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Paper No PCSG 8 01/02

Committee	PRUDENTIAL CODE STEERING GROUP
Venue	Council Chamber, CIPFA, 3 Robert Street, London, WC2N 6RL
Date	21 September 2001
Author	David Thomas, Director, Butlers
Subject	Prudential Code - Scope

Introduction

At the last meeting there were differing opinions expressed on the scope of the Code. The secretary had suggested at the last meeting that the scope should be such that the Code encompassed all elements of Part IV of the 1989 Act. This would include items such as temporary revenue borrowing. I took a differing view that the Code should focus on capital expenditure and its capital and revenue implications, and further that revenue transactions and resources should not occlude the understanding of the capital situation of the local authority. In short, the Code should be a replacement for the existing control framework for capital finance.

As a result of this alternate view, I was asked by the Chairman to prepare a paper for the September meeting. This paper is my response. It has been written based on my experience of working daily on capital finance and treasury management issues. It lacks the finesse of a commissioned piece of work as many issues are only mentioned briefly. It is intended to stimulate debate on the scope of the new Prudential Code.

Background

I thought it may be helpful to set out what I see as some of the key issues for the development of the Code and the key considerations for a new capital control system.

Key Issues

1. Prudential Indicators need to be sensitive to the existing financial environment, both nationally and locally, and to the new rules which emerge from this review. To create that sensitivity it may be useful to look at separate prudential indicators for:

The capital financing situation at the start of the new system, as represented by the closing credit ceiling.
Supported expenditure, whether revenue or capital grant supported
Unsupported expenditure

This approach would allow the historic situation to be managed by indicators arising from the current system and allow the new system to focus on indicators untrammelled by history and relevant to the new freedoms on offer.

2. The agreement of an opening position statement could be seen as a fundamental principle for the introduction of the new system and not simply a transitional issue as suggested in one of the earlier reports. This could show capital expenditure not yet financed (or underlying long-term borrowing requirement, if looked at from the debt management aspect) and the temporary use of revenue resources. This separation is important for a full understanding of a local authority's borrowing and investment positions.

3. The prudential indicator for the full revenue effects of capital investment is the most significant, given the switch from capital to revenue control outlined in the Green Paper. The significance of this bottom line impact attracted considerable support at the last meeting.

4. The scope of the Code should be capital expenditure and all its revenue consequences. There is a need to avoid other revenue resources clouding the issue. As an example, "Treasury Investments" should be separated into capital and revenue.

5. At a detailed level, in deciding which prudential indicators are to be used, is it worth considering each indicator in the light of its usefulness for planning and decision making and separately for historical reporting/demonstrating compliance?

6. Gross indebtedness and net indebtedness could both be beneficial indicators as discussed at the last meeting. The real benefit may depend on what is deducted from the gross figure to achieve the net. For example, where a local authority has cash-backed set aside receipts, the deduction of investments relating those set aside receipts would produce a meaningful net figure. This is because the cash is held pending repayment of debt. The deduction of investments relating to revenue reserves would not produce a meaningful net figure.

7. A further issue was raised at the last meeting, which may also affect the scope. The relative weights of the component parts of the prudential system were discussed. Stephen Sheen suggested that the main emphasis of the system should be on the capital commitments aspects, with external debt aspects being secondary. These were seen as cause and effect. In my view, this distinction had some merit and is worthy of further consideration. If this approach were accepted, control would be through new commitments and controls on new debt would not be necessary. In this case, the debate on the scope would be less material as the differences of opinion relate largely to debt.

Exploring the need to replicate Part IV

The prime purpose of the Prudential Code is to replace the existing capital control regime, which is a part of Part IV, at the local authority level. Part IV also provides the powers to borrow and defines the amounts that can be borrowed.

Legislation will be required to provide powers to borrow and the Government has already indicated that reserve powers (as a minimum) will also be required to limit the amount of borrowing. (DETR paper PCSG 3 00/01) One of the benefits of the Code is that control can be exercised through the Code rather than through legislation.

There is a question to be answered about the extent of national controls. Is the primary need to control local authority borrowing per se or control the need for underlying long term debt attributed to capital expenditure?

I would argue that it is the latter as the former can be influenced by short-term revenue reserves which are not subject to external control. Resources represented by revenue reserves are spent purely on the decision of the local authority. It is incumbent on the Chief Finance Officer to have the necessary cash available to fund the Council's spending programmes. This should not be subject to external control on borrowing which it would be if the control was on movements in overall borrowing, i.e. capital and revenue combined.

As well as movements in revenue reserves, the levels of borrowing and investments are influenced by day to day cash flow requirements. They are, however, not part of the fundamental underlying borrowing requirement of the local authority.

The arguments for excluding revenue items are:
That they cause volatility in the selected indicators; consistency in the long-term indicator would be difficult to achieve. The exercise by Martin Easton (LGA) demonstrated this.
Revenue reserves and balances are temporary in nature; they reflect current surpluses. Comparing them with an underlying long-term funding need, with a permanent impact on the local authority's finances, would be unhelpful.
The use of revenue reserves and balances is not controlled at present and, as far as I know, no proposal is being made for change.

Isolating capital elements in the balance sheet

Capital expenditure not yet financed relates to capital expenditure incurred, borrowed for (generally) and not yet charged to revenue account. In England and Wales, this underlying long term borrowing requirement is presently represented by the credit ceiling. Martin Easton has shown in his analysis that the balance sheet can be separated into cash related balances and non-cash related balances, with the balancing figure on each side being the credit ceiling.

By recognising the credit ceiling as the underlying long term borrowing requirement, a view can be formed on the nature of the local authority's borrowing. Borrowing in excess of the credit ceiling would be either revenue borrowing or debt that has not been repaid from set aside PCL. In the latter case, this would be capital borrowing which should be mirrored by an equal amount of capital investments.

Similarly, the balance sheet can be analysed to identify available revenue and capital resources; these will be invested or used temporarily in lieu of long-term borrowing. Local authorities across the country have adopted one of two approaches to borrowing and investment.

Some adopt the gross strategy, whereby borrowing relates to capital borrowing requirements and revenue and other balances are externally invested. These local authorities will have argued that there are different influences on the borrowing needs and temporary management of available funds and resources. Having understood the various influences, these local authorities have the option of managing each independently, or amalgamating the two. The choice will be based on sound treasury management reasons.

Others adopt the net management approach, being driven by cash requirements rather than an understanding of the funds being managed. An important development stemming from the introduction of the Prudential Code is that all local authorities appreciate the importance of the balance sheet analysis. An analysis which clearly demonstrates the revenue and capital balances and the way in which the cash generated by those balances is being used.

In Scotland, local authorities have traditionally adopted the net management approach. A balance sheet analysis identifies revenue reserves and balances and the amounts of these invested; the conclusion is often that where these resources are not being invested they are being used in lieu of long term capital borrowing. The need to make good this shortfall in borrowing, when revenue spending takes place, means accepting market rates at that time rather than having a considered treasury management strategy.

Short term and long term borrowing

The above analysis has concentrated on understanding the nature of borrowing and investments from the balance sheet and isolated cash backed accounts into capital and revenue. The accounting distinction on the balance sheet between short-term and long-term borrowing is not particularly helpful for this analysis as it simply identifies borrowing that is repayable within twelve months or outside the twelve-month period.

It is clear that long-term borrowing is synonymous with capital debt. Short-term borrowing can be either long term capital debt maturing within twelve months or temporary borrowing (as defined in the Act). The Treasury has indicated that temporary borrowing would be excluded from proposed controls on increases in debt. (PCSG 2 00/01)

Summary

In summary,
Capital and revenue aspects of the balance sheet can be isolated.
A prudential code focusing on capital aspects of debt will produce more stable indicators, which are more capable of informing on the underlying financial standing of the local authority.
Including revenue funds in composite indicators could impede local authorities spending revenue resources.

David Thomas
Director
Butlers
18 September 2001