David Green: Streamlining the Prudential Code is the best tonic for capital investment

David Green, Arlingclose

CIPFA has launched a review of its Prudential Code for Capital Finance in Local Authorities, which has remained largely unchanged since its first publication in 2003. Given that the past 14 years have seen a global financial crisis, sharp funding cuts and increasing commercial activities, a wholesale review is very welcome.

Few would argue against the code’s aim to ensure that capital plans are prudent, affordable and sustainable, and that decisions are taken in accordance with best practice under robust corporate governance. And I think the code provides a reasonably useful framework for achieving this. But in my experience, the implementation of the code at individual local authorities is variable.

For example, it is relatively uncommon for elected members to debate and approve the capital programme at the same time that they approve the prudential indicators showing the impact of that programme.

Sometimes indicators are hidden at the back of another report to the same meeting, sometimes they are reported at a subsequent meeting, and in a few cases they are even taken to a completely different committee. They certainly receive very little scrutiny, and are often described as “technical requirements” inferring that they are only in a report because they must be, not because they contribute anything useful.

I think the blame for this state of affairs must be shared between the code itself and its extensive un-useful requirements; overstretched finance officers that have never read or understood the code and its guidance notes; elected members focused elsewhere; and us treasury advisers with our one-size-fits-all templates. And I think we all have a part to play in repairing this situation. But we need to start with the Prudential Code.

The code’s introductory sections are all very well — local authorities should have procedures in place to ensure that this and that happens. But it is only through the application of the Prudential Indicators that the Code really achieves anything. And there are plenty of areas where these can be improved.

Placement: The indicators are split into capital ones, best presented with the capital programme, and treasury indicators, best presented in treasury management reports. But the Code could be clearer on this preferred division, despite the recommendation in the otherwise excellent Scottish Government guidance that they should all be presented together. Report templates covering “all the technical things that our advisers help with” will also need to change.

Number: Fewer indicators, better explained, would focus the minds. Obvious candidates for deletion include the three operational boundaries (the limits that are not limits), whether the authority has adopted the CIPFA Treasury Management Code or not (when it is mandatory to do so) and the total capital expenditure (which is always reported elsewhere). And why we have one indicator for external debt, one for the capital financing requirement (CFR) and then a third one comparing the first two is beyond me.

Timeframe: The Prudential Code requires most indicators to be prepared for three years in advance. But one year would be entirely adequate for many of them e.g. the authorised limits and the interest rate exposure limits, while a longer timeframe would be better for some such as the incremental impact on council tax. After all, it is quite feasible to agree a capital project with a three-year build phase during which time there would be no impact on council tax since interest and MRP (minimum revenue provision) costs can be delayed until the asset is operational.

Percentages: The ability or requirement to report certain indicators as percentages can hinder their understanding, especially when the answer can be negative or greater than 100%. One authority had a net exposure to fixed interest rates of -20,000% one year. And it certainly tempts people into setting 100% limits. It’s generally much better in my view to set indicators in monetary amounts, so members can be clearer about what they are approving.

Presentation: The Prudential Code is fairly unclear about, and its many users are very confused by, which indicators need to be presented when.  Some are to be set in advance of year, some are for in-year monitoring, and some should only be reported after the year has finished. But authorities commonly report every indicator at every opportunity, again leading to an overload of incomprehensible data. For example, I often get asked how to calculate the actual impact on council tax for the year just past, a meaningless figure. And have you ever tried to determine the actual CFR for quarter one without a set of accounts? A simple list of the code’s minimum reporting requirements would aid clarity.

Spurious certainty: Indicators are set as if the future is known, with no account taken of the risk to the underlying projections. Once upon a time, when everyone borrowed at fixed rates, capital was only spent on services and slippage could be ignored, that might have been forgivable. But with commercial projects increasingly needing uncertain income to fund their debt costs, and cheap variable rate borrowing and expensive index linked bonds being ever more popular, the risks to projections should be clearly set out. After all, the central case for every commercial project must be that it will have a beneficial impact on council tax, leading some to think that the bigger the better. But what happens if tenants leave or go bust, or interest and inflation rates move against you? These adverse scenarios should also be modelled and presented to members before spending commitments are made.

Whole life cost: Finally, I’m amazed that nowhere in the Prudential Code’s fifty pages does it once mention discounted cash flow, net present value, internal rate of return or any other textbook method for capital investment appraisal. Some focus on the short-term revenue budget impact is understandable, but the absence of any indicator or guidance on whole life cost is quite unforgivable in a code of practice on capital finance.

A streamlined Prudential Code, focusing on the few key things that really matter, will be the perfect opportunity for officers, members and advisers to up their game. Maybe then we will have a framework where local authority capital investment is demonstrably prudent, affordable and sustainable for the future.

David Green is Client Director at Arlingclose Limited.