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Paper No 5 00/01

Committee	PRUDENTIAL CODE STEERING GROUP
Venue	Robert Street
Date	31 May 2001
Author	Maureen Wellen Policy and Technical Manager Tel 01628 623 652 Capital and Treasury
Subject	Outline of process and issues to be developed for the Prudential Code

To discuss a report on the outline of process and issues to be developed for the Prudential Code and to agree next steps.

REPORT

Process

1 The work on the development of a Prudential Code for capital finance in local authorities is an important element of the work programme of CIPFA's Policy and Technical Directorate. It is within the agreed work programme of CIPFA's Treasury Management Panel. The Treasury Management Panel has established a Steering Group to undertake the development work and the Panel has approved the protocol, composition and terms of reference of the Steering Group. Details were included in paper PCSG 1 00/01.

2 The following is an outline of the process and timetable that is envisaged:

(a)	Prudential Code Steering Group discusses and agrees subject areas for the Prudential Code	31 May 01
(b)	initial draft for the Prudential Code is drafted section by section by the Secretariat	mid June 01
(c)	initial draft is discussed and developed by correspondence with members of the Steering Group - it is suggested that a correspondence reference group be formed for each section of the code	early July 01
(d)	second meeting of the Steering Group considers resultant first drafts	mid July 01
(e)	Secretariat turns round each section in the light of comments of the Steering Group and develops first full draft of the Prudential Code for consideration at the third meeting of the Steering Group	Sept 01
(f)	Third meeting of the Steering Group finalises the first full draft of the Prudential Code	mid Sept 01
(g)	draft Prudential Code considered by Treasury Management Panel for approval	27 Sept 01
(h)	draft Prudential Code considered by Technical Committee for approval and discussed by Local Government Committee	8 Nov 01
(i)	draft Prudential Code published as an exposure draft for consultation and subject to a two month consultation period	Nov 01
(j)	following this, the Steering Group will consider responses to the consultation draft, and actual legislation with respect to capital finance as it develops. Future development work will be dependent on the outcomes of these, and will also be undertaken in the light of pilots (see below). It may be necessary to undertake a second consultation draft in the light of actual legislation developed. Timing will depend on when legislation is introduced and enacted and whether the draft Code then requires significant revision. If a Bill is introduced in 2002 and all proceeds smoothly, implementation by April 2004 should be possible.

3 The process outlined above is consistent with CIPFA's governance arrangements. In particular, CIPFA codes of practice are only issued after consideration and formal approval by the Institute Council.

Issues for development

4 CIPFA's responses to:

- Modernising local government finance: a green paper (England)
- Simplifying the system: local government finance in Wales
- The Local Government Committee's inquiry into local government finance (Scotland)

outlined the process for the development of a possible CIPFA Prudential Code and what it might contain. The appendix to this report is an extract from these submissions, relating to the content.

5 Following on from this, it is recommended that the proposed content for the Prudential Code is considered in three sections:

- a prudential system and external debt

- a prudential system and capital commitments

- a prudential system and treasury management.

A prudential system and external debt

6 From the earlier work undertaken by the CPWP groups, a clear 'front runner' for an indicator within a prudential system would be a measure of external debt related to a measure of the local authority's revenue stream.

7 It is suggested that factors to be considered in the development of such an indicator or indicators include the following:

- definition of external debt

- gross and/or net of external investments

- other long term liabilities

- transferred debt

- measure(s) of the local authority's revenue stream

- estimates for the medium term, and process for estimation, as well as actuals

- credit ratings.

8 CIPFA's comments to earlier consultation papers raised the question of whether there would be one statutory long stop indicator for local authorities, or whether it would be for each local authority to set its own local PI. In the case of the latter, process issues would include:

- the process for setting, reporting and reviewing/revising the PI(s)

- for what time-frame

- the nature of the PI(s) (eg budgeted, average during year, minimum, maximum, year-end)

- any transitional arrangements.

9 The Steering Group is asked to discuss the above, amend/add to the issues outlined, and to agree a reference group of Steering Group members for the further consideration of the prudential system and external debt.

A prudential system and capital commitments

10 A prudential system for capital finance will need to consider capital commitments as well as actual debt. CIPFA's earlier responses suggested that PIs for capital commitments will need to include:

- looking forward, the level of capital expenditure which the authority has already committed but not incurred

- looking forward over the medium term (3 to 5 years) the level of capital expenditure which the authority plans in total

- looking backwards, the level of capital expenditure which the local authority has already incurred and which has yet to be financed.

The work of the CPWP groups also suggested a PI based on the level of and changes in all sources of capital finance, to relate borrowing to the capital programme generally.

11 It is suggested that factors to be considered in the development of an indicator or indicators with respect to capital commitments include the following:

- the definition of what constitutes capital expenditure

- CIPFA would recommend UK GAAP as base line position

- in addition need to consider position of deferred charges

- and 'capitalisation directions'

- how to measure capital expenditure already incurred but not financed

- how to measure capital expenditure committed but not incurred

- how to measure capital expenditure planned but not committed

- the revenue consequences of the capital programme.

12 Process issues would include

- the process for setting, reporting and reviewing/revising the PI(s)

- for what time-frame

- the interrelationship between the Prudential Code and any statutory requirements for the MRP (England and Wales), loans fund debt charges (Scotland), or any statutory replacements for these.

13 The Steering Group is asked to discuss the above, amend/add to the issues outlined, and to agree a reference group of Steering Group members for the further consideration of the prudential system and capital commitments.

A prudential system and treasury management

14 There is a CIPFA Standard of Professional Practice for Treasury Management and a CIPFA Code of Practice for Treasury Management in Local Authorities. CIPFA is currently undertaking a revision of the Standard of Professional Practice, and is developing a Code of Practice for Treasury Management in the Public services, which will replace the current codes for individual sectors. The exposure draft of the code was published in March and comments were requested by 23 May. Within the principles laid down by the Code of Practice for Treasury Management, the Prudential Code could specify indicators which each authority would be required to set locally.

15 It is vital not to place too much emphasis on numerical indicators with respect to treasury management in isolation from the good practice processes established by the code of practice for treasury management.

16 Process issues in relation to treasury management indicators would include:

- the process for setting, reporting and reviewing/revising the PI(s)

- for what time frame

- the nature of the PI(s) (eg budgeted, average during year, minimum, maximum, year-end).

17 The Steering Group is asked to discuss the above, amend/add to the issues outlined, and to agree a reference group of Steering Group members for the further consideration of the prudential system and treasury management.

Pilots

18 It will be helpful to the development of the Prudential Code to ensure that practical experience of how any indicators will operate is developed, so far as possible, before any system goes live. In the first instance, it is suggested that members of the Steering Group from local authorities examine the indicators in their individual reference group section(s) as they are developed.

19 It is also suggested that some full (but non-live) pilots are undertaken during the first exposure draft consultation. It is recommended that invitations for local authorities to participate in such full pilots are made. Such pilots would be undertaken by the local authorities themselves, using the exposure draft of the Prudential Code.

RECOMMENDATION

The Steering Group is asked to discuss this report on the outline of process and issues to be developed for the Prudential Code and to agree next steps.

EXTRACT FROM APPENDIX A TO CIPFA'S MEMORANDUM OF COMMENTS ON MODERNISING LOCAL GOVERNMENT FINANCE: A GREEN PAPER

4 A PRUDENTIAL SYSTEM AND EXTERNAL DEBT

4.1 The March 2000 CPWP report to CLP, "The Capital Finance Review : A new prudential system", included a possible shortlist of eight indicators which had been discussed by the CPWP technical group. The technical group has emphasised that this was not a definitive list and that the process of research and consultation to develop CIPFA's prudential code will provide a structured way to develop a final set of indicators.

4.2 The indicators were chosen in order to cover three key areas. The three areas are considered in this and the next two sections of this report.

Definition of external debt

4.3 The level of external debt of a local authority will be a key element of a prudential system.

4.4 CIPFA would recommend that a definition of external debt is adopted which is consistent with generally accepted accounting practice. This could be either gross external debt or external debt net of external investments, or both. The definition of external debt could include both standard borrowing and other long term liabilities. Again, CIPFA would recommend that the definition of long term liabilities used should be consistent with generally accepted accounting practice. The issues involved are discussed in more depth in Appendix B on accounting standards and balance sheet treatment vis-à-vis credit arrangement provisions of the LGHA 1989.

4.5 A significant advantage of using a measure of external debt in a prudential system is that the actual level of (gross and/or net) debt can be established as a question of fact at any given time. Indeed, it is standard practice in local authorities for actual external debt for standard borrowing and approved investments to be monitored on a daily basis, as part of standard treasury management practice. Actual other long term liabilities and investments, such as investments in local companies, can be monitored relatively easily on demand.

4.6 It would also be feasible to estimate future levels of external debt for the medium term, say 3 to 5 years ahead, taking into consideration the local authority's strategic capital programme, asset management plan and treasury management strategy. The prudential code would need to include guidance on the processes necessary to undertake the estimates.

What would be the nature of the PI(s) in relation to external debt?

4.7 This would need to be considered during the development of the code. However, a clear 'front runner' from the earlier work of the CPWP groups is a measure related directly to a measure of the local authority's revenue stream.

4.8 There is an obvious analogy here with the new fiscal framework introduced by the Government in 1998. At the centre of this are two fiscal rules:

(a) the golden rule: over the economic cycle, the Government will borrow only to invest and not to fund current spending

(b) the sustainable investment rule: over the economic cycle, net public sector debt as a proportion of Gross Domestic Product (GDP) will be held at a stable and prudent level, which is defined by the Treasury as being less than 40 per cent.

These rules reflect the Government's view that "a key component to the new approach to fiscal policy is to distinguish between current and capital spending."

>4.9 This appendix assumes that the golden rule would apply to all local authorities in any new capital finance system.

4.10 The question arises as to whether there would be one statutory long stop indicator for local authorities similar in nature to the sustainable investment rule, but related to the local authority's revenue stream rather than GDP, or whether it would be for each authority to set its own local PI.

4.11 An overall prudential limit for the long term could be combined with transitional arrangements to control maximum yearly increases.

Conclusion

4.12 PI(s) based on a sustainable investment rule would be a measurable on a regular basis, transparent to audit, capable of local control within statutory limits, and capable of being estimated over the medium term.

5 A PRUDENTIAL SYSTEM AND CAPITAL COMMITMENTS

5.1 Any prudential system for capital finance will have to consider capital commitments as well as actual debt.

5.2 This is akin to the credit ceiling approach of the current system.

5.3 PIs for capital commitments will need to consider:

looking forward, the level of capital expenditure which the authority has already committed but not incurred
looking forward over the medium term (3 to 5 years) the level of capital expenditure which the authority plans in total
looking backwards, the level of capital expenditure which the local authority has already incurred and which has yet to be financed.
5.4 The definition of what constitutes capital expenditure for the purposes of the PIs would need to be established. CIPFA would recommend that the definition is consistent with generally accepted accounting practice, plus any capitalisation directions (currently s40(6) of the LGHA 1989).

5.5 It is impractical and inappropriate for local authorities to calculate measures on this basis frequently. Whilst actual debt can be determined on a daily basis, total capital expenditure incurred cannot. Expenditure will need to be incurred within due process and with due diligence by services. However, the final determinations as to what constitutes capital expenditure are only made after the year end, as is the final determination of the resourcing of this expenditure by for example direct revenue contributions or useable capital receipts.

5.6 The opening balance of unfinanced capital expenditure incurred at the start of the new system is likely to be the closing credit ceiling. However, the individual circumstances of each local authority will need to be examined by that authority and agreed with its external auditor. For example, credit approvals can currently be used to justify credit arrangements as well as borrowing and for those authorities opening adjustments may be necessary to better reflect unfinanced capital expenditure.

5.7 During the development of the prudential code, further research will be necessary on the relationship between capital commitments and actual debt; and how capital expenditure which is not financed immediately ( through direct revenue contributions, capital grant or capital receipts) and which therefore potentially may require external borrowing is to be written down will need to be determined.

Conclusion

5.8 PI(s) based on capital commitments will be necessary to monitor and manage resources, are capable of being estimated over the medium term, but are only available as actuals after the year end.

6 A PRUDENTIAL SYSTEM AND TREASURY MANAGEMENT

6.1 There is a CIPFA standard of professional practice for treasury management and a CIPFA code of practice for treasury management in local authorities. CIPFA is currently undertaking a revision of the standard of professional practice for treasury management, and is developing a code of practice for treasury management in the public services, which will replace the current codes for individual sectors. Exposure drafts for consultation are expected early in 2001.

6.2 The code of practice for treasury management (both existing and proposed) is a high level document which sets out the principles and practices to be followed by an organisation in its treasury management activities. In addition, it requires as a minimum a report to the relevant Committee or to Council:
at or before the start of the financial year on the strategy for treasury management for the forthcoming year
at least once a year a report on the outcomes of those activities.
6.3 Within the principles laid down by the code of practice for treasury management, the prudential code could specify local PIs which each authority would be required to set of the type envisaged in the earlier CPWP report on PIs for treasury management.

6.4 It is vital not to place too much emphasis on numerical treasury management PIs in isolation from the good practice processes established by the code of practice for treasury management.

Conclusion

6.5 Risk aversion is key to treasury management in the public services. All PIs for treasury management must be developed within this overall context.

7 SINGLE PURPOSE AUTHORITIES

7.1 Whilst this would need further consideration during the preparation of the code, there is no immediately apparent reason why local PIs would need to be different for single purpose authorities.

8 HOUSING AUTHORITIES

8.1 The interaction between the current local authority capital finance and housing subsidy arrangements is complex. This means that treasury management decisions which, on the face of it and looking at the accounts as a whole, would be beneficial can impact adversely on the local authority's general fund because of the housing subsidy implications. The reverse can also be true.

8.2 Such a situation is clearly not optimum for public finances as a whole, but the matters are highly complex and structurally embedded.

8.3 If this situation continues into the new system, it will complicate PIs for local housing authorities. However, whilst it is not the focus of this report, there may well be opportunities to ensure that the current perverse incentives do not continue into the new system.