Chapter 3

Capital budgets and resources

Capital Budgets

A council’s capital budget covers the money it spends on investing in buildings, infrastructure and expensive pieces of equipment. Capital spending by councils is mainly for buying, constructing or improving physical assets such as:

■buildings – schools, houses, libraries, museums, police and fire stations, etc
■land – for development, roads, playing fields, etc
■vehicles, plant and machinery – refuse collection vehicles, fire engines, police cars, etc.

It also includes grants and advances made to the private sector or the rest of the public sector for capital purposes, such as advances to housing associations. In order to count as capital expenditure, new assets or additions to assets must have a life of more than one year.

At the discretion of the secretary of state, certain revenue costs can be treated as if they are capital costs. This process, known as a capitalisation direction, is subject to an annual application process and is typically used for one-off items such as redundancy costs and meeting the costs of equal pay claims. The secretary of state can also extend the definition of capital expenditure using regulations.

Councils in England spent £23.3bn on new assets and additions to existing assets in 2016/17, an increase of 3% on the £22.6bn spent in 2015/16. In Wales, councils spent £1.1bn in 2015/16, an annual decrease of 45% mainly due to the housing revenue account subsidy buyout included within ‘other services’ in the previous year.

Capital receipts are received when a council sells capital assets. Capital receipts for councils in England have increased modestly in 2016/17 to £3.586bn from £3.580bn in 2015/16, increasing by 0.1%. In 2016/17 councils in Wales received capital receipts of £93.7m, an increase of 38.1% from the £67.9m in 2015/16.

The chart below shows capital expenditure and capital receipts for the period 2012/13 to 2016/17.

Figure 3.1: Capital expenditure and receipts – England and Wales 2012/13 to 2016/17

Source: National Statistics, Local Authority Capital Expenditure and Receipts: England 2016/17 Final Outturn, September 2017 and Welsh Government Statistical Release, Local Authority Revenue and Capital Outturn Expenditure: 2016/17, October 2017

The chart also shows the expenditure excluding the Greater London Authority (GLA), as the GLA tends to distort the total council capital spending figures as it includes expenditure on large infrastructure projects by Transport for London.

Financing of Capital Expenditure

Councils finance capital spending in a number of ways, including:

■the use of their own revenue funds – councils are free to spend money from their revenue budgets on capital schemes; this is known as direct revenue financing. This includes the major repairs reserve which is a special reserve that provides capital funding for housing
■capital receipts – this is the money received from the disposal of capital assets and generally can only be used for repayment of debt or to finance new capital expenditure
■borrowing – councils can borrow money to pay for capital assets
■grants and contributions – these can come from central government or other organisations.

The following graph shows the proportion of capital expenditure financed by borrowing and other sources of finance in England and Wales over the period 2012/13 to 2016/17.

Figure 3.2: Financing local authority capital expenditure – England and Wales 2012/13 to 2016/17

Sources: National Statistics, Local Authority Capital Expenditure and Receipts, England: 2016/17 Final Outturn, September 2017; Welsh Government Statistical Release, Local Authority Revenue and Capital Outturn Expenditure: 2016/17, October 2017

The graph shows that the proportions of capital expenditure financed by:

■grants and contributions have risen over the years, reflecting that all support from central government in England now comes through grants rather than the previous supported borrowing. In 2016/17, 44% of capital expenditure was financed from grants and contributions
■capital receipts have remained at a broadly stable proportion of capital financing over the period 2012/13 to 2016/17, with 10% capital expenditure being financed from capital receipts in that year
■revenue contributions fell to 17% in 2016/17 from 20% of the total capital expenditure financed in 2015/16
■borrowing increased and reverted to the 2011/12 levels to 29% of the total capital expenditure finances in 2016/17. Capital Expenditure and Receipts, 2016-17 Final Outturn Statistical Release issued by the then DCLG in September 2017 indicates that a significant part of this increase in borrowing is due to local authorities making commercial acquisitions.

The Prudential Code

Before 2004, there was a very complicated framework of rules and regulations that controlled how councils were allowed to invest in assets and the amount that they could spend. April 2004 saw the introduction of CIPFA’s Prudential Code for Capital Finance in Local Authorities., which provides a framework within which councils can judge for themselves whether capital investment is affordable, prudent and sustainable in the year in question and in future years. The Prudential Code is given statutory backing, which means that councils are required to ‘have regard’ to it by the Local Government Act 2003 (in England and Wales) and the Local Government in Scotland Act 2003.

The current Prudential Code requires a council to think about six things when it agrees its capital programme:

1. The council’s service objectives – are the capital spending plans consistent with the council’s strategic plan and its future plans for its services?

2. The stewardship of the council’s assets – is the capital expenditure being spent on new assets at the cost of maintaining existing assets?

3. The value for money offered by the plans – have all the options for investment been considered and do the benefits outweigh the cost?

4. The prudence and sustainability of its plans – can the council afford the borrowing now and in the future?

5. The affordability of its plans – what are the implications for the council tax?

6. The practicality of the capital expenditure plan – does the council have the resources to manage the project and does the total capital programme look sensible?

The update to the Prudential Code in 2017 introduced the requirement to produce a capital strategy. The capital strategy should demonstrate that the authority takes capital expenditure and investment decisions in line with service objectives and properly takes account of stewardship, value for money, prudence, sustainability and affordability.

Councils need to prove that they are complying with the Prudential Code. This is done through a series of prudential indicators that are set locally and approved at the same time as the council sets its budget for the following year. The table below sets out the current key prudential indicators.

Table 3.1: Key prudential indicators

Indicator	Description
Estimate of the capital financing costs to the authority’s net revenue stream over the next three years	This indicator helps a council identify if borrowing costs become too high as a proportion of its budget. This is important as borrowing costs always have to be paid and are very hard to cut if resources fall.
Actual capital financing costs to the authority’s net revenue stream	The current value of the indicator above. This gives a baseline against which a council can see if borrowing is forecast to become a greater or a lesser part of the budget in the future. It also allows the accuracy of past estimates to be measured.
Authorised limit	The maximum amount of money a council can borrow. This amount can be changed at any point during the year by a meeting of the full council.
Operational limit	The maximum amount of money a council expects to borrow during the year. This is lower than the authorised limit and acts as a useful warning sign if it is breached during the year, which could mean that underlying spending may be higher or income lower than budgeted.
Debt compared to the capital financing requirement	Councils are only allowed to borrow money in the medium term to finance capital expenditure. Short-term borrowing can fund cash flows but borrowing cannot be used to fund the revenue budget. This indicator compares debt to the council’s underlying need to borrow (its capital financing requirement) in order to show that borrowing is only being used to finance capital expenditure over the medium term.

Source: CIPFA, The Prudential Code for Capital Finance in Local Authorities (2017 Edition)

In addition to setting limits for borrowing and the capital programme, the council is required to set detailed ratios and limits for how it manages its borrowings and investments under CIPFA’s Treasury Management in the Public Services: Code of Practice and Cross-Sectoral Guidance Notes (2017) (‘Treasury Management Code’). CIPFA also publishes Treasury Management in the Public Services: Guidance Notes for Local Authorities incl Police and Fire Authorities (2018).

Treasury Management

Treasury management is the term used to describe the way a council manages the cash it needs to meet both its day-to-day running costs and borrowing for capital expenditure. The following table highlights some of the main cash inflows and outflows of a council.

Table 3.2: Key cash flows for a council

Day to day

Longer term

Cash in

Cash out

Cash in

Cash out

Council tax and business rate income (or precept for upper-tier authorities)

Revenue Support Grant

Other grants and income from charging for services

Precepts (from billing authorities to precepting authorities)

Wages and salaries

Payments to suppliers

Grants to other bodies

Cash-backed reserves and provisions

Capital receipts

Grants and contributions

Borrowing

Capital expenditure

Repayment of borrowing

Source: CIPFA

The treasury management function for a council will make the arrangements to borrow and invest money over either the short term or the longer term in order to ensure that it has money available when it needs it. Councils may borrow money from banks and building societies, other councils, the financial markets or the Public Works Loan Board (PWLB), which is part of the government’s Debt Management Office and allows councils to borrow at interest rates closer to those paid by central government for its borrowing. Councils invest money mainly with banks and building societies but may also invest in other places such as money market funds and the government’s Debt Management Office. The government intends to simplify the institutional arrangements by abolishing the PWLB and transferring its powers to the Treasury, which in turn will delegate operational responsibility to the Debt Management Office. These changes will have no practical implications for local authorities.

In making arrangements for treasury management, a council is required to follow CIPFA’s Treasury Management Code, which aims to help ensure that councils manage the significant risks associated with the function while also ensuring the council receives value for money. It defines treasury management as:

The management of the organisation’s borrowing, investments and cash flows, its banking, money market and capital market transactions; the effective control of the risks associated with those activities; and the pursuit of optimum performance consistent with those risks.

It is very important that councils understand the risks that are associated with treasury management, as highlighted by the collapse of the Icelandic banks a number of years ago, which put at risk substantial funds that had been invested by councils. The key treasury management risks are:

■credit risk – the risk that a bank or other institution will not be able to pay back the money invested in it
■interest rate risk – the risk that a council’s budget will be adversely affected by unforeseen changes in interest rates
■liquidity risk – the risk that a council will have funds tied up in long-term investments when it needs to use that money
■refinancing risk – the risk that when loans and investments reach the end of their term, the council will not be able to re-borrow or reinvest the money on acceptable terms or interest rates
■legal and regulatory risk – the risk that unforeseen legal and regulatory changes have an adverse impact on a council.

A council is required to approve a treasury management strategy, which sets out how it will borrow and invest money and manage those risks. The strategy is likely to include the following items:

■details of its appetite for risk and how it proposes to manage its risks, ensuring the key principles of security (getting your money back) and liquidity (having money available when you need it); and only when these two principles are ensured, considering yield (how much return it gets for its investment)
■details of how it assesses the credit worthiness of institutions it is planning on investing money with
■details of its training plans for both officers and members
■details of its use of third parties such as treasury management advisors.

It should also include the following treasury management indicators:

■An upper limit on the level of investments for periods longer than a year, which limits the amount of money that a council can invest for a fixed term of a year or more to ensure that the liquidity risk is managed. Longer-term investments also increase credit risk as councils may not be able to get their money back, or may face heavy penalties if they can do so, if an institution’s credit worthiness changes. When the Icelandic banks’ credit ratings were downgraded, many councils were unable to take existing investments out of these banks.
■Upper and lower limits for the maturity structure of borrowings. The maturity structure of borrowings is a term used to describe the profile of the dates that loans need to be repaid. A council will want to arrange its portfolio of loans so that they do not all come to an end at the same time and so that at any time it is borrowing only the amount of money it needs. This indicator helps a council manage its refinancing risk and avoid unnecessary credit risk by having to invest money as a result of over-borrowing.

As a result of increasing investments in other financial assets and property primarily for financial return, rather than as part of treasury management activity, the CIPFA Treasury Management Code includes specific requirements concerning these forms of investment. These forms of investment should follow the underlying principles that are prescribed for treasury management investment. For some investments, such as property, this can require specialist skills and expertise which councils will need to ensure that they have in place.

The way the treasury management risks interact is very complicated and councils will rely heavily on professional advice from specialist officers and external advisors. It is important, however, that senior officers and councillors understand the treasury management risks the council is taking and they should remember that the responsibility for treasury management must always remain within the council.

Previous | Next