Resource Accounting and Budgeting
We move now to agenda item 3. I apologise for keeping Irvine Lapsley and Brian Ashcroft waiting during the previous item.
Subsequent to our meeting last week, Professor Lapsley has prepared a briefing paper on resource accounting and budgeting. It is unlikely that members have had an opportunity to read the paper and it might be helpful for Professor Lapsley to talk us through it.
Professor Irvine Lapsley (Adviser):
This paper follows our very useful meeting with Dr Collings and Mr Macdonald of the Scottish Executive last week. The paper is not definitive; it simply maps some of the underlying principles of financial management and the key elements and issues around RAB that the committee might want to address.
Four principles underpin Scottish Executive and Treasury financial management. First, there is the intention to move closer to the private sector without achieving strict comparability. There are fundamental distinctions between public sector and private sector practices, such as the function of the assets and greater complexity on issues of public accountability in the public sector. Secondly, there is the golden rule, which involves financing long-term projects with long-term sources of finance. The final two principles are the intention to match outputs to inputs and to invest for sustainable output.
Although no one will disagree with those four principles, I should point out the limits on getting closer to private sector practice. There are also issues about the golden rule, which I shall revisit later. It is desirable to match outputs to inputs, because that shifts us away from the public sector's traditional focus of examining only inputs. However, we should recognise that the system is being developed and that there are problems with measuring outputs in public services. Nevertheless, we cannot advance unless something is done, so it is important to make the effort. RAB-type information should provide much more refined measures and information for finding out whether investment is achieving sustainable output.
Part 2 of the paper focuses on the key elements of RAB. First, the RAB system recognises continuing benefits that can flow from assets; it goes beyond the convention of considering cash investment in a given year as the only way to achieve visibility for assets. Historically, assets disappeared, effectively, from financial information after one year. That is clearly misleading and it will stop.
We also have a sharper definition of expenditure that includes commitments and liabilities. There is a definite and helpful attempt to link consumption of resources and flow of funds to resource usage in specified time periods. Finally, we have a framework now that links RAB analysis with objectives and outcomes.
Although all that is highly desirable and should prove beneficial, the system raises issues that the committee might wish to consider, especially the continuing costs of implementation, valuations, revaluations and getting accurate information. The committee might also wish to pursue issues about the robustness of the numbers that are generated, because—as we discussed last week—there are different bases of valuation for different financial scenarios. Shifting from one scenario to the other can have implications. For example, the decision to dispose of a principal asset can have financial consequences. The paper also flags up the major issue of pension liabilities, which has not been completely addressed.
Although the finance officers from the Scottish Executive gave a useful presentation, they did not dwell on the framework, but looked more at how the numbers were constructed. However, we should not lose sight of the fact that the framework is crucial to the exercise of accountability.
We have capital charging now. The cost of capital has been set at 6 per cent; however, that is a periodic figure that is generated by the Treasury and shows the marginal return on displacing a project in the private sector, with a depreciation charge included. We have information now that lets public service managers know that their capital is not a free good, but we need to address some important issues about interpreting what happens.
In summing up, I will try to draw some key issues together. First, does improving the information result in more effective and transparent financial management? For example, it was presented to us that we will deal initially with plans that are neutral in their fiscal implications. However, the intention that is behind the use of RAB is that things should be changed. RAB will change the perceptions and actions of key managers, who will then change their financial management accordingly. The Finance Committee should examine important issues such as the trade-offs between revenue and capital, especially in the big spending departments such as roads, health and education, where such trade-offs might have significant consequences. Managers will have to look hard at the complete set of assets that are at their disposal—human resources and physical assets such as buildings and infrastructure.
Secondly, we must consider issues about governmental accounting. There is a clear and laudable attempt to provide a more comprehensive picture of expenditure in the public sector and we now have a far more precise definition of expenditure on public corporations that includes both their capital spend and running costs.
Thirdly, the committee has also discussed local government accounting issues such as subsidiarity and different practices that have a similar cost-of-capital approach, but which are more notional than substantive. The move to more complete convergence on how we account will have important fiscal implications, such as potential increases in taxation and social housing rents.
The fourth key issue is the fact that RAB is about improving the visibility and transparency of financial information, which I am sure the committee agrees with. However, how do such developments sit with the former private finance initiative and new public-private partnership schemes? Such schemes could result in off-balance-sheet reporting of assets and a reduction in the quantum of principal assets of public sector institutions. A policy development that requires more transparency and openness sits side by side with a policy that means that we might lose sight of some assets.
The fifth point is that RAB might result in more accurate policies. For example, we mentioned greater visibility of the capital costs of maintaining roads, which raises all sorts of possibilities about cost recovery, pricing and charging or considering the costs of the road network vis-à-vis other forms of transport. Such information should inform debates and benefit policy makers.
Finally, I want to mention the sustainability of the golden rule. I should apologise for the cryptic note on that in the paper, but all it says is that the golden rule is entirely prudent and sensible. It makes sense to borrow for long-term capital, but—on the other hand—it is financially disastrous to borrow for revenue expenditure. However, there is an issue about financing capital from revenue, which happens in the private sector and might prove to be a pressure point for public sector institutions. Such institutions might feel constrained about the funds that they have available for capital expenditure and might be steered towards PFI/PPP-type schemes that they might find expensive. That would mean pressure to raise rates, charges and taxes, which is very important to the committee in the context of wider policy implications.
I apologise for the brevity of my paper, but it was produced at high speed, as members will see from one or two typographical errors.
I wish to pick up on point [3](6) of Professor Lapsley's note, document FI/00/22/4—I was able to follow the flow of thinking as indicated by the arrows. Will the approval of revenue for capital use put pressure on some of the public bodies—councils and so on—to carry out a short-term exercise, which would mean running into long-term debt management difficulties?
That depends. There is no optimal gearing level—I refer to the relationship between the amount of debt and the amount of equity for public sector institutions. There is not a well-developed rule of thumb about what the proportions of that should be.
Financial managers who manage services are subject to imperatives that might be entirely beyond their control, for example European Community legislation. That drives them to make changes that require capital and they might be forced to take a hard look at how they can fund that. Private finance initiative and public-private schemes might not cover all the necessary funds. The obvious recourse for financial managers is for them to consider how they can increase charges.
That is simply the pattern that I suggest members might wish to observe and consider carefully.
Professor Lapsley's paper is useful and gets us thinking about some of the issues. Those of us who attended the presentation last week realise that there is a great deal to resource accounting and budgeting. We will need to think carefully about whether we hold an inquiry or commission research.
One issue that is not raised in the paper is the implications for our relationship with the Treasury through the Barnett formula and how that feeds into this new system of accounting. Last week, Peter Collings said that RAB was set up to be neutral in terms of assessment of assets, their age and the requirement for replacement. I am sure that that is as it should be, but I wonder how we can monitor that to ensure that our position is protected. It strikes me that there are attendant upside and downside risks in the initial set-up of resource accounting and budgeting. We could end up gaining, but could just as easily end up losing significantly.
Why do you see RAB pushing public sector agencies towards public-private-partnership or off-balance-sheet financing?
There are two issues. First, it is unfortunate that one of the most fundamental changes to governmental accounting in 140 years coincides with a change in the Barnett formula allocations. It is therefore harder to detect what is happening and some careful monitoring is required.
Secondly, under the prudence rule, there is a directive to public sector institutions to go for the best package that they can put together, which has to be the best comparator to the private sector alternative. Clearly, the tendency is towards PPP schemes and PFI-type schemes.
Running costs might be higher. Organisations' initial expenses might be lower, because they will have an entire package put together for them, but they may as a consequence have to revisit their approach. It depends on the nature of the scheme. A PPP scheme might embrace part of an organisation's capital stock—possibly the principal capital stock—but not all of it. However, public sector institutions need other capital and other forms of equipment.
There is an issue about how we see such schemes being used. If we view them as being used for essential equipment to deliver a service that is consumed relatively rapidly, that is almost a form of private sector borrowing. If we view them as being about the delivery of substantive and principal assets, that gives rise to questions about continuity. I suspect that financial managers in public sector institutions might have to consider carefully other means. The presumption that financial managers can add charges assumes that they all do so. However, only certain institutions do.
Professor Brian Ashcroft (Adviser):
One important point to which Professor Lapsley has just alluded is that resource accounting and budgeting means that individual managers have, effectively, to pay for the opportunity cost of capital. The logic of that must be that there will be a degree of substitution from capital to revenue.
Previously, financial managers will not have had to meet the opportunity cost of capital. It is therefore likely that the next best alternatives will consist of revenue schemes to finance that capital—perhaps PFI. Leasing and other opportunities for smaller forms of capital equipment would be more likely to enter the frame. Clearly, there will be some impact on the balance of public expenditure, because the right price signals are now being put in place.
I do not doubt that there will be such a tendency in some services that use expensive equipment that has a short shelf life—due to technology change or due to the equipment simply wearing out. Are you suggesting that two forms of thinking will be required—one being short-term asset management and the other being long-term asset management?
No. One aspect of RAB is the inclusion of the opportunity cost of capital in the decision process. When they spent capital previously, managers would have tended not to do that—displacement in the private sector was not included. That introduces a new set of pricing rules, which will mean a switch towards revenue expenditure. To the extent that the capital project is bigger, the opportunity cost is much greater, so the substitution effect is also much greater.
Is that because of opportunity costs?
Yes.
Will there be a tendency among agencies—roads departments, for example—to seek to reduce the current asset value before getting into the matter of a notional cost? That would upset the balance of the asset base that was being negotiated around.
That might be the case—to the extent that a user cost is charged for existing assets. What I do not understand—I have to be honest—is the extent to which the notional costs buy, in terms of expenditures. If those costs are included in budgets, managers can make decisions, but there is no cash outlay. What happens to that cash?
The crucial factor is how robust the numbers are. Dr Collings said—I think he used the adjective "soft", although I may be misquoting him—that it is partly a matter of the system's novelty. The system is in its infancy. The numbers might not be as robust as we would like and we should consider carefully the consequences of that.
If financial managers are forced into making trade-offs between revenue and capital and if the capital numbers are not as hard as we would like, erroneous decisions could be made. We are in a developmental phase—the situation is still changing and developing. It is still new.
Professor Lapsley mentioned the sustainability of the golden rule. I am still not clear about that: the golden rule is not a new concept, so why would resource accounting and budgeting make the golden rule potentially unsustainable?
I just raised the question. I cannot say definitively what will happen, but I would say that RAB makes everything much more explicit for managers working within the system. If managers have some freedom, and if that lies in charging prices for services such as buses or rents for housing, they must be tempted, when looking at the numbers and trying to trade off capital and revenue, to try to raise revenue to offset the additional capital costs that are introduced.
Not all managers have such freedom—I am thinking of hospital expenditure, for example—but certain services might allow for it. There is an issue over how high the numbers would have to go before there would be some relaxation.
When we go back to the beginning, it is a question of moving closer to—but not being the same as—private-sector practice. In the private sector, lots of institutions, organisations and successful companies generate funds through pricing and plough them back into capital expenditure. That is not an unusual form of finance. Managers will make use of debt and raise funds on the capital markets, but if they have funds from successful investment they will also use them for capital spend. That highlights the extent of public sector managers' freedom to do the same.
My question is on a separate topic, but it is related to what has been said about the relationship with the funding mechanism and blocking formula. Can you clarify whether I am correct in thinking that this raises problems? We have a stock of capital in the public sector in Scotland that is assessed for the first year. An accounting mechanism is then set up so that capital charges are applied to the overall stock of capital. In the future, changes to that stream or initial chunk of capital charging will be made through the Barnett formula, so that if changes occur in the UK as a whole we get a set percentage share of that.
That leads to the question: is our stock greater or smaller than that of the rest of the UK and do we gain or lose through that funding mechanism? Is the stock older or younger—which will determine whether a replacement will come more quickly or more slowly? The updating is carried out through a population mechanism. That does not strike me as sensible.
That is a fundamental question. There is an issue about the vintage of the stock that we in Scotland have at our disposal, and about its pattern, disposition and the extent to which it relates to the situation—in other words, how sharp the numbers are.
I suspect that there will also be unevenness in England. If we consider the attempts to achieve equalisation in the health service, real disparities remain despite the best efforts of policymakers to achieve equivalence over five decades.
The continuing funding may not be sufficient to fund the existing asset base; it may be more a matter of hard decisions being made on revenue spent and on the amount of money coming in to service and maintain the assets. The whole thing might be put into sharper relief.
It would be interesting to see some comparative information on the vintage, structure and capacity of our assets vis-à-vis England and other regions.
Correct me if I am wrong, but it seems to me that there could be a perverse incentive inside the system. In the health service, the object has been to tell health boards that if they are holding assets they are not using they should dispose of them, but if those assets are disposed of and the situation becomes real—not just something being dealt with as an accounting matter—that will affect the distribution of funds to a devolved Scotland.
What you have described is an effect of the RAB system. When we met last week, you may recall that there was discussion of things being neutral. The reality is that the intention of the new information is to change things. What you have talked about is one example of that.
We would expect that, two or three years into the operation of the system, managers might reduce the capital at their disposal. That might be a perfectly prudent thing to do if they have surplus assets that are not being used and which could be used better. It may make perfect sense. If they are forced to do so, however, and if they have to procure other facilities which do not deliver the same level of service, there is an issue about how sensible that is. That is the perverse element.
We should try—because health boards have been doing it for a considerable time—to get some health finance managers to give us some examples of how RAB has driven decisions. That would give us specific examples and might allow us to be clearer about how RAB works.
The other area that I want to touch on is pension liabilities, because there has been a lot of concern and many disputes—for example with the transfer of pension arrangements from the public sector to the private sector in respect of transport, and issues over miners' pensions. Over the past year, I have been concerned by what happens to the capital assets and values of these nominal pension schemes. How could one start to unpack the effect of RAB? I am not asking you to do that today. How RAB would affect, or would have affected, decisions could be part of a separate briefing note.
I have two observations. First, your suggestion that the committee meet finance managers in the national health service and address these issues as experienced by them is superb. We would quickly get to the heart of the issues and the consequences of having RAB-type accounting systems, which would be beneficial.
Secondly, it strikes me that pensions is something that people want to talk about rather than do something about, because the implications are severe in terms of recognition of the extent of liability. If you had a full-blown RAB system, you would recognise pension liability and the assets needed to deliver it. There could be significant implications for the public sector. Dr Peter Collings said that for the pensions in the annually managed expenditure, the implications could be very significant.
Will they be transferred?
If they are transferred, the effect would be more than neutral, but we would have to look hard at the basis of pension funding, which is a huge issue in its own right. There is an issue about how that sits with the rest of the UK, but in terms of public services there is a big issue about recognition of liability.
It strikes me that we are getting into detailed areas now. After last week's briefing there was a feeling that this issue might merit wider consideration, and perhaps even an inquiry. How do members feel about that? Andrew Wilson more or less signified that it might be a good idea. When we get into areas such as pensions there is quite a bit of information that we need. Richard Simpson mentioned practice in the health service that we might learn from. How do members feel?
There are several issues, which both advisers have raised, that we have to address. It is our job and duty to look at them in detail. Having an eye on the implications for the incentives in our public services is a big issue. My major concern relates to more and more coming into the Scottish block and Barnett formula arrangements and the implications. This merits our attention. It has to, but what happens when we do not get any information? We require information. Let us commence our work, but it will be difficult.
As we go through this process I am thinking about the comments that were made at a cross-party meeting that I had with Aberdeenshire Council. If we are looking at rural councils, which have high infrastructure assets and a low population base, will the roll-out of RAB skew tremendously the local government finance settlement? I do not mean for Aberdeenshire Council in particular, but for councils in general. Account has to be taken of this issue.
As is obvious, RAB will not be introduced tomorrow, if that is when the Minister for Finance comments on it, but if you look at a valuation of assets that have traditionally been held by councils, such as assets that have been inherited from previous regional councils, you will find that there is a huge base of buildings that have been divided up on a geographic basis and which councils cannot do much with. RAB could be a tremendous strain on the asset base of less populous councils. How do we deal with that? Is it an issue for the Scottish Executive? Should we flag up that the Executive should come back to us with a view before we try to do anything, because there is a limit to how much work we can do on this?
The problem is more with health than with local government because local government is, to some extent, at one remove. It has its own system of dealing with capital and it has figures that look like RAB figures, but it has been astute in that they are neutral. They are really management information rather than figures that impact on tax and funding levels. So health is the one area that is locked in to the system. If you take David Davidson's interesting example of a sparse population with assets—hospitals, for example—you have a direct comparator. That is where there is a bigger problem.
Transport is a factor that bears on what Andrew Wilson said. There are more miles of road per head of population in Scotland than in the rest of the UK. Once you bring such capital into the frame, there are implications for the Barnett formula which the Barnett formula does not deal with because it is based on population. In that sense, it is not neutral. The vintage and the scale of the capital stock in particular areas—and its implications for Barnett—should be looked at.
Some of the points that David Davidson raised will, I presume, be dealt with by the Local Government Committee, which is considering local government finance. We will have to be careful not to cover the same ground, although we could benefit from the evidence that it takes. None the less, local government will have to feature in our inquiry.
We could benefit from having a short inquiry. It is clear that there are a number of areas on which questions need to be asked. We need to understand properly the asset base of Scotland, whether it is properly valued, and the implications for health, transport and other areas. The issue of pension liabilities sounds a bit worrying. I support the idea that the committee has an inquiry. Richard Simpson's suggestion that we should bring in people who have been running under RAB for some time is good.
To illustrate a point, I draw attention to the table in annex 2, on capital charges. It is interesting that capital charges in transport outweigh revenue expenditure by 30 to 40 per cent, whereas in health, where capital charges are important—£205 million—they are a small fraction. It is clear that, in transport, they are crucial.
If I may, I will speculate. Questions could be as follows. How do we recoup all this money? What about some cross-recovery schemes? What about road charging? It is about information and how it feeds in to decisions.
I see that there is general approval that we undertake an inquiry. We are pretty well tied up until the end of the year, but Callum Thomson has suggested that we invite written evidence as soon as possible, with a view to taking oral evidence at the end of the year. It would be reasonable to think that we could do that in December, after the budget has been dealt with. Is that agreed?
Members indicated agreement.
We will finalise a remit at the next meeting, although a number of the key issues that we would like to look at have helpfully been listed in Professor Lapsley's note to us today. I thank Professor Ashcroft and Professor Lapsley for their invaluable contribution.
We will now move into private session to consider agenda items 4 and 5.
Meeting continued in private until 11:36.