Contracting To Expand

01 June, 2007

As the country struggles to increase its recycling capacity before it is hit with fines for failing to meet EU landfill reduction targets in 2010, the matter of how best to finance plant investment to allow such growth is of keen interest. JCB Finance’s Nigel Greenaway argues why he feels contract hire may be the perfect solution.

Over the next few years it has been estimated that £11billion will have to be spent on the UK’s waste and recycling infrastructure in order to meet regulations set in motion by the EU landfill directives. The consequences of failing to meet these targets are dire.

The EU has already started legal action against the UK for its failure to implement the directive properly, and local councils face fines of £150 for each tonne of waste landfilled annually over the EU set quota after 2010.

According to the National Audit Office, by 2013 fines of up to £200million could hit taxpayers for the failure to cut the amount of waste thrown in landfills. With the Chancellor also hiking landfill tax annually by £8.00 from next April – a rise unplanned for by councils – the result will doubtless be higher council tax bills. Not exactly a vote winner.

Being responsible for waste collection and disposal, local authorities are busy shooting out PR to deflect some of the blame for the predicted tax hikes while busy trying to rush into place Waste Implementation Programmes in order to meet their targets.

Some of these programmes might be handled directly by a Council’s in-house team, or some by an external contractor. Collection might be handled by one party and disposal handled by the other. Some have even formed a Local Authority Waste Disposal Company (LAWDAC) to carry out these services.

Whichever method is chosen, one thing is clear. There is a focus on price per tonne, cost per tonne, recycling supplement per tonne or WCA Diversion Compensation Payment per tonne, etc. There are percentage recycling targets and percentage recovery targets.

Virtually every element is under close scrutiny and will have to be measured accurately because of the financial implications. Whether you are part of the council’s infrastructure or an external contractor you will have to pitch for the business and accurately calculate the cost per tonne in handling or recycling the waste at any point in the process.

This means you need to measure the costs involved in providing these collection and disposal services accurately and reduce the risks of miscalculating these costs. It is here that contract hire can help.

Contract hire combines elements of finance (operating lease), service, repair and maintenance contracts that can cover the entire spectrum of plant operations, underwriting defined operating risks for a fixed-cost so you can say goodbye to unexpected bills.

Servicing, mechanical repairs, breakdowns, insurance and even relief machines become one agreed budgetary expense with any risk on overspend being borne by the supplier. The risk of disposing of the machine at the end of the contract also rests with the supplier, who will take a view on the likely future residual value and attempt to recover this amount by selling to an unrelated third party.

By removing the residual value from the capital element of the repayments the overall monthly repayments are dramatically reduced for the end user. It becomes very easy to calculate the cost per hour based on the contracted hours and hence a cost per tonne based on the handling capabilities of the machine.

Agreements usually run for between three and five years but could be as long as seven years, depending on certain criteria recently introduced in April 2006. There are a number of complicated tests that have to be used in order to define which classification the lease falls under.

To keep this simple the important thing to remember is that, broadly speaking, the majority of leases of five years’ length or less will fall under the old tax and accountancy rules. Longer leases of between five to seven years will have various tests applied which could result in them being defined as a long funding lease (LFL).

In LFL schemes the lessee is treated as the owner of the equipment for capital allowances purposes. The lessee is also entitled to deduct the finance charge included in the lease rents.

The lessor is treated as though the lease is a loan and taxed on the finance element of the rents only. Special adjustments apply where a long funding lease is accounted for as an operating lease.

The short answer to this question is yes. The regulations to allow the use of privately funded operating lease and contract hire packages have been around for almost two decades. Such arrangements officially fell outside capital expenditure restrictions while still having to pass scrutiny under Value for Money and Risk Transfer tests.

The rules were eased further in 2004 with the introduction of The Prudential Code for Capital Finance in Local Authorities. The new system is one based largely on self-regulation and allows local authorities to take greater control of their investment in assets that are central to the delivery of quality local public services.

In addition, the Government has emphasised the importance of partnership with the independent sectors in delivering best value. Local authorities have for a long time been encouraged to consider new approaches to service delivery and sources of funding.

Contract hire facilities go a long way towards helping local authorities compare the whole life costs of the different methods of delivering the same service, be it in-house, outsourced or a combination of both.

Contract hire, by definition, meets all the criteria laid down governing the use of operating leases within the local authority sector and offers considerable assistance towards achieving best value performance indicators.

Ownership and the impact on the balance sheet

Depending on the nature of your business, ultimate ownership of your plant and its position as an asset on your balance sheet may not be very important if the plant is part of a production process and there are already other significant assets – a waste transfer station or recycling plant, for example.

In these circumstances it is often more important to know how much each piece of plant contributes to the overall cost of production or the cost per tonne of material processed.
Finance products such as operating leases or contract hire allow this while keeping the plant off the balance sheet and improving financial gearing because the leased asset will not count as interest bearing debt.

Equally, accounting ratios such as return on capital employed may be dramatically improved by removing such assets from the balance sheet.

This off-balance sheet treatment is allowed because the residual value risk and the responsibility for disposing of the plant, to a third-party buyer, rests with the leasing company.

It was for this reason that the 2006 changes in tax regulations left the bulk of operating leases unchanged in their tax treatment. Hence operating leases remain a very popular option within niche sectors such as quarrying, waste and recycling.

So as local authorities or private operators seek to help the UK increase the country’s recycling capacity and minimise any fines or council tax hikes waiting around the corner, contract hire is a good tool to help them achieve it.

Nigel: 01889 594126