Section 5

Capital financing and budgeting

5.1 Financing strategy

The setting of the capital budget and the way it is to be financed should be based on a sound capital financing strategy that is clearly linked to the rest of the capital strategy. This will help to ensure that the financing of the capital programme reflects the organisation’s
long-term objectives rather than short-term expedience.

The following sections describe capital budgeting and the various sources of capital funding. Section 5.5 explains the importance of fully assessing the revenue implications of capital financing.

5.2 Capital budgeting

Capital budgeting differs from revenue budgeting because:

• ■the need for capital investment tends to fluctuate year on year to a much greater degree than the need for revenue spending
• ■there is usually significant discretion over how or when to make use of the capital funding that is potentially available, eg to determine the level of borrowing and the use made of capital receipts in a particular period
• ■there is usually significant discretion over when particular capital projects take place
• ■capital budgets, unlike revenue budgets, can usually be carried forward from one year to another
• ■many public sector organisations are able to fund capital expenditure from sources that they are not permitted to use to fund revenue expenditure, such as borrowing.

There is therefore a judgement to be made, as part of the medium-term financial planning process, about the size of the programme, depending on the organisation’s overall financial position and its capital investment priorities.

Some public sector organisations receive all their capital funding in the form of grant from central government or another external body. The organisation receiving the grant may be required to submit capital investment proposals to the body that makes the grant, in which case the level of the grant may depend wholly or partly on the capital investment needs set out in the submission. In order to develop its submission, the organisation may need to start with a working assumption about the likely level of funding, which is then revised as investment needs are refined.

5.3 Sources of funding for capital expenditure

The sources of funding that may be available to public sector organisations to finance capital expenditure include:

• ■revenue contributions
• ■borrowing
• ■capital receipts
• ■grants and third party contributions.

All public sector organisations, including central governments, face varying degrees of constraint on their ability to fund capital investment. The cost of providing assets ultimately falls on revenue budgets under most forms of capital funding. For most public sector organisations, therefore, it is their long-term revenue budget position that is the ultimate constraint.

These issues are explored in more detail in the following sections.

5.3.1 Revenue contributions

Revenue contributions are contributions from the current year’s revenue budget, which are either used to meet capital expenditure incurred in the current year or put into a fund, or reserve, to be used to meet capital expenditure in future. Public sector organisations usually have the legal power to finance capital expenditure from revenue funding, but in a time of austerity their ability to do so is severely constrained. The overall impact of capital funding on revenue budgets needs to be fully considered before any decision is made about using revenue contributions.

5.3.2 Capital receipts

Capital receipts are the proceeds from the disposal of assets, usually land and buildings.
They may be used to fund capital expenditure. Indeed it is normally considered imprudent to use them to fund revenue expenditure.

Public sector organisations may dispose of assets for various reasons, including:

• ■reductions in demand for services, eg a decrease in the birth rate resulting in a reduced need for school places
• ■a decision to cut services, eg central government deciding to reduce its international defence commitments
• ■changes in the way that services are provided, eg providing care to elderly people in their own homes rather than in institutional facilities
• ■more intensive use of assets, eg use of hot-desking to reduce the organisation’s need for office space (see section 8.4).

A disposal may take the form of either:

• ■an outright transfers of ownership, or
• ■the grant of a long-term lease of land in which the public sector organisation retains the freehold or a head lease.

It is sometimes tempting to dispose of assets quickly in order to plug a short-term capital funding gap. However, the disposal strategy should be planned, as part of the asset strategy, so that:

• ■the decision to dispose of assets is based on a considered judgement that they are surplus to requirements
• ■best value is obtained, eg if a large number of assets become surplus to requirements at the same time, it may be better to dispose of them in phases rather than flooding the market
• ■receipts are made available in accordance with the needs of the capital programme, as set out in the funding strategy that forms part of the capital strategy.

The role of the head of property (as described in section 2.1) is critical in ensuring that the disposal of assets is carried out in accordance with a proper, long-term asset strategy.

Organisations sometimes ring-fence receipts for reinvestment in the relevant service. This makes sense where:

• ■receipts only become available as part of a project that requires capital investment to be incurred, eg where an asset is being replaced or a group of assets is being rationalised, as in the Coventry City Council example described in section 8.4.2, or
• ■grant funding is conditional on a receipt being used as match funding.

In some cases it may also be useful to allow departments to keep a proportion of receipts so that they have an incentive to identify assets that are surplus to requirements. However, where the organisation has a robust asset management culture and a strong ‘corporate landlord’ model (ie a corporate approach to the management of assets), such incentives should not be necessary.

It is otherwise rational to consider receipts as a corporate resource, along with all the other sources of capital funding, and to allocate overall levels of funding to specific services in accordance with the corporate prioritisation of investment needs.

5.3.3 Borrowing

Central governments and various other public sector organisations have the power to borrow. Their ability to do so is ultimately constrained by their long-term revenue budget position.
It may also be constrained in the short to medium term by a poor credit rating, which makes it more expensive, or in extreme cases impossible, for them to borrow.

Most public sector organisations, other than central government, that have the power to borrow have a limited power to do so. Local authorities in the UK, for example, are subject to a capital financing regime. This prescribes what may be classed as capital expenditure and how it may be financed. All other expenditure must be met from revenue funding. Authorities have discretion to borrow in accordance with the Prudential Code (see section 5.5) and they are required to make a prudent provision from their revenue budgets to cover their borrowing commitments. This means that the ability to borrow to finance capital expenditure is determined largely by the authority’s revenue budget position. Detailed guidance on the capital financing regime that applies to local authorities in the UK is provided in Practitioners’ Guide to Capital Finance in Local Government (CIPFA, 2012).

Tax increment financing, which enables local authorities to undertake additional borrowing for infrastructure developments, is described in section 8.2.2.

Some loans are available to the borrower only to use for a specific purpose. The implications of this are discussed in section 5.4.

5.3.4 Grants and third party contributions

Grants and third party contributions include:

• ■government grants
• ■grants and contributions from other bodies.

There is no clear distinction between grants and contributions. Grants tend to be made by organisations that have a role to provide funding to other organisations. Contributions is a less well-defined term that includes:

• ■statutory contributions from developers towards the cost of providing infrastructure or other public assets related to a development, eg to build a new school required as a result of a housing development
• ■voluntary contributions or bequests from an individual or an organisation towards a worthy project, eg provision of a memorial.

Some grants and contributions are available to be used only for a specific purpose, as explained in the next section.

5.4 Funding for a specific purpose

Various forms of funding from central government and other external sources may only be used for a specific purpose. These include:

• ■specific grants and contributions, eg grants from the UK’s Heritage Lottery Fund
• ■loans made for a specific purpose, eg the Green Investment Bank’s loan for the Glasgow street lighting scheme described in section 8.2.3
• ■bequests.

The purpose may be widely defined (eg ‘investment in schools’) or narrowly defined (eg ‘improvement of school kitchens’). In a time of austerity, public sector organisations may be inclined to welcome any additional funding, but an opportunistic, piecemeal approach to the use of funding that may only be used for a narrowly defined purpose is likely to skew capital investment, so that it does not reflect the organisation’s own objectives.

Making use of specific funding opportunities may not always be in the organisation’s best interests because:

• ■applying for these funding streams and managing the projects in question diverts resources away from other projects
• ■the number and variety of specific funding opportunities can sometimes make it impracticable to identify and investigate all of them
• ■specific funding is frequently conditional on the applicant organisation providing match funding, which is not then available to meet other priorities
• ■the investment may saddle the organisation with long-term operating costs that it cannot afford.

As part of the capital strategy, therefore, public sector organisations should plan how they will:

• ■use specific funding to meet their capital investment priorities
• ■identify, investigate and apply for specific funding opportunities

and they should be prepared to turn down funding opportunities that are inconsistent with the strategy.

5.5 Revenue budget constraints and prudence

Most forms of capital funding have an impact on the revenue budget, as the following table shows.

The table shows that the cost of capital investment met from revenue contributions and from borrowing falls wholly on revenue budgets either in the current year or in future years.

For most public sector organisations the ongoing revenue budget position is the key constraint on their ability to fund capital expenditure. So, in considering how much capital investment they can afford, they should estimate the overall impact on future revenue budgets and exercise prudence. This means ensuring that the level of capital investment is sustainable, taking into account the whole life cost of the assets as well as the cost of funding capital expenditure. The Prudential Code for Capital Finance in Local Authorities (CIPFA, 2011) provides guidance on good practice in this area. It refers to the need to:

• ■carry out option appraisal and whole life costing to ensure value for money
• ■consider the implications for external debt
• ■consider the impact on affordability.

While adherence to the Prudential Code is a statutory requirement for UK local authorities, its principles are relevant to all public sector organisations.

In the new era of austerity, revenue budgets have become severely constrained; public
sector organisations must adapt their capital strategies accordingly. This theme is explored in section 8.