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					                                                            TREVOR EMMOTT
                                                            HEAD OF LOCAL GOVERNMENT CAPITAL BRANCH

                                                            DEPARTMENT OF THE ENVIRONMENT
                                                            TRANSPORT AND THE REGIONS

                                                            ZONE 5/H3
                                                            ELAND HOUSE
                                                            BRESSENDEN PLACE
                                                            LONDON SW1E 5DU

                                                            DIRECT LINE: 0171 890 4226
                                                            FAX: 0171 890 4259

                                                             23 DECEMBER 1999

Chief Executives and Chief Finance Officers,
       Part IV authorities in England
Chief Constables in England
Chief Fire Officers in England
Receiver for the Metropolitan Police District
Other interested parties

Dear Sir/Madam

The Local Authorities (Capital Finance) (Amendment) (England) Regulations 1999

I wrote to you on 17 September enclosing a consultation note on a proposed amendment to
the regulations relating to local government PFI schemes and on changes to the PFI
revenue support arrangements.

The Department is most grateful for the comments it received. These have been discussed
with the local authority associations, the 4Ps and other interested parties. The need was
identified for some slight changes to the new regulation 40 to improve its flexibility. These
have been incorporated in the text. I enclose a copy of the regulations as now laid before
Parliament. They come into force on 1 April 2000.

The regulations amend the PFI risk-transfer test in regulation 40. The effect is to bring the
test in line with the newly established standards for accounting for PFI contracts. I attach
an informal summary of the new regulation.

The letter of 17 September also dealt with the administrative arrangements under which
revenue support grant may be made available for PFI schemes. No changes have been
made to that guidance, which is reproduced for convenience in the attached note.

Enquiries on this letter should be directed to: Simon Oliver [Zone 5/H3 at the above
address] Fax: 0171 890 4259 Telephone: 0171 890

Yours faithfully

                       LOCAL GOVERNMENT
                             AND THE
The Local Authorities (Capital Finance) (Amendment) (England) Regulations 1999

    A note by the Department of the Environment, Transport and the
This note contains: (I) an informal explanation of the changes made to the PFI risk-
transfer test; (II) details of changes to the arrangements for applications for PFI
revenue support


1. The Local Authorities (Capital Finance) (Amendment) (England) Regulations 1999 [SI
3423], effective from 1 April 2000, amend the Local Authorities (Capital Finance)
Regulations 1997 [SI 1997/319 as amended], made under the Local Government and
Housing Act 1989. They significantly change the PFI risk-transfer test in regulation 40.

The Present Test

2. A “private finance transaction” is defined in regulation 16 as a contract under which an
asset (or works) and associated services are provided to an authority and where the
consideration given by the authority includes a fee varying in relation to performance
and/or usage. Regulation 40 only applies to contracts satisfying that definition.

3. Regulation 40 itself sets out what is known informally as the “contract-structure test”. It
determines whether an authority entering into a private finance may be relieved of the
need to provide the credit cover which would otherwise be required for a credit
arrangement under sections 48 to 50 of the 1989 Act. It is a measure of the degree to
which risk is transferred to the contractor through the mechanism of the variable fee.

The New Test

4. Regulation 40 is replaced in its entirety. The new test reflects the approach to
accounting for PFI contracts set out by the Accounting Standards Board in its Application
Note entitled Amendment to FRS5 - Reporting the substance of transactions: Private
Finance Initiative and Similar Contracts [issued on 10 September 1998]. The Treasury
Taskforce, in the light of this, on 24 June 1999 issued its own Technical Note No.1
(Revised) - How to Account for PFI Transactions. The requirements of the Application
Note have been incorporated into CIPFA’s Code of Practice on Local Authority
Accounting in Great Britain 1999 - A Statement of Recommended Practice (see Appendix
E). As a result, it has become part of “proper practices” for local authorities, as defined in
section 66(4) of the 1989 Act.

5. The broad effect of the new regulation is that no credit cover will be required
where there is no increase in any amounts on the authority’s balance sheet in respect
of the assets provided, constructed or improved under the contract. In two cases,
specified in regulation 40(2), balance sheet increases are ignored for this purpose. These
are: (a) where the authority transfers an asset to the PFI contractor in return for reduced
fees; and (b) where an asset provided under the PFI contract is transferred into the
ownership of the authority at the end of the contract. Where such transactions lead to
an item being recognised as an asset in the authority’s balance sheet, the authority is not
prevented from benefiting from the regulation.

6. The new regulation, in referring to an item being recognised as an asset, is using that
term as defined in FRS5. Recognition is the process of incorporating an item into the
primary financial statements under the appropriate heading; it involves depiction of the
item in words and by a monetary amount and the inclusion of that amount in the statement
totals. Accordingly, the regulation is only concerned with additions to balance sheet
amounts. Any reduction in such amounts is irrelevant for the purposes of the regulation.

7. The test depends upon the authority’s own determination of the balance sheet
treatment. That determination may be made (or reviewed) at any time in the financial year
in which the contract is entered into, or up to 30 September in the following year. After
that date, reappraisal of the treatment by the authority (or any other person) cannot result
in a change in the statutory requirement for credit cover (unless of course the contract is
varied and that reappraisal is undertaken in accordance with s51 of the 1989 Act).
However, like all other decisions under the capital controls, the original determination will
be subject to scrutiny by authorities’ external auditors. The Department recommends that
authorities keep in touch with their auditors on an informal basis throughout the
development of any PFI proposal.

8. The test is only concerned with balance sheet entries relating directly to the assets
which are the subject of the private finance transaction as defined under regulation 16.
The test can still be passed even if the contract leads to an increase in the balance sheet
value of an asset owned by the authority but not provided or improved under the contract.
This might happen where the PFI project enhances the value of a freehold interest in land
retained by the authority - typically, land on which the PFI development takes place under
a lease or licence granted to the contractor, but perhaps sometimes adjacent land.

9. It is important to note that the test depends upon the accounting treatment of the
transaction and not the legal title to the assets involved in the transaction. A PFI scheme
for the refurbishment of property already owned by the authority may be structured so that
the asset being improved is recognised entirely on the contractor’s balance sheet. The
value of the asset will be increased by the works, but the authority’s own balance sheet
will record no increase, even though the authority remains the owner of the improved asset
throughout the contract. The authority’s balance sheet would in fact show a decrease at the
start of the contract as soon as the asset is recognised on the contractor’s balance sheet.
Such a scheme would comply fully with the new regulation 40.

10. Where a contract is for the provision or improvement of a number of assets, the test
could be failed if one of those assets is on-balance sheet, even though the rest are off-
balance sheet. This is one kind of case in which it may be appropriate for the authority to
seek a supplementary credit approval (see paragraph 19 below).


General procedures

11. Where a scheme passes the new regulation 40 test, the credit arrangement will have an
“initial cost” of nil and will not require credit cover under the capital finance system. It
will only need to be submitted to a Government department if the authority wish to apply
for a Notional Credit Approval (NCA) which confers additional revenue support for PFI
projects endorsed by the Project Review Group (PRG). The amendment to the regulations
does not affect the basic arrangements for seeking NCAs, though there are more
significant changes to the procedures for handling schemes which fail the new test (see
paragraphs 19-25 below). Applications for NCAs should continue to be made in
accordance with current guidelines, subject to the points made below. The relevant
guidance is in the following documents already issued by DETR:

   Local Government and the Private Finance Initiative - An explanatory note on PFI
    and Public/Private Partnerships in local government [September 1998] - Section 4
    and Appendix 3; and

   Dr C J Myerscough’s letter to Chief Executives and Chief Finance Officers of 21
    December 1998 headed Revised Criteria for Allocation of “PFI Credits”.

Criteria checklist

12. The criteria for the allocation of PFI credits were set out in the Annex to the 21
December 1998 letter. These include general criteria (page 1 of the Annex), departmental
criteria (pages 4 to 9) and Treasury Taskforce criteria (page 10). All formal applications
for NCAs should in future be accompanied by a short checklist indicating the paragraph
numbers in the main documentation submitted by the authority where information on each
of the criteria is to be found. This will help authorities to ensure that all points have been
covered and assist departments and the PRG when processing applications. A similar
checklist should be provided when applying for a SCA under the procedures described in
paragraph 24(b) below.

13. Departments need the authority’s clear statement and, where appropriate, evidence,
that each of the criteria has been addressed. Requirements of different departments may
vary and should be checked at an early stage. Subject to that, submissions should be kept
as concise as possible. However, when dealing with the points mentioned under the
heading Use of Appropriate Comparators, more detailed treatment will normally be
required, since value-for-money issues are central to the appraisal. If a comparator other
than the public sector comparator is used, reasons should be given. In all cases, the
quantified results of the comparison should be given in summary form.
Accounting treatment

14. The NCA application should also confirm that the new regulation 40 risk-transfer test
is likely to be passed. This statement must be supported by the provision of an initial view
of the accounting treatment, as set out in Section 2 of the Treasury Taskforce’s Technical
Note No. 1 (Revised) How to Account for PFI Transactions [June 1999]. As stated above
(paragraph 7), authorities are advised to keep their auditors informed about such matters.

Sharing of information

15. Authorities are reminded that they are required to share information about endorsed
schemes (see paragraph 5.8 of the explanatory note and paragraph 10 of the Annex to the
21 December 1998 letter). The contract and related documentation should normally be
available on request to other authorities and the 4Ps. Commercially confidential
information may be withheld, but authorities should aim to keep such material to a
minimum, enabling the majority of the documentation to be released. Authorities should
make clear to potential contractors that this is a formal condition of the issue of the NCA.

Prioritisation of schemes

16. The letter of 21 December 1998 makes clear that departments are keen to encourage
innovative schemes to come forward. This is a factor, among others, which Ministers may
wish to take into account when prioritising schemes. Another relevant factor is the size of
the NCA required. Again, this was mentioned in the letter, but may become more
significant when it is necessary to decide between several schemes of similar quality
which cannot all be accommodated within the allocation. Ministers may choose to favour
smaller schemes instead of larger ones; or may offer a large scheme a credit lower than
that sought, where this would be consistent with the scheme’s affordability.

17. To reduce the risk of abortive work, it remains important that authorities should at an
early stage discuss their proposals with the 4Ps and notify the department concerned of the
estimated amount of credit required and the likely financial year for contract signature.
Authorities should, however, appreciate that no commitment on revenue support can ever
be given until a scheme has been formally endorsed by the PRG and approved by

Self-financing schemes

18. Where an authority decide that a scheme passes the new test but that revenue support
will not be sought, because the costs will be met from revenues generated by the project
itself (or perhaps from other resources of the authority), that decision does not require the
agreement of the Government and does not need to be brought to their attention.
Authorities are encouraged to explore the scope for self-financing schemes wherever


19. Where a scheme for any reason fails the new regulation 40 test, the authority will be
required to provide the full amount of credit cover calculated in the normal way - broadly,
the net present value of all payments due under the contract throughout its life.
20. The policy underlying the Private Finance Initiative is to encourage authorities to
pursue best value PFI contracts. In the great majority of cases risks will be sufficiently
transferred to the private sector so that assets provided or improved under PFI contracts do
not fall to be recognised on authorities' balance sheets.

21. The Government is however keen to ensure that authorities do not transfer risks to the
private sector purely to comply with the new regulation, where this may in fact reduce
value-for-money. If, exceptionally, a best value PFI contract does result in assets being
recognised on a local authority’s balance sheet, departments will be prepared to consider
an application for a supplementary credit approval (SCA) equal to the credit cover
required for the contract.

Details of application procedure

22. DETR’s booklet Local Government and the Private Finance Initiative - An
explanatory note on PFI and Public/Private Partnerships in local government (Appendix
3) describes the current arrangements for dealing with schemes which do not meet the
requirements of regulation 40. Such schemes cannot receive NCAs but may be eligible for
Non-Scoring Credit Approvals (NSCAs). The latter are normal SCAs which both provide
credit cover for the credit arrangement and confer revenue support. Under present
guidelines, a NSCA may be issued where, for example, a scheme fails the contract-
structure test but is off-balance sheet for the authority.

23. When the new regulation 40 comes into force, a generally similar twin-track approach
will continue. Where a scheme passes the test, the authority will, as now, be able to seek a
NCA entitling it to revenue suppport. Where a scheme fails that test, it will be open to the
authority to apply for a SCA, which will meet the need for credit cover and entitle the
authority to receive revenue support. To that extent, the arrangements will be similar to the
present ones. However, the criteria for the issue of the SCAs will differ from those
currently applicable to NSCAs and are set out below. The term “NSCA” will cease to be
used and any application should simply refer to a “SCA”.

24. In applying for a SCA, authorities should cover the following points.

       (a) The authority should confirm that the scheme is a private finance transaction
       as defined in regulation 16.
       (b) The authority should confirm that the scheme meets the general PFI criteria
       specified by the Project Review Group (PRG) and DETR, as well as service-
       specific criteria.
       (c) The authority should give full details of the accounting analysis and explain
       why the scheme might fail the new regulation 40 test - i.e. why some or all of the
       assets covered by the contract might be shown on the authority’s balance sheet. If
       the need for this accounting treatment has become apparent only at a relatively late
       stage in the development of the scheme, the authority should explain why it was
       not identified in the initial analysis.
       (d) The structure of the contract as it affects the key risks should be described;
       reasons should be given where it does not follow the Treasury Taskforce’s
       guidance in their publication Standardisation of PFI Contracts [July 1999].
       (e) The authority should set out the value-for-money case for proceeding with a
       PFI project when considered against the Public Sector Comparator and in the
       context of its Best Value strategy. The implications of structuring the project to
       take all assets off the local authority balance sheet should be explained.
        Confirmation should be given that the on-balance sheet items have been minimised
        consistent with achieving best value.

25. Authorities should be aware that the value-for-money aspects of SCA applications will
be considered particularly closely. In the circumstances that best value-for-money can be
delivered only by bringing elements of the transaction on-balance sheet, this should be
identified as early as possible and the consequences planned within the procurement
strategy. The need for a SCA should not emerge at a late stage in the development of a
scheme merely as a result of some oversight. Authorities should give departments at least
a preliminary warning when submitting the Outline Business Case if there is any
possibility that they may need to seek a SCA under these arrangements. They should
supply as much of the information specified in paragraph 24 as is then available. If the
need for a SCA is subsequently confirmed, full details will be required in accordance with
paragraph 24. The relevant department will then consider the case on its merits.

Transitional arrangements

26. The DETR letter of 21 December 1998, in giving notice of the change in regulation 40,
undertook that projects endorsed by the PRG prior to December 1998 would not be
affected by the amendment. If such a scheme reaches contract signature on or after 1 April
2000 and passes the new regulation 40 test, there is no problem and no action will be
needed. Arrangements will however be made to ensure that, if it does not meet the new
test, it will be treated as if the contract-structure test still applied. If, therefore, it passes the
latter test, there will be no adverse effect on the authority’s capital resources.

                                                                       DETR/LGC2 23 December 1999