Scotland's Fiscal Outlook: the Scottish Government's five-year financial strategy

3. Financial Management and Fiscal Rules

3.1. The Fiscal Framework is an agreement between the Scottish and UK Governments that determines how the Scottish Government is funded. This agreement will be reviewed in 2021, following the first five years of its operation.

3.2. The funding model agreed in the Fiscal Framework provides a transparent mechanism to adjust the Scottish Government block grant to reflect the introduction of newly devolved revenues and the transfer of additional responsibilities, such as social security, to the Scottish Government. The Fiscal Framework gives the Scottish Government access to resource and capital borrowing powers to ensure budgetary stability and manage the volatility associated with greater revenue-raising powers. Within the Framework the Scottish Government is also permitted to operate a (limited) Scotland Reserve.

3.3. This Chapter describes the range of fiscal rules and financial management mechanisms available in more detail and explains how the Scottish Government is using them.

Capital borrowing

3.4. The Scottish Government's capital borrowing powers were originally granted in the Scotland Act 2012 and the limits were increased in the Scotland Act 2016. In addition to the capital block grant, the Scottish Government can increase capital expenditure through borrowing up to £450 million per year up to a maximum total of £3 billion under the provisions of the Scotland Act 2016. These capital borrowing limits came into effect for the Scottish Government on 1 April 2017.

3.5. The Scottish Government may borrow from the UK Government through the National Loans Fund, by way of a commercial loan (directly from a bank or other lender) or by issuing bonds. Where borrowing is through the UK Government, repayment arrangements are set out in a Memorandum of Understanding between the Scottish Government and UK Government.

3.6. Capital borrowing powers have been used in each year to date to support the capital investment programme and promote economic growth in Scotland. The Scottish Government agreed a notional borrowing arrangement with HM Treasury in 2015-16 and 2016-17 as part of managing the budgetary impact of Office for National Statistics classification decisions on a number of Non-Profit Distributing ( NPD) projects, including the Aberdeen Western Peripheral Route. As a result, the amounts recorded against borrowing limits for those years are notionally repaid over 30 years (linked to the life of the underlying NPD contracts). This notional borrowing arrangement counts towards the overall capital borrowing cap, but does not have a cash impact on the Scottish Budget.

3.7. The Fiscal Framework requires the Scottish Government to notify HM Treasury each month of its planned capital borrowing, its outstanding debt and its debt repayment profile. The Scottish Government is able to borrow within the agreed limits as it deems appropriate.

3.8. The Scottish Government has to date borrowed exclusively from the UK Government. The 2018-19 Scottish Budget plans to make full use of the £450 million capital borrowing powers available to maximise infrastructure investment and economic impact. Final decisions on the specific borrowing arrangements for 2018-19 will be taken over the course of the year, reflecting an on-going assessment of programme requirements and value for money assessment of the options available.

3.9. This document models the impact of one further full year of capital borrowing in 2019-20, but final decisions on future borrowing levels will be taken as part of the 2019-20 budget and subsequent budget processes. These decisions will be taken annually in light of the economic outlook at the time, weighing the cost of borrowing and the opportunity cost of using up more of the overall £3 billion borrowing limit against the potential benefits of economic stimulus.

3.10. Table 3.1 (below) sets out the capital borrowing and repayments, based upon capital borrowing undertaken to date, plus planned borrowing of a further £450 million in 2019‑20.

Table 3.1 – Capital borrowing and repayments

£m	2015-16	2016-17	2017-18	2018-19	2019-20	2020-21	2021-22	2022-23
Borrowing	283	333	450	450	450	-	-	-
Repayment on 2015-16 borrowing	-	9	9	9	9	9	9	9
Repayment on 2016-17 borrowing	-	-	11	11	11	11	11	11
Repayment on 2017-18 borrowing	-	-	-	7	14	15	15	15
Repayment on 2018-19 borrowing	-	-	-	-	7	14	15	15
Repayment on 2019-20 borrowing	-	-	-	-	-	7	14	15
Total Annual Repayments*	-	9	21	27	41	56	64	65
Repayment period for borrowing (years)	30	30	25	25	25	-	-	-

Note 1: *This reflects the repayment of the principal loan and in addition there will be interest costs to meet (at around 2% for borrowing to date). Note 2: Figures may not sum due to rounding.

3.11. The affordability and sustainability of all Scottish Government long-term revenue commitments, including repayment of debt stock, are assessed through the budget process and are kept within a maximum of 5 per cent of the total annual budget available.

3.12. The Scottish Fiscal Commission has a duty to assess the reasonableness of Scottish Government projections of borrowing in its economic forecasts. To date the Commission has assessed the borrowing projections as reasonable.

3.13. Local authorities also have the power to borrow under the Local Government (Scotland) Act 1975 which defines the purposes for which local authorities may borrow, meaning that they can only borrow for capital expenditure. Capital borrowing by local authorities sits outside the Scottish Budget.

3.14. The amount of borrowing that a local authority can undertake is regulated by the Prudential Code under which authorities determine the maximum amount that they can afford to borrow based on a series of indicators such as affordability, prudence and sustainability.

Overall affordability of capital investment

3.15. The Scottish Government is committed to ensuring that revenue-funded methods of investment are maintained at a sustainable level and do not constrain choices in future years.

3.16. The Scottish Government uses a self-imposed limit to ensure that revenue-funded investment – including repayment of capital borrowing under the new powers – will not exceed 5 per cent of the total annual budget available.

3.17. Under current plans and arrangements, committed Scottish Government projects are estimated to peak in 2019-20 at 3.88 per cent. When planned projects, which are not yet contractually committed, and planned borrowing in 2018-19 and 2019-20 are included, this increases to 4.23 per cent in 2020-21. These investments are consistently monitored and the Scottish Budget documents include an analysis of the performance against this 5 per cent limit. Table 3.2 illustrates revenue commitments as a percentage of the annual total budget available for the years 2018-19 to 2022-23.

Table 3.2 – Revenue commitments as a percentage of the annual total budget

	2018-19	2019-20	2020-21	2021-22	2022-23
Committed projects	3.63%	3.88%	3.79%	3.71%	3.59%
Committed projects plus planned projects and planned borrowing	3.74%	4.11%	4.23%	4.17%	4.04%

3.18. Table 3.3 splits out the commitments and planned commitments into the different categories of revenue-funded investment.

Table 3.3 – Breakdown of committed projects plus planned projects and planned borrowing into categories (%)

	2018-19	2019-20	2020-21	2021-22	2022-23
PPP/ PFI	1.94%	1.93%	1.85%	1.81%	1.72%
NPD/Hub	0.63%	0.67%	0.80%	0.81%	0.80%
Network Rail Borrowing – RAB	1.06%	1.30%	1.30%	1.28%	1.25%
Capital Borrowing	0.11%	0.21%	0.28%	0.27%	0.27%
Total	3.74%	4.11%	4.23%	4.17%	4.04%

3.19. Committed projects are those where a contract has been signed. The assets will therefore be under construction, or the project is operational. Committed projects also include the Scottish Government's share of the revenue costs of PFI projects (which are completed and in operation) and the five pre-pipeline NPD projects. Unitary charges usually include on-going maintenance commitments over the project life, as well as costs associated with project construction and financing. Costs associated with planned projects and investments are those where a contract is not yet signed.

3.20. It should be noted that, following the reclassification of Network Rail from a private to a public sector organisation, the funding regime will change from 2019-20 and rail projects will become entirely grant-funded. This will change the way the 5 per cent limit takes account of rail projects which are currently revenue-financed.

3.21. In the interests of maintaining comparability, current modelling of commitments contains estimates of the Network Rail investment as if it had been Regulatory Asset Base ( RAB) funded. The Scottish Government is therefore currently reviewing this approach to reflect the new and more complex fiscal environment.

Resource borrowing

3.22. The Scotland Act 2012 gave the Scottish Government access to a resource borrowing facility of up to £200 million per year within a statutory overall limit for resource borrowing of £500 million. This could be used to meet any in-year excess in expenditure over income.

3.23. The Scotland Act 2016 extended this facility to enable the Scottish Government to borrow from the National Loans Fund in certain situations where there are specific cash management challenges. The Scottish Government now has the power to borrow up to £600 million each year within a statutory overall limit for resource borrowing of £1.75 billion, for the following reasons:

• in-year cash management, with an annual limit of £500 million;
• forecast error on devolved and assigned taxes, and on devolved social security expenditure, arising from forecasts of Scottish receipts/expenditure and corresponding UK forecasts for the Block Grant Adjustments, with an annual limit of £300 million; and
• observed or forecast shortfall in devolved or assigned tax receipts or devolved social security expenditure incurred where there is, or is forecast to be, a Scotland-specific economic shock, with an annual limit of £600 million.

3.24. It is important to note that if an economic shock occurs it is not possible for the Scottish Government to apply resource borrowing to provide an economic stimulus – only to meet a shortfall in tax receipts or demand-led social security spending.

3.25. These enhanced borrowing powers came into force from 2017-18 onwards. All resource borrowing must be from the National Loans Fund and the repayment period must be between three and five years, to be determined by the Scottish Government at the time of borrowing. The Scottish Government is required to provide regular monthly forecasts to HM Treasury of the amount of resource borrowing it expects to make, outstanding debt and repayment profiles and can borrow within the agreed limits as deemed appropriate.

3.26. The resource borrowing power is deliberately restricted to very specific circumstances and does not detract from the fundamental requirement for a balanced Scottish Budget each financial year. If circumstances arise where the conditions to allow resource borrowing become available, the Scottish Government will make a decision on whether and how to use it based on the overall situation at the time.

3.27. A decision will depend on assessing the impact of resource borrowing, including the repayments over future financial years, against the impact of taking other steps, such as reducing expenditure in-year or using money available in the Scotland Reserve.

Scotland Reserve

3.28. The Scotland Act 2016 replaced a previous power under the Scotland Act 2012 to operate a limited cash reserve. This can be used to build up funds when devolved revenues are higher than forecast and to drawdown funds when devolved revenues are lower than forecast. The Scotland Reserve replaced the previous Budget Exchange provisions set out in the Consolidated Budgeting Guidance.

3.29. The Scotland Reserve allows the Scottish Government to smooth all types of spending and is intended to assist the management of tax volatility and to determine the timing of expenditure. The Scotland Reserve applied from 2017-18 onwards and is split between resource and capital.

3.30. The Reserve is capped in aggregate at £700 million, or only 2.2 per cent of the total Scottish Budget in 2018-19, which falls to 1.8 per cent in 2022-23, based on the central projection in this document. Annual drawdowns from the Reserve are limited to £250 million for resource and £100 million for capital.

3.31. The Scotland Reserve is now the mechanism by which any underspend in the Scottish Budget can be carried forward to be used in a subsequent financial year. In recent years, with very tight financial management, underspend has been low, less than 1 per cent of the total discretionary budget, but even so, managing money across financial years is likely to use up a substantial proportion of the £250 million resource and £100 million capital limits. This very severely restricts the Scottish Government's ability to build up a reserve and draw down from it.

3.32. The balance in the Scotland Reserve at the start of 2017-18 was £74 million. The closing balance on the Reserve for 2017-18 will be reported as part of the provisional outturn statement to the Scottish Parliament in June 2018. Spending plans for 2018-19 anticipate around £230 million of expenditure that will be funded from carry forward from 2017-18, which will be managed through the Scotland Reserve.

3.33. The Scottish Government intends to build up the balance in the Scotland Reserve over time as resources allow, in order to have a financial cushion available, while ensuring that there remains sufficient capacity in the Reserve to prudently manage any underspend across financial years.

Effective financial management and reporting

3.34. The Public Finance and Accountability (Scotland) Act 2000 provides for the use of resources by the Scottish Government (and other directly funded bodies) and sets out accountability arrangements for management of those resources. The Scottish Public Finance Manual ^[6] ( SPFM) is issued by the Scottish Government to provide guidance to itself and other relevant bodies on the proper handling and reporting of public funds. It sets out the relevant statutory, Parliamentary and administrative requirements, emphasises the need for economy, efficiency and effectiveness, and promotes good practice and high standards of propriety.

Economic intervention and investment

3.35. The Scottish Government's consideration of any investment or significant financial decision follows the principles and procedures of the SPFM to ensure the regularity, propriety and value for money of the use of resources.

3.36. This includes:

• preparing and refining a business case to ensure that proposals are in line with strategic objectives, the evaluation of options, detailed analysis of costs and benefits and all relevant commercial and financial considerations, including the affordability and balance of risks of the proposal;
• carrying out due diligence to substantiate the assessment where relevant;
• acting within EU State aid rules; and
• where appropriate, consultation with and scrutiny from the Scottish Parliament.

3.37. Before entering into any form of agreement giving rise to a contingent liability, for example a guarantee or indemnity, the SPFM requires a careful appraisal of the risks, with steps to be taken to restrict the total contingent liability to a minimum. All such arrangements are monitored as part of regular financial management activity.

Developing financial reporting – tailored for Scotland consolidated public accounts

3.38. While the Scottish Government already publishes a range of financial and economic information, it is continuing to develop its approaches. Working with financial year 2016‑17 as a shadow year, the Scottish Government has collected the necessary information to support further reporting outputs. This brings together the financial information of all sectors of the devolved public sector in Scotland, including public bodies and local government, and has established a process for the 2017-18 financial year.

3.39. The Scottish Government is currently considering options for the presentation of this information, with the focus being to minimise the burden on Scottish public bodies and ensure that what is produced is useful and adds value. As part of this process, the Scottish Government will be engaging with Audit Scotland.