The Prudential Code for Capital Finance in Local Authorities

Posted On: June 10 - 2024
Posted By: Jackie Shute

The Prudential Code for Capital Finance in Local Authorities: A Detailed Overview

Introduction

The Prudential Code, established by the Chartered Institute of Public Finance & Accountancy (CIPFA), is a vital framework for capital finance in local authorities in the UK. Updated last in December 2021, this code aims to ensure that local authorities' capital expenditure and investment plans are affordable, prudent, and sustainable. This article delves into the key aspects of the Prudential Code, its implications, and the emerging behaviours in capital finance among local authorities.

Background to Capital Financing

Capital financing in local authorities involves managing funds to support long-term investments in infrastructure, facilities, and services. Unlike revenue budgets, which must be balanced annually, capital budgets can be financed over several years, providing greater flexibility but also requiring robust controls to manage debt and ensure affordability.

Historically, before the Local Government Act of 2003, the government prescribed limits on local authority borrowing. This prescriptive approach was replaced with a more flexible framework focused on affordability and sustainability. Local authorities are now responsible for determining their capital financing limits based on prudential indicators that assess the affordability, prudence, and sustainability of their plans.

Emerging Behaviours in Capital Financing

Recent trends in local authority capital financing have shown significant increases in commercial investments and the assumption of excessive debt to generate income. This behaviour poses risks to taxpayers' money, often leading to opaque financial transactions and creative approaches to Minimum Revenue Provision (MRP).

For example, some local authorities have engaged in complex financial arrangements such as income strips and derivatives, which obscure the true level of financial risk. The Prudential Code aims to curb these risky behaviours by reinforcing the importance of transparency, affordability, and prudent management.

Links to the Treasury Management Code

The Prudential Code is closely linked to the Treasury Management Code, another CIPFA publication that governs the management of cash flows, investments, and borrowing. Treasury management is not limited to prudential borrowing but encompasses the entire spectrum of an organization’s cash flows.

Key indicators in the Treasury Management Code include the liability benchmark, maturity structure of borrowing, and interest rate exposures. These indicators help local authorities manage their cash flow profiles and external borrowing requirements prudently.

Content of the Prudential Code

The Prudential Code provides a comprehensive framework for capital spending controls. It includes requirements for:

Capital Financing Requirement (CFR): This measures cumulative unresourced capital expenditure, which must be amortized through the revenue account over time. The CFR includes outstanding liabilities from finance leases and Private Finance Initiative (PFI) contracts.
Minimum Revenue Provision (MRP): Local authorities must charge an amount to the revenue account that they consider prudent. The MRP should align with the period over which the capital expenditure benefits are realized.
Prudential Indicators: These indicators help ensure that capital expenditure plans are affordable and sustainable. They include estimates of capital expenditure, CFR, and external debt limits.
Governance and Risk Management: The Prudential Code emphasizes the need for robust governance frameworks to manage capital investments and borrowing prudently.

Local Authority Financing Controls

Local authorities must adhere to a hierarchy of legislative controls to maintain a balanced budget. This includes guidance from the Secretary of State and adherence to the Local Government Act 2003, which mandates that borrowing must be affordable and prudent.

Before the 2003 Act, capital control frameworks were more prescriptive, with the government dictating borrowing limits and amortization schedules. The current framework allows for greater flexibility but requires local authorities to demonstrate the affordability and sustainability of their capital financing decisions.

The Capital Financing Requirement (CFR)

The CFR is a critical measure of a local authority's capital financing position. It represents the total capital expenditure that has not yet been financed by capital resources such as grants, receipts, or revenue. The CFR must be amortized over time through the MRP.

For example, a local authority might have a CFR of £780 million at the start of the year, which is expected to decrease as capital expenditure is amortized through the MRP and capital receipts are applied.

Resourcing Unresourced Capital Expenditure

Local authorities must determine the amount of MRP they consider prudent. This involves aligning the MRP period with the period over which the capital expenditure provides benefits. While the Prudential Code recommends several options for calculating MRP, authorities can adopt alternative approaches that meet their specific needs.

Emerging Behaviours

Significant increases in commercial investments have led some local authorities to assume excessive debt in pursuit of income. This behaviour exposes taxpayers' money to undue risk, often involving complex financial transactions that lack transparency. The Prudential Code aims to address these issues by reinforcing the principles of prudence, affordability, and sustainability.

Links with the Treasury Management Code of Practice

The Prudential Code is inherently linked to the Treasury Management Code, which governs the management of cash flows and borrowing. Treasury management encompasses the entire cash flow profile of an organization, not just prudential borrowing.

Prudential indicators in the Treasury Management Code include the liability benchmark, which helps determine the most prudent borrowing profile, and the maturity structure of borrowing, which manages the timing of debt repayments. These indicators are essential for maintaining a balanced and sustainable capital financing strategy.

The Liability Benchmark

The liability benchmark is a governance framework that helps local authorities determine the most prudent and least risky borrowing profile. It involves projecting the net treasury position based on financing plans, adjusting for investment balances to manage liquidity, and objectively determining the optimum balance of loans and investments.

Objectives of the Prudential Code

The Prudential Code aims to ensure that local authorities' capital expenditure and investment plans are affordable, proportionate, and sustainable. It seeks to ensure that all external borrowing and long-term liabilities are within prudent and sustainable levels and that the risks associated with investments for commercial purposes are proportionate to the financial capacity of the authority.

Demonstrating Achievement of Objectives

Local authorities demonstrate compliance with the Prudential Code through a series of prudential indicators, set and revised alongside the budget-setting process. These indicators provide a high-level overview of how capital expenditure, financing, investments, and treasury management decisions contribute to corporate objectives.

The Prudential Indicators - Prudence and Affordability

Prudence in capital financing involves ensuring that borrowing is not undertaken primarily for financial return, and investments are reviewed for their long-term sustainability. Affordability involves assessing the totality of an authority's resources and the long-term implications of capital financing decisions.

Prudential indicators for affordability include the ratio of financing costs to the net revenue stream and the ratio of net income from commercial and service investments to the net revenue stream. These indicators help ensure that the revenue implications of capital financing are properly accounted for in the decision-making process.

Levelling Up & Regeneration Bill 2022 s74

The Levelling Up & Regeneration Bill introduces new provisions for risk mitigation. The Secretary of State may give risk mitigation directions if certain trigger events occur, such as breaches of capital risk metrics. These metrics include total debt to financial resources, the proportion of assets held for financial return, and the amount of MRP charged in a year.

Potential Changes to Minimum Revenue Provision

In November 2021, a consultation was launched to address potential changes to the Local Authority Capital Financing Regulations 2003. These changes aim to address issues such as the exclusion of a proportion of CFR from the MRP calculation and the application of capital receipts to the MRP amount. The post-consultation proposals will further strengthen the capital financing framework for local authorities.

Summary & Conclusions

The Prudential Code and its associated indicators provide a robust framework for managing capital finance in local authorities. By emphasizing prudence, affordability, and sustainability, the code helps ensure that capital expenditure and investment plans are aligned with long-term financial strategies and corporate objectives.

Key changes in the latest update include a focus on reducing exposure to commercial investments, new requirements for quarterly monitoring of prudential indicators, and forthcoming changes to the MRP regulations. The Levelling Up & Regeneration Bill will further strengthen the framework by introducing risk mitigation measures.

By adhering to the principles and guidelines set out in the Prudential Code, local authorities can ensure that their capital financing decisions are well-informed, transparent, and aligned with the broader goals of financial sustainability and public accountability.