5 August 2024
This advisory note formalises key messages from the CIPFA Practice Oversight Panel on the crucial importance of good practice in external borrowing. The note reinforces the good practice principles that local government bodies in the UK should adopt and uses the experience of others to identify examples of good practice. The panel expects all organisations to be aware of and learn lessons from recent examples of failure stemming from borrowing and this advisory note draws on those lessons.
The advisory note applies to all local government bodies in the UK.
Background
Borrowing by local authorities is driven by the Prudential Framework, which has been in existence since April 2004. Regulations and codes have undergone several revisions since then, but the principles remain unchanged:
- a local authority’s capital expenditure plans and investment plans are affordable and proportionate,
- all external borrowing and other long-term liabilities are within prudent and sustainable levels,
- the risks associated with investments for commercial purposes are proportionate to their financial capacity,
- treasury management decisions are taken in accordance with good professional practice.
It is important to recognise the inter-relation between capital and revenue when considering good practice on borrowing. Local authorities meet the costs of their statutory and discretionary services through a combination of revenue and capital expenditure. Revenue spending covers day-to-day costs such as wages. Capital expenditure relates to investments in assets such as buildings and transport infrastructure. Authorities cannot borrow for revenue costs and must recognise that there is a requirement to pay back both the interest and principal of any borrowing through its revenue budget. Too much borrowing could give rise to unsustainable pressures on the revenue budget.
A fundamental aspect of the prudential system is the necessity for each local authority to determine locally the need for capital investment against the option of revenue expenditure. This remains true when considering the best mix of capital and revenue for the achievement of any specific project or service delivery objective, even if the scope for an overall increase in capital investment is limited.
Further information on financial planning can be found in the 2018 CIPFA publication Thinking Ahead: Developing a Financial Strategy, and in relation to capital planning specifically in CIPFA’s Capital Strategy Guidance: A Whole Organisation Approach (2021).
The powers that enable local authorities to borrow are contained in Section 4 of the Local Government Act 2003 for England and Wales; for Northern Ireland, in Section 14 of the Local Government Finance Act (Northern Ireland) 2011; and for Scotland, in Section 36 of the Local Government in Scotland Act 2003.
Constraints on revenue funding have led many local authorities to re-evaluate their capital programmes to ensure that these programmes link to their latest corporate objectives and that they remain affordable, prudent and sustainable. This is best achieved by an integration of the Prudential Code principles into an authority’s broader planning framework within which strategic decisions about the capital programme are made.
The requirement in the Prudential Code for local authorities to have regard to the practicality of their capital programmes flows from the fact that they will no longer be constrained by financial resources alone. As a consequence, they will have to identify their capacity to deliver capital programmes as well as the scale of the programmes they can afford.
Recent well-documented examples of failure have occurred as a result of some – or all – of the principles above not being followed.
Good practice
The chief financial officer (CFO) has a key role to play.
The Prudential Code explicitly recognises the significant responsibilities of chief financial officers in local government (The Role of the Chief Financial Officer in Local Government, CIPFA, 2016). Through the Prudential Code the CFO is responsible for ensuring that all matters that must be taken into account are reported in an understandable and clear form to the budget decision‑making body for consideration, and establishing procedures to monitor performance.
CFOs need to be particularly aware that the Prudential Code sets out the minimum indicators necessary to demonstrate compliance with the legislative requirement that the authority’s financial plans are affordable. Additional local indicators may be set where this is considered appropriate eg to assist the authority’s management processes.
The liability benchmark
Authorities should include a long-term projection of external debt and the capital financing requirement (CFR). This projection should enable review of how the level of underlying borrowing for capital purposes (the CFR) is offset by other cash flows and balances, which generally speaking reduce the level of actual borrowing required. It is especially important to forecast non‑CFR cash flows, such as the use of or additions to reserves, pension contributions paid more than a year in advance and movements in working capital, to establish a cash flow-based forecast of borrowing needs and debt outstanding. The prudential indicator graph of the liability benchmark could appropriately be used to present this information (see the Treasury Management Code Guidance Notes for Local Authorities, 2021).
Commercial activities
Authorities undertaking investments for commercial purposes – ie primarily for financial return –should ensure that these investments are subject to enhanced decision making and scrutiny as a result of the additional risk being taken on and the potential impact on the sustainability of the authority. The capital strategy (or separate investment strategy) should set out clearly the governance processes covering:
- how the authority’s overall risk appetite will be determined, including overall limits on investments and risk exposure, by subcategory if appropriate,
- the process by which the authority will bring forward potential investment opportunities, develop and approve outline business cases, consider full business cases and make final decisions allowing for sufficient scrutiny of decision making,
- appropriate arrangements for professional due diligence, including arrangements for obtaining external advice.
Paragraph 51 of the Prudential Code states that, to comply with the Code, an authority must not borrow to invest for the primary purpose of financial return. Commercial investments should be treated with great caution. Firstly, they are generally in higher risk asset classes. This is likely to mean uncertain and volatile asset prices or income. Commercial property is also illiquid and is likely to take several months at least to realise should that be necessary. An urgent sale, if circumstances dictate, may not produce the best price. Such investments require expert due diligence before purchase, and careful asset monitoring and management afterwards.
Conclusion
- Although regulations and codes concerning local authority borrowing have changed, key principles have not.
- The CFO is ultimately responsible for ensuring these principles are followed by the authority.
- The Prudential Code sets out the minimum indicators that are needed to meet legislative requirements. The CFO should consider what further monitoring may be required.
- The liability benchmark is the best tool for determining the level of borrowing required.
- Authorities must not borrow to invest primarily for financial return.
- Commercial investments are inherently risky and require specialist skills, knowledge and resources to manage effectively.