Contact: Jon Pittam, ext 7400

1. Summary

1.1 A new system for the control of local authority capital finance is due to be introduced from 1 April 2004. The emphasis is on allowing local authorities to determine their own programmes for capital investment in fixed assets, subject to demonstrating that those programmes are affordable, prudent and sustainable. The Code of Practice underpinning the system has just been published and this report considers the County Council's policy framework for determining the level of potential borrowing for capital purposes.

1.2 The following decision is sought:

· to approve the policies set out in paragraph 4 of the report as the basis of the County Council's prudential framework for capital finance.

2. Reason

2.1 The Leader and Cabinet needs to consider the framework for the future management of the County Council's capital finance, in advance of taking decisions on provisional revenue and capital guidelines for 2004/05 and following years.

3. Other options considered and rejected

3.1 Not applicable.

4. Conflicts of interest declared by the decision maker or a member or officer consulted

4.1 Not applicable.

5. Dispensation granted by the Standards Committee

5.1 Not applicable.

6. Reason for the matter being dealt with if urgent

6.1 Not applicable.

Approved by: (signature) Date: (date of decision)

Councillor T K Thornber

Contact: Jon Pittam, ext 7400

1. Introduction

1.1 The Prudential Code for Capital Finance in local authorities has now been approved and published by the Chartered Institute of Public Finance and Accountancy (CIPFA). It underpins the new prudential system for capital finance introduced in the Local Government Act 2003, replacing the current system of borrowing approvals, which becomes effective from 1 April 2004. The Cabinet previously considered the draft code of practice in April and the draft regulations at its last meeting. The executive summary of the Code is attached as Appendix 1.

1.2 The objective of the Code is to provide a framework for local authority capital finance that will ensure for individual local authorities that:

a) capital expenditure plans are affordable

b) all external borrowing and other long-term liabilities are within prudent and sustainable levels

c) treasury management decisions are taken in accordance with professional good practice

and that in taking decisions in relation to (a) to (c) above the local authority is:

d) accountable, by providing a clear and transparent framework

Further, the framework established by the Code should be consistent with and support:

e) local strategic planning

f) local asset management planning

g) prior options appraisal.

1.3 In exceptional circumstances the objective of the Code is to provide a framework that will demonstrate that there is a danger of not ensuring the above, so that the authority can take timely remedial action.

1.4 The framework of the Prudential Code is built around a set of prudential indicators which relate to:

· capital expenditure plans

· external debt

· treasury management

1.5 Appendix 2 summarises the indicators which the County Council will need to set in future on an estimated basis in approving the budget and capital programme and which will then be subject of monitoring during the year and approval at the year end. The initial set of indicators will be reported to the Cabinet in February 2004 to agree recommendations to the County Council at the budget meeting. The requirement to set indicators for three years will require the development of a more explicit three year financial plan.

1.6 However the main purpose of this report is to give initial consideration to the County Council's framework for determining the level of borrowing in setting the capital programme in advance of the Cabinet considering provisional and revenue budget guidelines at the next meeting.

2. Changes incorporated in the Code

2.1 The final version of the code includes few changes of substance from the consultation draft. The main change is that a three year projection of the council tax is no longer an indicator - instead there is an indicator of the incremental impact of investment decisions on the council tax.

2.2 The County Council in commenting on the draft code drew attention to the difficulties of forecasting the council tax over a three year period, when the Government's spending plans may only cover two years and decisions on grant distribution, such as on floors and ceilings, may be taken on an annual basis. The change in the Code of Practice can therefore be welcomed, although there remain some issues to be resolved on how the replacement indicator is defined.

3. Outline of Prudential framework

3.1 The key element of the framework is the `capital financing requirement' - the potential borrowing level for capital purposes.

3.2 This indicator does not necessarily provide a straightforward signal as to the affordability, prudence and sustainability of capital investment plans. This will require an examination of the components of the capital financing requirement between:

· Government supported borrowing

· borrowing financed by virement from service revenue budgets

· `temporary' unsupported borrowing pending the receipt of other capital resources eg capital receipts from a rationalisation project or a third party contribution

· any corporately financed unsupported borrowing - previously confined to Government approved unsupported borrowing on Local Government Reorganisation transitional costs and the local public service agreement.

3.3 The report examines each of these in turn.

4. Policies underlying the setting of the capital financing requirement

Government supported borrowing

4.1 It is proposed that the policy of making maximum use of Government supported borrowing should be retained, subject to reviewing the affordability of any additional running costs associated with proposed capital programmes, as at present. This is on the assumption that the Government will provide either capital grants or will continue to finance the marginal cost of approved borrowing through the revenue support grant.

Borrowing financed by transfer from service revenue budgets

4.2 One of the key objectives of the Prudential Code is to integrate more closely decisions on revenue and capital spending in support of corporate objectives. One way in which this can be achieved is by enabling services to incur capital spending financed by unsupported borrowing. The financing costs can then be met by means of transfer from the service revenue budget, so that the council tax impact is neutral. It is proposed that the criteria for approval of unsupported borrowing financed in this way should cover:

· projects of an `invest to save' nature generating improved efficiency (cost savings) or additional income sufficient to finance the borrowing costs

· projects which will result in the avoidance of at least an equivalent level of cost

4.3 Examples of the types of project that might fall within these criteria include:

· rationalisation/modernisation projects

· replacement of operational leasing either of equipment or property

· development of in-house provision in place of services procured from the private sector eg nursing care.

4.4 Robust project appraisal is essential to ensuring that the business case for unsupported borrowing is soundly based - existing project appraisal guidance will need to be supplemented for projects being promoted from unsupported borrowing.

4.5 Alternatively there may also be a case for allowing unsupported borrowing to be financed by virement from a service revenue budget, where the investment is not self-financing. There is a danger that if such virements are not identified specifically and have no policy underpinning, that they will simply result in budget pressures emerging which could otherwise have been accommodated within existing budgets. It is proposed therefore that virements of this type should only be approved as a basis for financing unsupported borrowing, if the virement is from a specific source and the policy of reduced spending in this area has been endorsed. Examples that might be considered would be reduced spending on library books, conservation grants or transport programmes eg in connection with SHRT. A condition would be that no new spending bids could be put forward affecting a budget from which a virement had been approved, without that virement first having been reinstated from within the services existing budget.

4.6 Though the renewal or taking out of new operational property leases will no longer `score' for capital purposes, it is proposed that for asset management reasons, it remains appropriate for leases to be approved by the Policy and Resources executive member either on an individual or an annual basis. The rental impact of either new or renewed property leases will need to be accommodated from within the approved service budget. It will also be necessary to demonstrate that leases have been tested to ensure that they meet the criteria for classification as operating rather than finance leases.

4.7 In order to enable possible uses of unsupported borrowing financed by transfer from the relevant service revenue budget, decisions also need to be taken on how the transfer process would operate. Having regard to the principles of prudence and sustainability and recognising the risks associated with the appraisal of cost savings and income generation, the following conditions are proposed:

· the repayment period to be limited to 10 years or any shorter period over which the investment is expected to yield benefits

· the interest rate to be set annually on the basis of prevailing long-term borrowing rates

· the revenue transfer to be calculated on an annuity basis, so that it does not have to be reviewed each year.

4.8 Based on an interest rate of 5% and a period of 10 years an annuity factor of 13% is generated. This would mean that a revenue budget transfer of £130,000 would be required to finance unsupported borrowing of £1m.

Capital investment of business units

4.9 The existing policy of earmarking depreciation of assets originally funded from a business unit's own resources and of allowing business units to retain all or part of operating surpluses to fund approved capital investment, means that business units are insulated from the normal process of determining capital programme priorities.

4.10 This flexibility could be supplemented by allowing business units to incur capital expenditure financed from unsupported borrowing. This would be subject to any capital charges not being earmarked for future business use, but instead being recycled into financing the cost of the unsupported borrowing.

`Temporary' unsupported borrowing

4.11 The Prudential Code provides the scope for accommodating capital expenditure which will eventually be financed from capital receipts or other capital contributions, but in the short-term from unsupported borrowing, providing the cost of `bridging' is affordable. This would supplement the existing alternatives of meeting the initial investment from within capital programme limits or by drawing upon earmarked reserves.

4.12 The cost of bridging could be borne either by:

· a contribution from the service revenue budget to meet the temporary financing costs - calculated on a minimum revenue provision basis for each year of the bridging period

· rolling up interest so that the eventual capital receipt used to repay debt takes account of the financing costs of bridging.

Corporately financed unsupported borrowing

4.13 The use of unsupported borrowing as a means of integrating decisions on capital and revenue spending or as a means of temporary `bridging', can operate within a framework in which the costs of unsupported borrowing have to be accommodated within existing service revenue and capital budgets, as set out in paragraphs 4.1 to 4.12 above.

4.14 However the Code also provides an opportunity for the County Council to consider whether to set a larger capital programme than it would be able to under current capital controls, by supplementing revenue contributions to capital, by unsupported borrowing. The cost of financing unsupported borrowing without the requirement for cost savings or additional income will result in higher future council taxes than would otherwise be required. It is the issue of determining what (if any) use is made of long-term unsupported borrowing that lies at the heart of the principles in the Code of affordability, prudence and sustainability. However this is also the weakest aspect of the portfolio of prudential indicators contained in the Code - and the change introduced in the final version of the Code to the council tax indicator does little to alter this.

4.15 There are a number of arguments for giving priority to developing the use of the new flexibilities which the Code provides to integrate capital and revenue decision making and to facilitate invest to save initiatives, but to be cautious about corporate use of unsupported borrowing as a means of supplementing the capital programme.

· the County Council is already managing a very large capital programme and has been extremely successful in its asset management policies of recycling surplus or under used assets in order to generate capital receipts in support of its capital strategy. Few other local authorities are in this favourable position

· the continuing increase in building costs at well above the general rate of inflation illustrates the lack of capacity in the construction industry to handle current workloads, which are already due to be further stretched by the nursing care investment programme. Further stimulation of the capital programme may not represent good value for money currently

· the corporate objective of maintaining a council tax in the lowest quartile of County Council council taxes was only narrowly achieved in 2003/04 and this provides little scope for even small increases in council tax in financing unsupported borrowing

· there is also a danger that if local authorities make immediate and extensive use of general unsupported borrowing that the Government will either make use of the reserve power to set borrowing limits or perhaps more likely will use this as an opportunity to reduce Government support for capital expenditure. This is a particular concern given the less favourable prospects for the next spending review in 2004. The danger therefore is that unsupported borrowing financed entirely by council taxpayers merely takes the place of Government supported borrowing.

Recommendation

To approve the policies set out in paragraph 4 of the report as the basis of the County Council's prudential framework for capital finance.

Section 100 D - Local Government Act 1972 - background papers

The following documents disclose facts or matters on which this report, or an important part of it, is based and has been relied upon to a material extent in the preparation of this report.

NB the list excludes:

Published works.

Documents which disclose exempt or confidential information as defined in the Act.

TITLE FILE

None

Appendix 2

List of prudential indicators

Indicators based on estimates must be prepared for the forthcoming financial year and the following two years. Those based on actuals will be calculated after each year end using the Council's accounts.

Key indicators of affordability

Estimates of the ratio of financing costs to net revenue stream

Actual ratio of financing costs to net revenue stream

Estimates of the incremental impact of capital investment decisions on the council tax

Indicators for prudence

Net borrowing and capital financing requirement ie over the medium term net external borrowing must not exceed the capital financing requirement (see below)

Indicators for capital expenditure

Estimates of total capital expenditure

Actual total capital expenditure

Estimates of the capital financing requirement at the year end (similar to the current credit ceiling)

Actual capital financing requirement

Indicators for external debt

Authorised limit for external debt (ie borrowing plus other long-term liabilities)

Operational boundary for external debt (ie borrowing plus other long-term liabilities)

Note: the operational boundary should be the Council's estimate of the most likely and prudent scenario, whereas the authorised limit should provide headroom for unexpected or unusual cash movements.

Actual external debt

Treasury management

Adoption of the CIPFA Code of Practice for Treasury Management in the Public Services

Upper limits on fixed rate exposures, either in terms of interest payable or principal outstanding

Upper limits on variable rate exposures

Upper and lower limits on the maturity structure of fixed rate borrowing (ie borrowing maturing during each stipulated period as a percentage of total fixed rate borrowing at the start of the period).

(Note: stipulated periods are: under 12 months; between 12 and 24 months; between 24 months and 5 years; between 5 and 10 years; and 10 years and above).

Upper limit on total principal sums invested for periods longer than 364 days