Highlights

Strong system with effective monitoring mechanisms, good transparency, and safeguards.  These include the operating balanced budget requirement and associated Section 114 (s114) failsafe, almost uninterrupted access to government liquidity facilities, and a high financial reporting standard.

Nonetheless, structural issues were left unaddressed over the past few years as short-term challenges--such as Brexit, the COVID-19 pandemic, and high inflation--have taken priority.  This has resulted in a deficit of revenue sources to adequately finance expenditure responsibilities. We think the government will implement long-standing reforms, which will be broadly positive for the sector and add certainty to medium-term planning. The planned changes will likely be gradual and their implementation will require time, to allow for financial and operational adjustments.

We think revenue and expenditure reforms will contribute to the economic recovery in the U.K.  This will lead to continued increases in government grants and other revenue sources. Combined with moderating inflation, these increases will improve the level of services and local authorities' financial standing.

We also expect the devolution in the sector will continue and provide more autonomy for local authorities.  We think the continued delegation of responsibilities and related income will enhance authorities' flexibility, local power, and accountability.

Trend: Stable

We expect the institutional framework for local authorities in the U.K. will remain stable over the next three to five years. We anticipate the central government will remain committed to ensuring the financial standing of local authorities and that the implementation of reforms will add certainty to local authorities' medium-term planning and clarity to funding arrangements.

We could take a more positive view of the framework if we see longer-term certainty in funding mechanisms that facilitates the tackling of potential future challenges in a timely way. In our view, this would also likely introduce more fiscal flexibility. On the other hand, a continued mismatch in funding, delegation of additional responsibilities without adequate revenue resources, or sector reforms that derail authorities' financial position could put downward pressure on our assessment of the sector's institutional framework assessment.

Predictability Of The Framework

Overall mature system, although several sector reforms remain in the pipeline

The U.K. local authority system is well established and defined, with strong foundations codified in statute and regulation. It features a wide range of operational freedoms but remains closely tied to the central government through funding, policy, and regulatory mechanisms. Proposed sector reforms generally involve extensive consultation and communication, then gradual implementation over several years. They often include transitional arrangements to mitigate any short-term adverse effects on authorities. Brexit, the pandemic, and the high inflation environment have delayed the implementation of key reforms.

The number of local authorities varies across the U.K., with 317 in England, 32 in Scotland, 22 in Wales, and 11 in Northern Ireland. Local authorities in the U.K. are responsible for the provision of a wide array of services. There are different types of local authorities, each with differing accountabilities to the local public and, therefore, differing cost and revenue bases.

Table 1

The overall framework for local authorities' administrations remains generally consistent across the U.K. and among various types of local authorities, with only minimal differences, despite the devolution of certain policies. Devolution arrangements for Scotland, Wales, and Northern Ireland have transferred responsibility for local governments to the respective devolved administrations. In addition, several new devolution deals in England have been supported by the government.

We anticipate that the government will address several sector reforms over the next three to five years. The main ones will address funding allocation, the business rates framework, and the adult social care funding mechanism. We expect changes to the system would take a few years to implement as they would require consultations, changes of funding mechanisms, operational adjustments, and time for implementation. Overall, we anticipate that these reforms are likely to improve the financial position of local governments.

Limited ability to influence reforms, but local authorities are consulted

U.K. local authorities have the power to act autonomously, without central government consent, on certain matters and within a set of limitations. We expect continued devolution in the sector to provide more autonomy to local authorities and therefore more active management over local matters. While authorities cannot directly block reforms, they have a strong political lobby via trade bodies such as the Chartered Institute of Public Finance and Accountancy (CIPFA), the Local Government Association (LGA), and other regional groups. Furthermore, the central government has a track record of consulting with local and regional governments on policy and funding matters, which is important because of the fairly-high share of central government funding to the sector. That said, during a decade of austerity the central government has passed on large spending reductions to local authorities relatively easily, through cuts to grants.

Revenue And Expenditure Balance

Deficient revenue sources relative to expenditure responsibilities have resulted in a reduction in the level of services

Local authorities' flexibility regarding revenue sources is limited because of their high reliance on government grants, which account for almost half of their revenue, and due to fairly-rigid tax revenues, in the form of council tax and business rates. The central government determines the permitted annual increase for council tax and sets the retention rate for business rates. Currently, council tax can be raised by a maximum 3% a year, with an additional 2% social care precept for authorities that deliver those services. For business rates, most authorities retain 50% of collection, though some retain more (up to 100%). The rates are set by the government based on a property ratable value and can increase with revaluation or changes in the multiplier.

Chart 1

We anticipate that planned reforms will increase efficiencies and flexibility for local authorities. This will contribute to economic growth, which, in turn, will enable the central government to provide more grant funding to the sector. Slowing inflation and a continued focus on cost management would also support fiscal outturn. With supportive external factors, we anticipate that local governments will address a spending backlog and the underfunding of services in certain areas, such as adult social care, transport, and public health. This means operating spending will remain high. The spending backlog increased during the decade of austerity and, more recently, due to challenges--such as Brexit, the pandemic, and high inflation--that were prioritized over structural issues in the sector.

Chart 2

Over the past two years, expenditure growth has outpaced revenue growth. This is because of the high share of inflexible expenditures, inflationary pressures, and increased demand for services, while pandemic-related grants from 2021-2022 have been used up. Unlike many funding frameworks globally, U.K. local authorities' revenues do not directly benefit from short-term high inflation effects, meaning that revenue growth is lagging behind cost increases.

Chart 3

We expect local authorities will accelerate delivering infrastructure projects to stimulate economic growth. Capital expenditure has been subdued in past years due to labor and materials shortages, as well as the lingering effects of the pandemic.

In our view, potential additional cost pressures that may necessitate more debt funding include the increased focus on improving the quality of homes and the introduction of stricter consumer regulations--notably where local authority housing associations have underperformed, compared with private registered providers.

We expect fiscal deficits will likely translate into a gradual debt build-up. We forecast the sector's debt will increase to about 75% of operating revenue over the coming years, which we consider moderate, compared with international peers. About 70% of local authorities' total debt is contracted through the Public Works Loan Board (PWLB). Authorities cannot access PWLB funding if their capital plans include investments primarily for financial return. Alternative sources of finance include intra-authority lending, traditional bank loans, and municipal bonds.

Chart 4

Strong safeguard mechanisms and tight monitoring of financial indicators

We regard the local authority system as well monitored and regulated, both internally and externally, via central government and independent audits. It benefits from various levers (both self-controlled and in the hands of the central government) to redress imbalances or financial shocks. Early warning reporting helps to mitigate unforeseen financial issues that would impair an authority's creditworthiness. In particular, we see the statutory requirement for a balanced budget, and the associated s114 failsafe, as step-in provisions for the central government that are very strong credit positives for the sector.

All U.K. local authorities are required to balance their operating budget annually and are prohibited from borrowing to achieve this. Budgets are set on an accrual basis, meaning they include non-cash items such as transfers from reserves, although the latter is not sustainable over time. This underpins our view that, on average, local authorities will maintain an operating surplus on both an accruals and a cash basis.

Over the last three years budgetary pressures and uncertainty over multiyear funding allocation contributed to a growing number of s114 notices being issued. Long-term planning was difficult for local authorities, as the finance settlement provided funding distribution for only one year. That, combined with uncertainty over future of funding reform, limited the planning horizon. An s114 notice is an early warning sign that a local authority cannot balance its budgets in either the current year or the coming three years. We view the s114 regime as a system safeguard to prevent financial distress, rather than a default or bankruptcy. It is a proactive approach to addressing potential issues before financial performance deteriorates. The issuance of a s114 process would typically include stricter measures to restore financial stability including, for example, freezing all non-statutory spending and the issuing of a revised budget. This process is usually done in conjunction with the central government and external auditors. The central government can exercise further step-in powers to temporarily control the authority's financial activities or ultimately reorganize the authority, effectively closing it down.

Exceptional support from central government in place, but no bail-out policies

Due to the relatively centralized nature of the system--either within the U.K. government or the devolved nations--there is a high level of monitoring and oversight of activities. There are no bail outs in the sector, but support provides flexibility and power, although on an ad-hoc basis.

During the pandemic, the central government provided support to the sector, including via a pass-through to support businesses or direct support to local authorities. The government pre-funded these initiatives to prevent cash flow issues in the sector, which contributed to the strongest performance in years during that time.

Transparency And Accountability

Clearly defined roles and responsibilities

The U.K. local authority system operates on a democratic structure, with elected council members and non-political officers employed to deliver on policy mandates.

The transparency of the sector is strong, with many requirements codified in statute. U.K. local authorities clearly define the roles and responsibilities for elected members and senior officers. This information is publicly available on authorities' websites. Financial publications, such as budgets and annual accounts, as well as key statistical information, are also made public. Local authorities are subject to the Freedom of Information Act 2000 (Scotland has a separate but equivalent Act enshrined from 2002), which promotes transparency and accountability. The central government monitors and reports on spending, and local authorities report back on their ability to deliver value for money.

Unified, yet complex, accounting standards for all local governments

The sector follows U.K.-wide accounting standards under CIPFA for comparability and transparency. These standards are well-established and use IFRS as a framework. CIPFA has the Prudential Borrowing Framework to ensure affordable and prudent debt levels and capital investment plans. Annual accounts are comprehensive and include disclosure on related parties but can be difficult to interpret. Some local authorities publish interim reports, although materially less detailed. In our view, the complexity of accounting standards results in slight differences in reporting and is affecting transparency.

Reliable information, but delays in publishing audited accounts

Authorities are required to have accounts audited by independent auditors in accordance with the applicable legislation. The accounts are made available for public scrutiny, as well as full council scrutiny by elected members who are ultimately accountable. Authorities must also operate an internal audit function that performs annual reviews of financial, governance, and policy processes and controls. Many authorities also operate finance and audit committees that provide further oversight of an authority's financial stewardship and performance.

We note that, over the past couple of years, the sector has accumulated a backlog of unaudited accounts. This is partially a result of pandemic-related exemptions, which led to delays in the publication of audited statements, but the backlog also highlights the complexity of financial reporting in the sector. Cases of severe delays may also signal governance issues. In 2023, for example, only 1% of English councils met the deadline to publish their 2022-2023 audited accounts. We further understand that some authorities have accumulated an audit backlog of up to six years. The central government aims to address this issue and bring authorities' financial reporting back on track.

Related Criteria

• Criteria | Governments | International Public Finance: Methodology For Rating Local And Regional Governments Outside Of The U.S., July 15, 2019

Related Research

• Institutional Framework Assessments For Local And Regional Governments Outside Of The U.S., June 18, 2024
• U.K. Local Authorities Are Bending, But Adapting, June 6, 2024