Issue 2: March 2012

THE ROLE OF THE SCOTTISH BUDGET IN STIMULATING INVESTMENT

By Paul Brewer, Senior Partner, PricewaterhouseCoopers LLP

‘A Budget for Recovery’

The Scottish economy continues to struggle its way out of the recession, which was shallower here than in the rest of the UK but slower to recover too. According to Scottish Government figures the Scottish economy grew by just 1.1% last year compared to 1.5% for the UK as a whole. The latest data from the Office for National Statistics estimates the current unemployment rate in Scotland at 8.6% with youth unemployment, those aged 16-24, reaching 102,000. In such conditions private sector businesses are wary and uncertain of their ability to generate timely and attractive returns on their investments.

Meanwhile the UK government’s policy of fiscal austerity remains firmly in place. The financial crisis exposed underlying fragility in the public finances and added to them with the bail out of key financial institutions. The constrained room for fiscal manoeuvre at a UK level was recently re-confirmed by Moody’s placing of a negative outlook on the UK’s cherished AAA credit rating, any future downgrade would serve to push up the UK’s borrowing costs. In spite of growing calls for fiscal stimulus in the face of flagging growth the UK government insists that balancing the books must remain the priority and Scotland must take its share of the pain.

The constrained room for fiscal manoeuvre at a UK level was recently re-confirmed by Moody's placing of a negative outlook on the UK's cherished AAA credit rating, any future downgrade would serve to push up the UK's borrowing costs.

This set the backdrop for John Swinney MSP, the Cabinet Secretary for Finance, Employment and Sustainable Growth, presenting the Scottish Budget for 2012/13 to the Scottish parliament on the 8th February. In doing so he had two main issues to deal with in stimulating investment. First, how to continue investing in the national infrastructure in the face of significantly reduced capital budgets and second how to stimulate private sector investment and boost growth in time to offset the impact of public sector cuts.

Maintaining Investment in National Infrastructure

Looking at the first point Scotland is facing a headline 32% reduction in its devolved capital budget over the next 4 years. That the figure sounds so high is a result of the areas hardest hit at UK level in capital terms also carrying a heavy weighting in the Barnet formula which determines Scotland’s budget settlement. However the Scottish Government took an early decision to offset some of this and prioritise capital investment by diverting resources totalling £750m by 2014/15 from the revenue budgets, covering day-to-day spending and relatively less constrained with around a 9% reduction, towards capital investment. In total the core capital budget will be around £2.5bn in 2012/13 but this compares to a peak closer to £4bn in 2009/10.

In total the core capital budget will be around £2.5bn in 2012/13 but this compares to a peak closer to £4bn in 2009/10

Good quality infrastructure is widely understood to have a positive long term impact on economic growth, so, with the public sector as its traditional provider, the decision to prioritise it in this way is understandable. An increase in public sector investment will also be welcomed for its potential to boost the economy in the short term too.

The Scottish Government is also keen to avoid past situations from which we are still recovering where short term cuts and capital underinvestment has stored up a much costlier long term problem. Compared to the scale of investment required in the public sector estate – the Scottish Government's recent State of the Estate report identified a £1bn maintenance backlog in the NHS estate in Scotland for example - the capital budget announced will still need aggressive prioritisation, with many perceived needs not met.

The publication last December of the Scottish Government’s updated infrastructure investment plan gives an idea of these priorities. By far the lion’s share of capital investment will be taken up by the “vital” New Forth Crossing and new Glasgow Southern General hospital. Transport in general fares well with priority status given to upgrades to the strategic road network including the M8, M73 & M74 Improvement Programme and Aberdeen Western Peripheral Route.

Broadband and so called digital infrastructure also receives priority in the plan. The financial crisis demonstrated underperformance in exports and in today’s global market place the internet provides a portal to the world. Productivity gains and the potential to connect an otherwise potentially remote Scottish market into the heart of the global market place makes it a desirable area for the government to invest. The government hope to leverage additional funding from the private sector to extend high speed internet access throughout Scotland including to the most rural areas.

The need to leverage in additional funding to boost the core capital budget is evidenced elsewhere too. Through its Scottish Futures Trust the Scottish Government has announced a £2.5bn pipeline of ‘revenue funded’ projects largely in the social infrastructure sector with initial projects including schools and FE colleges. These projects will utilise the Non Profit Distributing (NPD) model an updated version of the PFI model which delivers capital investment upfront and is typically repaid from revenue budgets through a unitary charge over a 25 year period. The fact that education appears to have been prioritised is no surprise given its long term importance to economic growth and the worrying figures on youth unemployment. Other measures include using Network Rail's Regulated Asset Base borrowing capacity for the Borders Railway and the Glasgow - Edinburgh improvements programme.

In total the combination of capital budget and other measures to support investment is intended to generate infrastructure investment of £12bn over the next three years.

Stimulating Private Sector Investment

Maintaining investment in infrastructure has a second positive dividend which goes someway to addressing the second challenge facing Mr Swinney of stimulating private sector growth. If public sector projects can get to market quickly, however financed, then they should provide a short term ‘Keynesian style’ stimulus to the economy, for example by providing additional jobs in the construction sector which was hard hit during the recession. History suggests, however, that revenue funded projects in particular can take a long time to come to the market in the UK. Perhaps there is a role for Government to examine how this time might be reduced to levels closer to those seen in continental Europe such that the opportunity for shorter term stimulus is not missed.

Just as he has prioritised investment in infrastructure the Finance Secretary also appears to have taken a strategic approach to boosting growth in the private sector, targeting additional support to key sectors where Scotland already has, or might be able to build, competitive advantage. These include Low Carbon Industries, Renewable Energy, Life Sciences and Manufacturing. Here it is hoped that targeted investment and support by the public sector might find it easiest to have a bigger impact by attracting multiples of subsequent investment from the private sector. The confirmation in the budget of 4 new Enterprise Areas, which are likely to follow their counterpart Enterprise Zones in England in offering incentives such as a more favourable business rate regime, more generous capital allowances and access to high speed broadband, should benefit these sectors in particular.

It is perhaps in the renewables arena where the government has been most "strategic" in its attempts to open private sector pockets and it has set a very positive "tone from the top" to attract investors.

Another good example of the public sector seeking to maximise the impact on private sector growth of its investment is the Tax Increment Finance (TIF) model. Like the NPD programme this Scottish Futures Trust sponsored programme allows local authorities to borrow against the future business rate income expected to arise as a result of investment it makes in infrastructure. This directly links the investment by the public sector to future private sector investment, in the case of the Edinburgh TIF £1 of investment by the public sector is expected to ‘unlock’ up to £7 of private sector investment. It comes as no surprise also that the recent selection of TIF pilot projects by the Scottish Government includes a number with ties to the priority Energy and Renewables sectors. TIF has another desirable property in that it taps into the ability of Local Authorities to borrow from the PWLB, an ability denied to the Scottish Government itself. Scotland has led on the development of this model with the rest of the UK watching with very keen interest as they finalise their own plans for TIF.

It is perhaps in the renewables arena where the government has been most ‘strategic’ in its attempts to open private sector pockets and it has set a very positive “tone from the top” to attract investors. The scale of the investment challenge is potentially huge. PwC estimated around £30bn of investment would be required to build out existing offshore leases in Scottish territorial waters, and it is not yet clear where such resources will be found. Sovereign wealth and pension funds remain cherished targets but much needs to be done to de-risk the renewables industry sufficiently to attract investment. Here the public sector should consider how to put its scarce resources to best use. Prioritising technologies with the most realistic deliverability and extending the reach of its funding through intelligent co-investment and recycling of funds where possible would help leverage maximum input from the private sector and maximise both the economic and carbon impact. The Fossil Fuel Levy and Green Investment Bank, neither factored into the budget, will prove important in this regard.

Making the Most of It

Perhaps the lesson that should be taken away is that the challenge and scale of investment required remains huge across the public sector estate and to convert big growth opportunities like renewables. Mr Swinney's budget represents a good start. He had little scope for manoeuvre but in choosing to prioritise capital investment in infrastructure, make use of new funding models and act as a strategic investor in key sectors he has made at least a stab at maximising its impact.

 

Paul Brewer is Senior Partner, Edinburgh Office. PricewaterhouseCoopers LLP. Paul leads PwC's Government & Public Sector practice in Scotland and is a corporate financier specialising in the financing and delivery of large infrastructure and renewables projects.

By Paul Brewer, Senior Partner, PricewaterhouseCoopers LLP

Issue 2: March 2012

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