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The mood music running up to the Budget has been characterised by two motifs: the sorry state of the public finances, and the sorry state of the public infrastructure. The UK, we are reminded, is in a state of both physical and fiscal disrepair. These twin predicaments point to a shared solution — rebuilding the physical foundations of economic growth — but this harmony could quickly turn to dissonance upon codifying the details of the fiscal regime. In this instance, it appears that the dual meaning to the word investment — in the real sense of fixed capital formation (“spades in the ground”), versus the financial sense of portfolio allocation — may be playing out in the public investment space too. With this comes the risk that the long overdue turn towards public investment may entrench economic and financial orthodoxies. Whether the Government delivers on the Prime Minister’s conference slogan of “Britain that belongs to you” will still come down to judgement and discretion of the Treasury.
The Chancellor’s long-running performance of restraint — performative, that is, in the technical sense of effecting change in the world through its utterance — aimed at anchoring market expectations about the sustainability of government debt, has now crystallised in the choice of “public sector net financial liabilities” (PSNFL) as the target measure for her fiscal rule, permitting any increase in debt that is offset by the acquisition of financial assets.
Quantitatively speaking, a boost in public investment is welcome and overdue. As Figure 1 shows, public sector net investment since the 1980s has been devastatingly low and tilted increasingly towards capital grants to the private sector (its post-70s decline driven by the privatisation of public corporations and the disempowerment of local government). The Chancellor boasts of a total increase of £100 billion over five across all areas (£20 billion per year across all areas, compared to the £28 billion per year of green transition spend ditched in February 2024). Some of this will be swallowed by simply undoing the cuts set in motion by the previous Chancellor’s political manoeuvring.
[.fig][.fig-title]Figure 1: Public Sector Net Investment by Type (% of GDP)[.fig-title][.fig]
[.notes]Source: OBR[.notes]
At stake is not just the quantity of money “released”, however, but the nature of its deployment. A theme running through Common Wealth’s research is that, with proper governance measures, public ownership and operation of key strategic assets can equip investment projects with the robustness and flexibility that other models — including government financing without ownership — often lack. This is of particular importance for GB Energy, where there is debate over whether it should seek minority stakes in projects and, relatedly, the extent of investment decision making and operational control it will have.
One fiscal rule concerns the flow of income and expenditure, the other the stock of assets and liabilities. The former targets current day-to-day spending. Under Jeremy Hunt’s Chancellorship, the latter targeted public sector net debt (PSND), stipulating that it must be projected to be falling at the end of the five-year forecast window.
This formulation has four immediately obvious weaknesses:
The Chancellor has taken aim at the first of these weaknesses, and with good reason. The last fifteen years’ myopic attention to the liability side of the balance sheet (netted only against liquid financial assets) reflects an impoverished and ultimately impoverishing approach to public investment. The new stock measure of choice is PSNFL. Figure 2 illustrates the widening scope from PSND through PSNFL to PSNW (public sector net worth). On the asset side at least, PSND and PSNFL are distinguished primarily by liquidity, whereas PSNFL and PSNW are distinguished by the assets’ financial versus non-financial character. Hence the Chancellor’s boast that PSNFL “recognises that government investment delivers returns for taxpayers” was immediately qualified by the selective explanation: “by counting not just the liabilities on a government’s balance sheet, but the financial assets too” (our emphasis). Not all assets are born equal.
[.fig][.fig-title]Figure 2: Comparison of Different Measures of Government Debt[.fig-title][.fig]
[.notes]Source: Resolution Foundation[.notes]
Much will depend therefore on what types of assets are deemed financial or non-financial. The National Wealth Fund, subsuming the existing UK Infrastructure Bank, will operate through equity stakes and loans to businesses, and will therefore be PSNFL-neutral, but screened by the quality controls of the new Financial Transaction Control Framework (FTCF). As for GB Energy, “initially, while it is established, the government expects that Great British Energy’s investment activity will be undertaken by the NWF” (paragraph 4.8). This will help get money out the door quickly but developing a strategic relationship between them over time will be important.
Importantly, the implications of PSNFL for the type of investments undertaken by GB Energy, whose mission concerns decarbonisation and not industrial strategy, are far more limiting. PSNW will still inform Treasury’s picture of the public finances, but is eschewed as a target due to the “practical challenges: valuing non-financial assets, such as schools and hospitals, can be complex, and these assets often do not generate direct financial returns” (paragraph 3.6). Energy assets of the kind that GB Energy must invest in are most certainly revenue-generating — though the IFS suggests this is not sufficient to qualify for PSNFL, which “does not include the kinds of assets that an increase in investment spending is likely to buy — such as energy pylons or hospitals”. The FTCF characterisation of “financial assets and instruments” (see Figure 3) defines equity assets as “residual claims held by a public sector entity on the assets of private sector corporations through share holdings or ownership” (our emphasis). This would preclude by default from the fiscal rule anything that confers meaningful control to the public sector — such as the ability “to block the passing of special resolutions” — since by that token the entity would no longer be classified as private sector. In the instance of NatWest, that ability was considered by the ONS to be an equity threshold of 25 per cent.
[.fig][.fig-title]Figure 3: Definition of Financial Assets and Instruments[.fig-title][.fig]
[.notes]Source: HM Treasury, Financial Transaction Control Framework[.notes]
Ultimately, however, it is still Treasury discretion that determines the exception — specifically judging whether greater public control will enhance the delivery of policy objectives or deliver better value for money. The FTCF states in its list of other financial transaction (FT) best practice to consider:
[.quote][.quote-text]Classification — FTs, especially equity investments, may lead to reclassification of investees into the public sector if they result in public sector control over investees, which needs Treasury approval and which the department is responsible for managing … Equity stake — the size of the stake should be limited to avoid inadvertent nationalisation, alongside consideration of other factors like control being taken. In some scenarios, taking a larger stake may be value for money and this principle would not apply.[.quote-text][.quotee]FTFC[.quotee][.quote]
Keir Starmer’s speech to Labour Party Conference made a slogan of offering “a Britain that belongs to you” and further attempted to reappropriate the Leave campaign’s memorable “take back control” slogan, reminding us that “markets don’t give you control – that is almost literally their point.” And yet control now appears to be the default criterion by which the new fiscal rule excludes assets from consideration, barring exceptions.
It is our view that public control over investment projects, especially in clean energy, is advantageous both to policy delivery and value for money, satisfying both the discretionary criteria considered by Treasury. The form that GB Energy’s assets take therefore is hugely consequential for whether it will be sufficiently resourced to overcome the considerable investment hurdles impeding the power decarbonisation mission. The PSNFL’s bias favour of financial over non-financial assets may threaten to tilt the investment balance in favour of instruments that derisk private investment, and away from direct public investment and ownership. The OBR chair Richard Hughes appears to agree — telling a Resolution Foundation event that PSNFL encourages “close to market” equity stakes and loans and that his institution will need to take a “closer look” at the uncertain nature of returns on such investments as part of its fiscal modelling.
As Common Wealth has argued, financial assets such as lending or minority equity stakes may assist with investments but do not fully address their brittleness in the face of macrofinancial and supply chain turbulence, especially if they must still go through the flawed CfD regime. Freeing the pursuit of necessary investment projects from the constraints of ex ante price-fixing agreements and assuring ROI ex post cannot be achieved through loans or minority equity stakes. Furthermore, continuing operation of those assets will improve the coordination of grid balancing by allowing the system’s component assets to be operated directly according to system need rather than indirectly through the proliferation of interlacing balancing, curtailment and capacity markets. How investment projects are appraised is considered briefly further down.
On a separate note, the Chancellor told a fringe event at this year’s Labour Party Conference that she was considering asking the OBR to assess the productivity improvements of planning reform, as it does with respect to labour migration and childcare. The productivity effects of these reforms are relevant to the fiscal rule’s GDP denominator, but the reform’s impact on the target’s numerator should be recognised too.
The Labour manifesto committed to reforming the 1961 Land Compensation Act, which requires that public agencies pay “hope value” to the recipients of compulsory purchase orders (CPOs), reflecting the uplift in land value created by the prospective infrastructure for which the CPO was issued. If the Government succeeds in revoking this toxic legacy of England’s abortive bourgeois revolution, then the land value uplift resulting from public investment projects will once more be captured by the public balance sheet instead of landowners. This capture can allow direct financing of public infrastructure by borrowing against the value uplift — as is routinely practiced to great success elsewhere — rather than having to go to capital markets. However, for the purpose of the fiscal rule the numerator may or may not also be positively impacted depending on whether or the benefits are registered as land assets (and thus excluded as non-financial) or as an improved cash position from paying out less to acquire the land.
The fiscal rule’s temporal dimension is also important. Short-termism has rendered the infrastructure investment pipeline brittle, as countless reviews have complained. The Chancellor’s new PSNFL rule will (over the next two years) gradually shorten the target horizon from five to three years. OBR analysis judges that only after five years or so does public investment start paying for itself. HM Treasury’s stated rationale for shortening the horizon is to make the rule less gameable, though this makes more sense with regard to current deficits than to balance sheet measures like PSNFL. A mitigating factor is that, unlike with PSND, where the GDP denominator was the only variable through which further borrowing could be validated, the PSNFL target dilutes the impact that the time horizon might otherwise have. But, again, the question comes down to how the investment’s prospective benefits are capitalised in the accounts before the window closes.
The fiscal rule is far from the only screening process for public investment projects. The Treasury still applies its Green Book principles to assess the business case for a project. On top of this the new Financial Transaction Control Framework aims to ensure the new fiscal space is not used irresponsibly, building on and not supplanting existing frameworks. It requires that major financial transactions (FTs) above a soon-to-be-specified threshold must be delivered by designated expert public financial institutions rather than by government departments, except when Treasury allows otherwise on the basis of “exceptional reasons where [doing so] would undermine the objectives of the policy”.
FTs return on investment (ROI) must be at least as high as the yield on gilts — in other words covering the debt issued to finance it. This risks privileging a focus on securing certain returns with defined revenue streams, without due regard to wider strategic value that investments can bring in securing delivery of government targets and a long term industrial strategy. The FTCF stipulates that ROI be considered at the portfolio level, in line with conventional financial diversification. However, the specific character of the relationships between system components when guided towards strategic objectives — such as industrial strategy or especially decarbonisation — present severe challenges to the backward-looking correlations that traditionally inform portfolio diversification. As we have previously argued, the economics guiding this approach is ill-suited to the non-linearities and disaggregability that characterise system-level consequences of the infrastructure we need to build, and with which GBE will be concerned — in particular the Green Book’s current “net present social welfare” approach compares unfavourably to new frameworks like “risk opportunity analysis”.
Given the timescales of the kind of investments needed, much also hinges on the choice of discount rate employed in this analysis. Green Book discount rates make heroic assumptions of a constant 2 per cent annual increase in GDP per capita and are updated infrequently and at a lag to interest rates that ground the concept in financially meaningful counterfactual rather than hedonic metaphysics. Other issues also pertain to cross-sectional variation in discount rates between projects, instances of double-discounting. The benefits calculation also depends on the overly simplistic monetisation of externalities such as abated greenhouse gas emissions in a manner that cannot easily account for path dependent and system-wide decarbonisation requirements and the uncertainty they bring.
Under the scrutiny of financial markets, good economic governance involves a mix of rules and discretion. The Chancellor’s much publicised changes to the former has broken with the tradition of the last fifteen years. But the latter will need a similar paradigm shift if the UK’s hopes of physical repair are not to be weighed down.
