The Prudential Code for capital finance in local authorities

Report: 07
Date: 10 April 2003
By: Treasurer

Summary

The report sets out the key elements of the draft Prudential Code for Capital Finance in Local Authorities, identifies implications for the MPA and GLA and proposes a process for agreeing a response to the consultation.

A. Recommendations

That

1. the proposed change to the capital finance control system and the need to have regard to this in considering the forward capital programme be noted; and
2. the Treasurer, in consultation with Chair of the Finance Committee, be delegated the responsibility to respond to the consultation on the Prudential Code.

B. Supporting information

Introduction

1. Subject to the passing of the relevant legislation, the regulation of local authority capital finance is scheduled to change from 1 April 2004. The Authority needs to have regard to the proposed new system when considering its medium term capital programme and this report is therefore intended to inform members of the expected arrangements.

Current system

2. For many years the Government has imposed central controls over local authority capital expenditure because of its concern with the public sector borrowing requirement (PSBR). The current arrangements, which were introduced in 1990 under the Local Government and Housing Act 1989, rely on direct controls over local government borrowing. The Government allocates credit approvals on an annual basis, which represent a limit on the amount an authority can borrow including the capitalised value of any other defined credit arrangements. The latter covers, for example, long term and finance leases.

3. The value of credit approvals has tended to fall over the years as the Government has squeezed conventional capital provision. This has resulted in local authorities seeking alternative means of securing the benefits of capital investment, in particular private finance initiative projects (PFIs) and public-private partnerships (PPPs) not necessarily because they represent the most cost effective solutions but because they are the only available solutions.

Proposed system

4. The proposed changes to the control of capital finance are reflected in the Local Government Bill which is currently making its way through Parliament. The proposals were foreshadowed in a Green Paper in 2000 and subsequently in a White Paper published in 2001.

5. The principal feature of the new system is that local decisions on capital investment and borrowing should be taken in a prudential framework. The centrepiece of the arrangements will be a Prudential Code requiring authorities to have regard to affordability, prudence and sustainability and to publish relevant specified indicators to support their decisions. The system will therefore rely on self-regulation rather than central prescription. The legislation gives the Government reserve powers to set limits which would over-ride the self-regulation.

6. The Bill is expected to secure royal assent in the summer in which case it is intended that the prudential framework will operate with effect from 1 April 2004. That means that the Prudential Code will have to be followed in the budget process during 2003 leading to approval of the 2004/05 budget.

7. There will remain reservations over this timetable for some time not just because of the risk of delay to the primary legislation but also because there is little evidence yet of progress in addressing other consequential changes, e.g. to the grant system.

Prudential code

8. The Chartered Institute of Public Finance and Accountancy (CIPFA) has been charged by Government with the responsibility for developing and maintaining the Prudential Code. As Chair of CIPFA’s Treasury Management Panel, which has the responsibility within the Institute for securing development of the Code, and as a member of the Institute Council I have had a personal involvement in progressing this initiative.

9. The Code has been developed through a steering group which has brought together relevant government departments, local government representatives and practitioners. There has been an initial consultation draft and the final exposure draft was published in March 2003. The intention is that CIPFA will formally approve the final version in September. The executive summary of the exposure draft is attached at Appendix 1.

10. A preliminary guidance document has been produced and a copy, together with the full draft Code, is available in the Members Room.

11. The key objectives of the Code are to ensure that capital investment plans are affordable, sustainable and prudent, that treasury management decisions are taken in accordance with good professional practice, and that accountability is reinforced by providing a clear and transparent framework which is itself consistent with and supports strategic planning, asset management planning and proper option appraisal. The Code sets out the indicators that must be used and the factors that must be taken into account to demonstrate that these objectives have been fulfilled.

12. Affordability has to be assessed in terms of council tax impact and the Code therefore requires three year financial plans including council tax forecasts. To set financing costs in an appropriate perspective an indicator is required setting out the ratio of financing costs to net revenue stream.

13. Three year estimates of capital expenditure and the capital financing requirement are also specified indicators.

14. Limits for external debt are to be set at two levels. The ‘authorised limit’ is intended to be an absolute ceiling which cannot be exceeded during the period. The ‘operational boundary’ is a working limit representing the expected level and any persistent breach of this should result in remedial action. Both limits embrace other long term liabilities as well as borrowing.

15. There is also a series of treasury management prudential indicators which cover interest rate exposures, the maturity structure of borrowing and limits on investment longer than one year. The adoption of the CIPFA Code of Practice for Treasury Management is itself a prudential indicator.

Operation of the code within the GLA

16. The draft legislation specifically recognises the unique constitutional arrangements within the GLA group. In effect the operation of the Prudential Code will mirror the budget process. Thus functional bodies will consider their own capital investment plans in the context of the relevant prudential indicators. However the ultimate test of affordability will have to be made by the Mayor and Assembly as part of their consideration of the council tax precept and therefore the revenue consequences of capital plans together with the prudential indicators will be subject to confirmation at that stage.

Implications of the new system

17. Assuming that the reserve powers are not invoked the new prudential system eliminates the tight central control over local capital investment and borrowing decisions. The system will therefore allow greater flexibility to recognise local investment needs provided these are properly considered within the prudential framework and, in our case, subject to the final approval of the Mayor and Assembly.

18. Clearly this provides the opportunity to address, in a responsible manner, the current level of under-investment in the estate and the potential capital implications of continued officer growth. Members will wish to consider these implications in the context of the five year capital programme being reported elsewhere on this agenda.

Response to consultation

19. The exposure draft is circulated for consultation with comments requested by 15 May 2003. The intention is to put in a collective response from the GLA Group and I am in discussion with my opposite numbers in the GLA and other functional bodies.

20. Local government as a whole strongly supports the move to greater local discretion and flexibility over capital finance decisions and the Authority has concurred with that view in the past. One issue which has been identified in discussion with other police authority treasurers and within the GLA is the need to place the three year council tax projections into an appropriate context. This is particularly relevant to police authorities because the relatively high proportion of grant funding (the ‘gearing’ effect) can cause volatility in actual and projected council tax figures. This point will probably form part of the GLA Group’s collective response.

21. The draft response will not be available by the time of the Committee’s meeting and there is no other meeting before the response deadline. It is therefore proposed that the Committee delegate to the Treasurer agreement of the final response after consultation with the Chair of the Committee.

C. Equality and diversity implications

There are no direct equality implications of the expected change in capital finance controls.

D. Financial implications

The financial implications flowing from the operation of the new system will be considered as part of the revenue and capital budget process.

E. Background papers

• CIPFA Prudential Code for Capital Finance in Local Authorities – Second Exposure Draft, March 2003.

F. Contact details

Report author: Peter Martin, MPA.

For more information contact:

MPA general: 020 7202 0202
Media enquiries: 020 7202 0217/18

Appendix 1

Executive summary

Introduction

Exec 1 The Prudential Code [will] play a key role in capital finance in local authorities. Local authorities will determine their own programmes for capital investment in fixed assets that are central to the delivery of quality public services. The Prudential Code [is being] developed by CIPFA, the Chartered Institute of Public Finance and Accountancy, as a professional code of practice to support local authorities in taking their decisions. [It is expected that] local authorities will be required by Regulation to have regard to the Prudential Code when carrying out their duties in England and Wales under Part 1 of the Local Government [Bill] and in Scotland under Part 7 of the Local Government in Scotland Act 2003.

Objectives

Exec 2 The key objectives of the Prudential Code are to ensure, within a clear framework, that the capital investment plans of local authorities are affordable, prudent and sustainable – or, in exceptional cases, to demonstrate that there is a danger of not ensuring this, so that the local authority concerned can take timely remedial action. A further key objective is to ensure that treasury management decisions are taken in accordance with good professional practice and in a manner that supports prudence, affordability and sustainability. The Prudential Code also has the objectives of being consistent with and supporting local strategic planning, local asset management planning and proper option appraisal.

Exec 3 To demonstrate that local authorities have fulfilled these objectives, the Prudential Code sets out the indicators that must be used, and the factors that must be taken into account. The Code does not include suggested indicative limits or ratios. These will be for the local authority to set itself, subject only to any controls under [clause 4] of the Local Government [Bill] (England and Wales) and section 36 of the Local Government in Scotland Act 2003 (Scotland).

Exec 4 The prudential indicators required by the Code are designed to support and record local decision making. They are not designed to be comparative performance indicators and the use of them in this way would be likely to be misleading and counter productive. In particular, local authorities [will have] widely different debt positions at the start of the Prudential system and the differences are likely to increase over time as the result of the exercise of local
choices. The system is specifically designed to support such local decision making in a manner that is publicly accountable.

Scope

Exec 5 The Prudential Code applies to all local authorities, including police, fire and other authorities, which: in England and Wales are defined in legislation for the purposes of Part I [1] of the Local Government [Bill], from the date that part of the [Bill] comes into effect for the local authority; and in Scotland are defined in legislation for the purposes of Part 7 of the Local Government in Scotland Act 2003, from the date that part of the Act comes into effect for the local authority.

Process and governance issues

Exec 6 The Prudential Code sets out a clear governance procedure for the setting and revising of prudential indicators. This will be done by the same body that takes the decisions for the local authority’s budget – ie usually it will be the full Council for the authority concerned. The Chief Finance Officer will be responsible for ensuring that all matters required to be taken into account are reported to the decision making body for consideration, and for establishing procedures to monitor performance.

Exec 7 Prudential indicators for previous years will be taken directly from information in local authorities’ statements of account. If any item within a local authority’s statement of account that is relied on for a prudential indicator is the subject of audit qualification, this must be highlighted when the prudential indicators are set or revised.

Matters required to be taken into account

Exec 8 In setting or revising their prudential indicators, the local authority is required to have regard to the following matters:

• affordability, eg implications for Council Tax and Council housing rents
• prudence and sustainability, eg implications for external borrowing
• value for money, eg option appraisal
• stewardship of assets, eg asset management planning
• service objectives, eg strategic planning for the authority
• practicality, eg achievability of the forward plan.

Exec 9 The Local Government [Bill] and Local Government in Scotland Act 2003 refer solely to affordability, whereas this Prudential Code refers to both affordability and prudence. The two are related concepts. When making a decision to invest in capital assets, the authority must do more than simply determine whether it can afford the immediate cost. In order to ensure long term affordability, the decisions have also to be prudent and in the long term sustainable. Therefore, in carrying out their duties under Part I of the Local Government [Bill] (England and Wales) and Part 7 of the Local Government in Scotland Act 2003 (Scotland) in respect of affordability, local authorities are required to have regard to all those aspects of the Prudential Code that relate to affordability, sustainability and prudence. The Prudential Code also requires local authorities to have regard to wider management processes (option appraisal, asset management planning, strategic planning and achievability) in accordance with good professional practice.

Affordability

Exec 10 The fundamental objective in the consideration of the affordability of the authority’s capital plans is to ensure that the total capital investment of the authority remains within sustainable limits, and in particular to consider its impact on the local authority’s ‘bottom line’ Council Tax. Affordability is ultimately determined by a judgement about acceptable Council Tax levels and, in the case of the Housing Revenue Account, acceptable rent levels.

Exec 11 In considering the affordability of its capital plans, the authority is required to consider all of the resources currently available to it/ estimated for the future, together with the totality of its capital plans, revenue income and revenue expenditure forecasts for the forthcoming year and the following two years. The authority is also required to consider known significant variations beyond this timeframe. This requires the development of three year revenue forecasts and three year forward estimates of Council Tax, as well as three year capital expenditure plans. These are rolling scenarios, not fixed for three years.

Exec 12 When considering affordability, the authority needs to pay due regard to risk and uncertainty. Risk analysis and risk management strategies should be taken into account.

Exec 13 The following prudential indicators are key indicators of affordability:

Looking ahead for a three year period:

• estimates of the ratio of financing costs to net revenue stream
• estimates of the Council Tax [2] that would result from the totality of the authority’s plans.

After the year end:

• actual ratio of financing costs to net revenue stream.

Local authorities that have a housing revenue account (HRA) are required to do separate calculations for their HRA and non HRA elements and for the estimated impact on rents as well as Council Tax.

Exec 14 Other prudential indicators that relate to affordability are:

Looking ahead for a three year period:

• estimates of capital expenditure
• estimates of capital financing requirement (underlying need to borrow for a capital purpose)
• authorised limit for external debt (see paragraph 15 below)
• operational boundary for external debt (see paragraph 15 below).

After the year end:

• actual capital expenditure
• actual capital financing requirement
• actual external debt.

Exec 15 Both the authorised limit and operational boundary for external debt need to be consistent with the authority’s plans for capital expenditure and financing; and with its treasury management policy statement and practices. Risk analysis and risk management strategies should be taken into account. The operational boundary should be based on the authority’s estimate of most likely, ie prudent, but not worst case scenario and should equate to the maximum level of external debt projected by this estimate. The operational boundary is a key management tool for in-year monitoring. It will probably not be significant if the operational boundary is breached temporarily on occasions due to variations in cashflow. However, a sustained or regular trend above the operational boundary would be significant and should lead to further investigation and action as appropriate. The authorised limit will in addition need to provide headroom over and above the operational boundary, sufficient for example for unusual cash movements.

Prudence

Exec 16 By virtue of the requirements already listed above, the prudential indicators in respect of external debt must be set and revised taking into account their affordability. It is through this means that the objectives of sustainability and prudence are addressed year on year.

Exec 17 In order to ensure that over the medium term net borrowing will only be for a capital purpose, the local authority should ensure that net external borrowing does not, except in the short term, exceed the total of the capital financing requirement in the preceding year plus the estimates of any additional capital financing requirement for the current and next two financial years. This is a key indicator of prudence.

Exec 18 It is also prudent that treasury management is carried out in accordance with good professional practice. The Prudential Code includes the following as required indicators in respect of treasury management:

• compliance with the CIPFA Code of Practice for Treasury Management in the Public Services
• upper limits on fixed interest rate and variable interest rate exposures
• upper and lower limits for the maturity structure of borrowings
• upper limit for principal sums invested for periods longer than 364 days.

Decision making on capital investment

Exec 19 A soundly formulated capital programme must be driven by the desire to provide high quality, value for money public services. The Code recognises that in making its capital investment decisions the authority must have explicit regard to option appraisal, asset management planning, strategic planning for the authority and achievability of the forward plan.

Exec 20 The Code does not specify how the local authority should have regard to these factors. All of them represent elements of good practice for which guidance has already been provided by CIPFA and other authoritative sources. The Code instead concentrates on the means by which the authority will demonstrate that its proposals are affordable, prudent and sustainable.

The prudential indicators

Exec 21 The Code promotes transparency in decision making by using information contained within the published statements of account of the local authority and by having definitions for prudential indicators that are consistent with the definitions used within the statements of account.

Exec 22 The prudential indicators specified in the Prudential Code are the minimum required. Local authorities are encouraged to set further prudential indicators where this would assist their own management processes. However, any additional prudential indicators set locally should not, unless required to do so by legislation, associate any part of the authority’s external borrowing with particular items, categories or purposes of expenditure. The authority should have an integrated treasury management strategy within which its borrowing and investments are managed in accordance with best professional practice.

Conclusion

Exec 23 The Prudential Code [will] support the system of capital investment in local authorities. It is integrated within the wider statutory and management processes of local government. Key elements of the system [will] continue to be determined through legislation, in particular the amount required to be charged to taxation by local authorities in respect of capital investment and the amount and method of government support for capital investment. These will be significant considerations when local government takes decisions on capital investment. However, the level of capital investment that can be supported will, subject to affordability and sustainability, be a matter for local decision.

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