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LGC FINANCE SUPPLEMENT - BURNING A HOLE IN YOUR BUDGET

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Fuel costs are going up and emissions must be cut in order to control global warming. Mark Smulian looks for answer...
Fuel costs are going up and emissions must be cut in order to control global warming. Mark Smulian looks for answers to one of the toughest challenges today

The rising cost of energy could be the next thing to blow a hole in council budgets.

Factors as diverse as North Sea reserves running low, increased demand from India and China, closure of coal-fired power plants, oil exporters' policies, instability in the Middle East and market speculation will all hit the price councils pay for fuel.

So how bad are things likely to get? Andrew Bainbridge, director general of the Major Energy Users Council, warns: 'It is going to be a bleak year. It is clear local authorities are going to have to find extra money from somewhere.'

Mr Bainbridge says there should be sufficient gas and electricity even for a severe winter, but warns councils to 'be prepared for a price helter-skelter'.

When competition for power supplies started in the early 1990s, prices fell as rivals firms vied for customers.

Since then industry consolidation has left only half a dozen major suppliers each for electricity and gas.

'The old ways of buying are gone,' says Mr Bainbridge. 'Our advice to members is to form very close relationships with the few suppliers that remain and then adopt risk management programmes to share risks between customers and suppliers.

'Suppliers say they only make a profit after 18 months of a contract, and they need to get to know clients' businesses and so are reluctant to take on customers who may ditch them as soon as someone else offers a better price.'

David Taylor buys energy for 68 public sector clients in southern England through the Laser consortium, based at Kent CC.

He says: 'The market is probably as high as it has ever been and there is substantial volatility in prices.

'Even if you buy outside tight periods you will find prices have risen. You must bide your time unless you have to do a deal.'

Most local government deals are for two year fixed periods, which has proved beneficial in the face of rising prices but can land councils with a large increase when their contract ends.

Mr Taylor advises: 'You need to plan ahead. We are in the market months ahead so can do a deal in February for October.'

The North East Purchasing Consortium, which buys for 21 councils, is trying to take advantage of price fluctuations.

Corporate procurement officer Michelle Gibbons says: 'The market has changed drastically and market intelligence suggests prices will continue to rise.

'We are looking at flexible contracts, perhaps buying in 10 tranches to get the best price on different days.

'Prices have risen 40%, and next year we fear another 50% increase.'

Councils have been hit hardest on their street lighting budgets. Because streetlights do not have individual meters, rates must be negotiated according to estimates of the power consumption of each type of lamp.

There are few savings available through reduced use, since councils must keep roads and public spaces lit for reasons of road safety and crime prevention.

They could also face legal action if accidents happened as a result of poor illumination.

Even if councils were willing to take this risk, it is technically difficult to turn off individual lamps.

Nor does energy efficiency offer much hope. Dave Coatham, technical services manager of the Institute of Lighting Engineers, says few efficiency savings are possible when old lamps are replaced because new lamps must meet a new and higher British Standard.

'Those new lamps tend to be more energy hungry,' he says.

Roger Elphick, head of highways maintenance at Durham CC and chair of the UK Lighting Board, saw his county's street lighting bill rise 44% in 2005 - an extra£650,000.

'It looks as if we are getting similar prices nationally,' he says. 'It is worrying that costs are likely to go up again because there is a knock-on effect as street lighting comes out of the pot that includes highway maintenance, and that will suffer.'

The LGA's research, part of its work on the annual financial settlement, found street lighting costs, which total some£133m, rose by 30-75% in 2005, depending on when contracts were renewed, with similar rises expected this year.

Mr Bainbridge gives a grim warning: 'Some councils coming out of long-term contracts have to face a white-knuckle ride to cope with the price increases - it could be as bad as 100%.

'Where prices will go to? We don't know.'

Start saving now

Energy efficiency might be of limited help for street lighting, but offers substantial potential savings for other needs.

It also helps a wider role of tackling climate change by reducing carbon emissions, both in itself and as an example to others.

Mr Taylor says: 'The days of cheap energy have gone. Conservation is very important and there is now a real will to implement it, and about time too.'

Councils take energy conservation more seriously than does the private sector, according to Mr Bainbridge, and are well-placed because they often have environmental evangelists among their staff.

He predicts that areas prepared to pay well-trained energy specialists generously will more than make their money back.

But he urges that efforts should be directed as much at education as technology.

'There is a lot of technical equipment which will control energy use, but it is expensive to rely on technical fixes and the payback period may be a long one, which is difficult for local authorities,' he says.

'There is a need to motivate staff to save energy and to motivate the public.'

Garry Felgate, director of the government-funded Carbon Trust, says rising prices mean councils face three options.

'You can put up council tax, cut services or reduce your energy demand,' he says.

'That choice ought to be quite a strong driver for energy efficiency. It should be a win-win because it mitigates the price issues and allows councils to show leadership on climate change.'

Staff and public awareness of what causes carbon dioxide emissions is important.

He explains: 'Every time you get in your car it is obvious that it emits exhausts, but when you switch on a light it is not obvious that anything is emitted.

'However, every light needs supplies from a power station and that emits carbon.'

Dr Felgate agrees with Mr Bainbridge that councils are often ahead of the private sector in promoting energy efficiency, 'because their staff are engaged with doing good and doing the right thing'.

Councils should look at where education or technology is most appropriate, he says.

'The order in which to do things is, switch off all the lights you don't need - that is education, then fit energy efficient bulbs to those left on - that is technology, and after that you might consider buying green energy,' Dr Felgate advises.

Energy efficiency offers councils a rare chance to save money and do something popular. And help is at hand.

The Carbon Trust offers a free carbon management service to councils, with guidance, technical support and software. There are also workshops for senior staff.

Bristol City Council was one of 16 that piloted the trust's programme for authorities in 2003.

It had emitted 55,612 tonnes of carbon from its premises and services, at an annual energy cost of more than£6m.

The trust made recommendations designed to save Bristol more than£400,000 in the next five years.

Its key recommendations were:

>> Energy efficiency - insulate heating valves and pipe work; install lighting and heating controls and energy efficient lighting; install time clocks on photocopiers and other equipment.

>> Awareness - education programme for managers, staff and school students devised to achieve a 10% energy reduction within three years.

>> Procurement - insist good carbon management is a requirement of tender processes for all building work and equipment bought.

>> Travel - give staff incentives and promote walking, cycling, public transport, and pool cars.

Next time you fumble in a foreign city to change your Paraguayan guaranis into Mauritanian ouguiyas, or even your euros into dollars, spare a thought for your council's pension fund - you might be helping it.

Currency speculation has been regarded dimly ever since Black Wednesday in 1992, when the markets destroyed the pound in frenzied selling. It has definitely not been seen as suitable for council pension funds.

That attitude is changing as part of fund managers' continual quest for higher returns and diversified investment.

With a dozen or so councils already entering the bureau de change, and others planning to, currency has become respectable.

There are two ways in which pension funds can become involved in currency dealing.

The first is where this is incidental to an overseas investment. If, for example, a fund holds overseas equities in US dollars, it is at risk from adverse movements of the dollar against sterling, even if the investment itself is unaffected, because it would lose when its value was converted back.

Hedge funds can offer cover against such risks by using the market to offset it - essentially a form of insurance against unfavourable currency movements.

The second is direct investment in currency, where a pension fund, say, uses sterling to buy euros and then, when the market appears ripe, sells those for dollars and Swiss francs, making money on each transaction.

Among the attractions claimed is that currency is an inefficient market. This is because most people who trade currency do so for business finance, travel or for governments' financial policy. Their main concern is not the currency itself.

For investors whose priority is currency, this opens the prospect of gains to exploit this divergence between their needs and those of active purchasers.

It is also a market that moves independently of others. Currency can offer gains while other investments are falling, and it is not tied to other markets. A further advantage is that currency markets never close. If something happens to move a currency up or down it can be traded 24 hours a day, enabling astute managers to take quick advantage of changes.

David Morley, director of institutional business at Henderson Global Investors, says most funds have chosen the 'currency overlay' route, where they hedge the currency exposures across their investment

portfolio.

Mr Morley says: 'We believe that there is a much wider opportunity than overlay available through investing in currency funds.

'This is because the currency overlay manager is constrained by the currency exposures of the underlying investment portfolio, whereas the [currency] fund manager has much more unconstrained opportunities.'

Jim Bonner, Henderson's director of foreign exchange and treasury, explains: 'The huge advantage of currency is that it is extremely flexible, as it can be traded pretty well at any time in any size and anywhere within reason.

'It is as liquid as you like in major currencies, you can hedge risks very easily and you can trade at any time.

'Currency is a very simple product and concept and the risks are easily controlled, you can restrict risk and we use a very tight stop loss in markets.'

This control, explains his colleague investment director Mitesh Sheth, simply means that if a manager is selling a currency and the market moves adversely, the trade will end at a predetermined point to limit losses.

One advantage claimed by Henderson for its approach of using hands-on investment managers is that it avoids the 'black box'.

These contraptions are, the company says, found in firms that trade currency through a computerised approach in which trades are made solely according to market trends detected.

Mr Bonner argues that black boxes miss opportunities because they trade only when the market moves.

For example, the pound and the dollar finished October 2005 as they began the month, but Mr Bonner says he made 71 basis points on trading the two as they shifted around on the days between.

'A box would have missed that,' he says, because it would not see a trend, merely a series of small up and down movements.

Mr Bonner says he will trade 'any currency that is liquid and tradable', the exceptions being where governments manipulate their currency so much that rational investments cannot be made.

Funds that use only overlays but not currency trading are 'missing a trick', says Mr Sheth, 'because if they depend on assets that they hold they can only trade in sterling against that currency, which means there is inevitably a less liquid market and you miss opportunities.'

Peter Wakefield, director and head of portfolio management at Record Currency Management, manages both overlay and currency trading.

He explains that overlay can be passive or active: 'Passive is where you iron out the movements to a fixed, predetermined extent,' he explains.

'Active hedging is where we manage the percentage of hedging so the client ends up ahead. We sit on our hands when it is sensible to do so and use a hedge at other times.'

Currency investment is increasing because council funds want to diversify from equities, he says.

There is no shortage of financial institutions seeking to tempt council funds into currency trading, but how appealing is it?

Brent LBC head of investment Martin Spriggs started currency investment in

December.

'It seemed to us that it was an inefficient market that offered opportunities for gains,' he says.

'If you look at the trends you can see where currencies are out of their true valuations.'

Brent has put 7% of its fund, equivalent to£28m, into currency and has appointed Mellon as its manager.

Mr Spriggs says: 'The potential pitfalls are that, for example with the dollar, if you look at the trade deficit in America you think it must go down, but then it suddenly goes up because, say, Far East governments have invested in dollars.

'Sometimes there is no discernable trend and at other times a sudden crisis may arise.'

Brent expects a return of 1.5-3% a year above the cash equivalent, but he points out that the use of futures - where deals are done for to buy currencies at a future date - means Brent's investment is in effect considerably greater than it appears.

'Futures mean the£28m invested is equivalent to about£150m,' he says. 'Say they make£3m, that is about a 12% return on our£28m. We are looking for 15-20% return over three years.'

Jack Johnson, pensions investment manager at Windsor & Maidenhead BC says currency is 'something that is on the radar for this year'.

'It appears that currency has a trend in one direction and despite the noise around it you can see what that line of travel is, so you can tell what is going on and where you ought to be.'

The council has a positive cash flow in its fund and is considering buying dollars at an advantageous time for transactions in overseas equities rather than buying them as purchases occur.

It is, however, sticking to actively managed overlay.

'I am not so sure of the efficacy of currency trading,' Mr Johnson says. He is concerned the speculative element could be inappropriate for a public authority fund. 'It could be viewed unfavourably by the government,' he says.

The mighty Strathclyde pension fund, managed by Glasgow City Council, expects to appoint two currency overlay management firms by March.

Each will be able to trade£200m worth of currency based on its overseas equities.

It has around one-third of its assets invested overseas and so has 'considerable exposure to currency movements', director of financial services Richard McIndoe says in a report to the fund's committee.

There has not previously been an explicit strategy to deal with this.

Mr McIndoe says diversification was important because increasing concentration in the UK equity market increased risk and the market lacked significant exposure to several new industries.

Increasing overseas equity investment would provide a solution but 'our analysis suggests that once the overseas equity exposure, if it remains unhedged, reaches around 50% of the total equity

exposure then the diversification benefits begin to be outweighed by the increased currency risk'.

Currency management has two principal virtues, he says, 'it is derived from a different source from the fund's existing sources of return and it is an inefficient market'.

He cites a survey by management firm Russell/Mellon CAPS, which showed that over the last five years the average currency manager it sampled has delivered added value of around 0.8% a year, which Mr McIndoe called 'a striking contrast to

equity managers'.

The currency firms will work to convince pension funds to consider them this year.

With the increased searched for diversified investments many funds will at least want to take a good look.

LGA warns action must be taken

With combined fuel bills topping£1.45bn, experts say authorities have no option but to introduce whatever energy-efficient measures they can

According to the Local Government Association, councils now face a combined energy bill of£1.45bn.

Thanks to gas prices rising by a third, electricity by a quarter and petrol and diesel by a tenth in 2005, councils' expenditure on fuel rose by almost£250m in the course of the year.

The LGA is urging councils to implement as many energy efficiency measures as possible, not only to keep costs down but to reduce carbon emissions and hold down global warming.

Association chairman Sir Sandy Bruce-Lockhart (Con) says councils have a responsibility to ensure the frail and vulnerable are kept warm through the winter months.

'Yet, like all electricity and gas users, councils are seeing their energy bills going through the roof,' he says.

'We cannot simply switch off lights or heating to save energy in the way that homeowners can.

'It's during the darkest and coldest days of winter that people rely most on us to deliver vital services such as street lighting, heating and gritting.

'With councils already making massive efficiency savings and having to tighten their belts, the rising energy costs will be a deeply worrying headache to everyone.'

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