing authority. Table 1—Interest costs avoided as a proportion of current costs Table 2 below shows an estimate of the cumulative interest costs which could be avoided over a 20 year period by using a national financing authority. That is, across all jurisdictions, councils using the authority could save approximately $431m in nominal interest costs over a 20 year period. Table 2—Cumulative interest costs avoided Table 3 below shows an estimate of the cumulative saving in interest costs which could be achieved as debt is progressively sourced through a national financing authority and not through existing arrangements. As noted, approximately $431m could be saved over 20 years assuming 65% of all debt used by local government is sourced from the authority. This estimate increases to $663m if it is assumed that 100% of debt is provided by the authority. Table 3—cumulative interest costs avoided with an increasing proportion of debt sourced from a national financing authority The estimates of savings in the tables above are limited to interest expenses. It is important to note that the estimates of savings do not include:
To the extent a monetary value is applied to these categories of cost, the overall estimate of savings—for local, state and territory governments—would increase.
A large scale waste-to-energy facility, capable of processing almost 1,000,000 tonnes of waste, is proposed to be located in a major regional city. The facility has the potential to generate significant economic growth in the region through the creation of employment opportunities, diversification of industries in the region and environmental and financial sustainability by harnessing the waste from five surrounding local government areas to produce usable products. The sponsoring council has developed a business case and a preferred procurement method. The project requires a capital investment exceeding $300 million, a portion of which is expected from the private sector, but council will need to raise debt finance to fund the balance. In this scenario, the value of a national financing authority could be:
Modelling method, assumptions and inputsThe purpose of the modelling is to estimate the size of savings which could arise from shifting a majority of local government borrowing to a national financing authority. As noted above, the primary financial benefit of a collective model is cheaper debt derived from scale and structured credit enhancement. The debt pricing which would be achieved by the preferred model can at this point only be estimated with a low level of confidence. However, a set of assumptions have been made to facilitate a calculation. The basis for these assumptions, and source of them, is in Table 4 below. The modelling estimates the savings on debt repayments which may be achieved in each jurisdiction if the majority of local government borrowing (65%) was sourced from a highly-rated collective model. The estimates of saving also rely on assumptions about the proportion of total debt by tenor in each jurisdiction: for simplicity, it is assumed there is medium term borrowing (10 years) and long term borrowing (20 years), noting more interest is paid over longer loan tenors. The estimate of savings is calculated as the interest expense in the baseline scenario less the interest expense in the national financing authority scenario. Interest expense is calculated using, for each jurisdiction and for the assumed volume of medium and long term debt, an amortising profile with semi-annual principal and interest payments. In the national financing authority scenario, two interest rates are used for all jurisdictions: one for medium term debt and the second for long term debt. In reality, different repayment profiles are used in the local government sector, including interest-only and sculpted repayment profiles. However, insufficient information is available to make an assessment of their frequency of use. Table 4: modelling inputs
Pricing and credit qualityIt is not possible to know precisely how the market would price instruments issued by the national financing authority. Yields, margins and spreads are determined by a range of variables including timing, size of issuance and liquidity, term, credit rating, and economic and market conditions. Especially when market conditions are difficult, local government bonds have the potential to be very attractive to investors. At a minimum, the tax-raising powers of local government represent a stable and regular revenue-raising capacity to provide liquidity and ultimately security over repayments. In the historically rare events of distress, this is backed by the implicit support from other tiers of government enjoyed by the sector. In the current macroeconomic environment, banks and other financial institutions are likely to systematically review their capital allocation to different segments and ensure that capital is preferentially allocated to segments that meet their requirements in terms of risk and return. Indeed, the introduction of APRA regulations implementing the Basel III recommendations around the quality of assets held by Australian authorised deposit-taking institutions (ADIs) presents something of a "window of opportunity". The market has an appetite for low-risk investments, and the national financing authority could have the ability to provide them. Domestic investors, particularly banks, hold approximately 60 per cent of semi-government bonds outstanding.10 Anecdotal evidence gathered during the consultation suggests debt issued by a national financial authority would be similarly attractive. The aim of the authority is to provide councils with the same opportunities that the Commonwealth, states and territories currently enjoy in terms of access to the institutional investment markets. Figure 2: Commonwealth Government, state government and corporate bond yields demonstrates that there is a clear pricing advantage a) between federal government and state government bond yields and b) between corporate and government bond yields. The national financing authority presents an opportunity to move into this space and provide further segmentation of issuance of government debt. Figure 2: Commonwealth Government, state government and corporate bond yields (source: Reuters) It is difficult at this point in time to estimate the relative pricing of local government bonds with state government bonds, it is anticipated that they would be competitive or comparable (and the New Zealand experience provides a good indication that this is a reasonable expectation). The appeal of securities issued by the national financing authority is likely to spread to international investors as well as domestic. Almost 80% of Australian Government issue, and about half of all semi-Government issue, are owned by foreigners.11 back to top Appendix D—Local government financing vehicles overseasThe table below provides details about what are considered to be the most relevant precedents of local government collective financing vehicles overseas. New ZealandNameNew Zealand Local Government Funding Agency Ltd Established2011 OwnershipMember councils (88%) and the NZ Government (12%) Rating (Moody's/S&P/Fitch)-/AA+/AA Lending remitMember councils Guarantee structureJoint and several guarantee from local and regional governments Liquidity policiesHold liquid assets equivalent to at least 10% of LRG assets. Access to a liquidity line from New Zealand's DMO initially NZ$500m increasing to NZ$1bn over 4 years. Portfolio repo-eligible Market shareForecast 30% by 2014 Lending activitiesAt 30 June 2012, 14 out of the 18 participating local authorities borrowed a total of $819m Fundraising activitiesAt the final bond tender for 2012 (12 December 2012), LGFA's bond outstandings increased to over $1.5b SwedenNameKommuninvest Sverige AB Established1986 OwnershipSubsidiary of Kommuninvest Cooperative Society (KCS)—owned by member councils. Rating (Moody's/S&P/Fitch)Aaa/AAA/- Lending remitMember councils or entities guaranteed by member councils Guarantee structureMembers of KCS sign a guarantee to be a member of Kommuninvest. Liquidity policiesPrimary liquidity reserves of at least 4% of total assets (currently 4% or SEK9bn) and a total liquidity reserve equal to a minimum 24% of the balance sheet ready to be sold (highly liquid prefunding of SEK45bn) Market share40% Lending activitiesLending on 30 June 2012 amounted to SEK 187.9b Fundraising activitiesIn total, SEK 64b was raised in long-term debt instruments during the first six months of 2012. During this period, a total of SEK 25b in long-term borrowings matured FinlandNameMunicipality Finance PLC Established1989/1993 OwnershipFinnish Government (16%), councils (53%) and local government pension fund (31%). Rating (Moody's/S&P/Fitch)Aaa/AAA/- Lending remitFinnish councils and public housing entities Guarantee structureMunicipalities on a joint pro-rata basis through Municipal Guarantee Board. Liquidity policiesCarry sufficient liquidity to carry on normal operations absent of new funding. Liquidity portfolio invested in liquid instruments Market share~50% Lending activitiesAs at 30 June 2012, total loans amounted to 14,680m Fundraising activitiesTotal funding acquisition for January-June 2012 amounted to 4,930m. Total amount of funding to June 2012 grew to 22,820m. In 2011, raised more than 99% of its funds outside of Finland DenmarkNameKommuneKredit Established1898 OwnershipMembers (100%) Rating (Moody's/S&P/Fitch)Aaa/AAA/- Lending remitDanish councils or entities guaranteed by Guarantee structureJoint and several guarantee from all local and regional governments Liquidity policiesFunding should at all times exceed lending. Ability to keep 25% of lending as prefunding. Currently stands at 17% Market share>90% Lending activitiesIn the first half of 2012, total gross lending was DKK 19,284 and total net lending was DKK 8,644 Fundraising activitiesIn 2011, total funding amounted to DKK 62.6b. In 2011, the following were issued: Debt securities: DKK11.1b Adjustable rate loans: DKK 7.4 Structured bonds: DKK 1.3b Traditional bonds: DKK 593m Non-callable bonds: DKK 1.8b. NorwayNameKBN Kommunalbanken Established1926 OwnershipNorwegian Government (100%) Rating (Moody's/S&P/Fitch)Aaa/AAA/- Lending remitCouncils or companies in the local government sector Guarantee structureLetter of support from Norwegian Government Liquidity policiesAvailable liquidity should equal 100% of net cash requirements for 12 months. Market share47% Lending activitiesIn the first three quarters of 2012, KBN paid out NOK 23.2b in new loan disbursements. Total loan growth during this period was NOK 8.7m (4.2%), below their target of 6% Fundraising activitiesNew borrowings for the first three quarters of 2012 amounted to NOK 93m. KBN completed its USD benchmark program for 2012 with three issuances totalling USD 4b. CanadaNameMunicipal Finance Authority of British Columbia Established1970 OwnershipNon-share capital Rating (Moody's/S&P/Fitch)Aaa/AAA/AAA Lending remitRegional districts, member municipalities, regional hospital districts Guarantee structureJoint and several guarantee from municipalities Liquidity policiesDebt service reserve fund and sinking fund of C$1.5bn, 180% of next 12 months debt service cover. Additional C$200m on demand back stop facility and 2 C$250m CP back-up lines Market shareNot known Lending activitiesLoan balance in 2011 was C$4.8b Fundraising activitiesIn 2011, MFA issued a 5-year C$515m debenture that provided a yield to investors of 3.029%, which was the largest in size and set a record as the lowest yield back to top Appendix E—Credit rating processThe role and importance of the credit ratingObtaining a rating from a reputable credit rating agency or agencies is an important part of building market confidence and achieving the lowest possible pricing for securities issued to the market. A poor credit rating leads to the likelihood of higher finance costs due to the perceived risk of default. Credit rating agencies assess an entity's risk profile to enable investors to make decisions on the ability of the entity to meet its obligations. This involves quantitative risk analysis, including comparing financial ratios with chosen benchmarks, and qualitative analysis, which focuses on the management character, legal, political and economic environment in which it operates. Rating methodology for government-related entitiesIt is anticipated that the local government financing authority would be rated by the major agencies as a government-related entity. The methodologies used by the major ratings agencies for rating government-related entities are similar in substance with some minor variances. Credit ratings are therefore generally, but not always, consistent. The approach to rating government-related entities generally involves the consideration of their credit quality as falling between the inclusive bounds formed by:
The proximity of the final assigned rating to either of these ratings is a function of the perceived likelihood of sufficient and timely extraordinary government intervention in support of the entity meeting its financial obligations, and the default dependency between the two entities. In circumstances where the government will likely extend timely extraordinary support, the rating of the entity tends to be close to, and move in tandem with, that of the government. Conversely where the entity's importance to government is low and the two entities are not closely linked, likelihood of government support is low and the entity rating will bear closer resemblance to its stand-alone credit rating. Final assessments will always be a function of issuer- and issue-specific attributes as well as assessment of the credit and, if applicable, structural risks for a given issuer or issue rating. Methodologies and assumptions may change from time to time as a result of market and economic conditions, issuer- or issue-specific factors, or new empirical evidence that would affect credit judgment. Determining the likelihood of sufficient and timely extraordinary government interventionRatings agencies have different methods of assessing the likelihood of sufficient and timely extraordinary government intervention. Two such approaches are explained below. (1) Standard & Poor'sTo determine the likelihood of sufficient and timely extraordinary government intervention, Standard & Poor's assesses two factors: the importance of the entity's role to the government and the strength and durability of the link between an entity and the government.
The two factors are used to form an assessment of the likelihood of sufficient and timely extraordinary government intervention as follows: (2) Moody'sMoody's assesses the likelihood of sufficient and timely extraordinary government intervention through their ‘support scorecard’ and consider the institutional framework (which includes legal requirements or barriers, government policy stance, degree of oversight, reputation risk and moral hazard), historical behaviour, and individual characteristics such as political relationships, strategic role and debt structure. Moody's estimates the default dependency between the two entities based on the following factors:
Based upon these questions, an entity is matched to one of a number of scenarios in a "dependence scorecard" as follows: Table III: dependence scorecard
Fiscal arrangements High level of transfers = fiscal transfers / operating revenues > 50% Medium level of transfers = fiscal transfers / operating revenues between 20% and 50% Low level of transfers = fiscal transfers / operating revenues <20% Distinct / similar own-source revenue bases Economic insulation / integration Other considerationsThe following considerations, which may be relevant to the national financing authority, are also taken in to account by rating agencies when assessing government-related agencies. Where an entity has links to more than one governmentAgencies analyse both the nature of the link between the entity and each single government, as well as the relationships between the different governments. If one government has a prominent link to the entity and appears likely to fully support the entity, its rating will generally apply. If government support is provided by all governments on the basis of their respective share, the lowest rating would generally apply. If "joint and several" support is expected, the entity's rating could be higher than their stand-alone credit rating. Conversely if slow decision making or asymmetries in interests could weaken support to the entity, it may reduce likelihood of obtaining a strong rating. Extraordinary government intervention may impair an entity's ratingWhile in most cases the likelihood of extraordinary government intervention enhances an entity's rating above its stand-alone credit rating, in a few instances government intervention is detrimental. An entity rating below its stand-alone credit rating may reflect the expectation of extraordinary negative intervention from the government, for instance through a tendency to increase taxes and dividends, to require the entity to provide subsidies, or to restrict the entity's flexibility in some other way in a period in which government faces fiscal or external stress. Rating an entity above the rating on its governmentWhilst generally a rarity, an entity may be rated above the government if the entity's ability to service its debt is superior to that of the government and that, ultimately, if the government defaults on its foreign currency debt, there is a measurable likelihood that the entity will not default. For this to happen, the first condition is that the entity's stand-alone credit rating will exceed the government's foreign currency rating. The second condition is that the government's willingness and ability to impair the entity's credit standing in periods of stress should be limited. Rating an entity's junior obligationsGovernments may not necessarily support entities in a manner that equally benefits all security holders. Indeed, supporting the entity's higher-ranking obligations may be to the detriment of lower-ranking, and specifically subordinated and/or deferrable, obligations, as contemplated by the terms of their respective issuances. Therefore, as for any other entity, specific obligations issued by an entity might be rated differently from its issuer credit rating. Hybrid capital or other subordinated obligations may be rated below the issuer credit rating or senior obligations if it is anticipated that intervention could be less beneficial (and possibly negative) than for other obligations. Rating an entity's subsidiariesWhen rating a subsidiary of an entity, the subsidiary's relationships with both its parent entity and the government are analysed. Generally a subsidiary will carry a lower rating than its parent, as the importance of the entity to government is lower and the link is more indirect. As such, extraordinary support by government is less likely. But in circumstances where the subsidiary may have a prominent role and links with government, it may be rated in the same manner as an entity and hold a higher rating than its parent. Sources
back to top Footnotes
back to top Status and limitationsWe would like to acknowledge the assistance and support provided by the Department of Regional Australia, Local Government, Arts & Sport. In particular, the Department assisted in providing access to the Inter-jurisdictional Working Group on Local Government, which consists of representatives of all state and territory governments, the Commonwealth and the Australian Local Government Association. Through this group we were able to access the preliminary views of key governmental stakeholders, and we would like to express our gratitude to the members of the group for their cooperation. We note, however, that due to time constraints, we were only able to consult with the group during the initial stages of the study. Although we have attempted to take the groups' views into account as much as possible, we have not been able to test our findings with its members or engage them in the evaluation of options. We also consulted with other stakeholders including the Commonwealth Treasury, state treasuries, local government representative organisations, councils, financiers and ratings agencies. We emphasise that the findings and recommendations in this study are preliminary. We would strongly recommend further consultation and refinement of the analysis. Confidence in the recommended option is based solely upon a high level evaluation of a long list of options against the identified criteria. We have relied on our own knowledge and on the input received from stakeholders. We may not have considered all relevant options or issues. The analysis has not been subject to legal advice. In particular, the financial modelling we have performed is high level and would need to be developed further. We have relied upon the inputs and assumptions provided to us and other assumptions discussed with the Department. The model has been developed in good faith and in the belief that the information provided to us was not false or misleading. We have not audited or reviewed any of the inputs or assumptions provided to us. Ernst & Young Assurance | Tax | Transactions | Advisory About Ernst & Young Ernst & Young is a global leader in assurance, tax, transaction and advisory services. Worldwide, our 152,000 people are united by our shared values and an unwavering commitment to quality. We make a difference by helping our people, our clients and our wider communities achieve their potential. Ernst & Young refers to the global organisation of member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organisation, please visit www.ey.com. © 2013 Ernst & Young, Australia. Ernst & Young is a registered trademark. Our report may be relied upon by Department of Regional Australia, Local Government, Arts & Sport for the purpose of only pursuant to the terms of our engagement letter dated 11 December 2012. We disclaim all responsibility to any other party for any loss or liability that the other party may suffer or incur arising from or relating to or in any way connected with the contents of our report, the provision of our report to the other party or the reliance upon our report by the other party. Liability limited by a scheme approved under Professional Standards Legislation. back to top |