Capital funding expectations (and the elephant in the room)

Departmental chief executives are expected to ensure their department accumulates sufficient depreciation funding to provide the capital needed to underpin future service needs. Given this, why are an increasing number of departments unable to internally fund their ongoing capital requirements?

A key reason for this is that many of the assumptions behind the capital funding model do not hold in practice:

1.      The cost of replacement assets should be approximately the same. In practice, the cost of replacement assets is often different. This can be due to inflation, technological change, new business requirements and increased demand.

2.      Service levels, capital demands, and stakeholder expectations should remain relatively constant over asset life cycles.  In practice, these continue to change and so do delivery mechanisms. For example, many ICT functions are now provided as a service and are funded from operating rather than capital funding.

3.      Assets should be replaced at the end of their life.  In practice, many assets have been sweated well beyond their “use by date” (agencies have been actively encouraged to do this), leading to higher whole-of-life costs, and increased health and safety and delivery risks that require additional funding to ensure effective mitigation.

4.      Depreciation reserves should be retained to replace long-term assets. In practice, depreciation reserves are often pooled and applied to more immediate capital and working capital priorities, rather than being 'ring fenced' for the replacement of business-critical assets.

5.      The annual charge on capital (known as the capital charge) should incentivise agencies to hold only the capital they need, drawing down additional capital at the time it is needed.  In practice, most departments with surplus capital have (despite the capital charge) chosen to retain capital given the process of obtaining additional capital (when they need it) has not always been easy or certain. On the other hand, departments without surplus capital have not had the benefit of reduced capital charge to support decisions to buy a service (rather than owning assets).

That many departments are not sustainable from a capital perspective is not necessarily due to poor financial management: most departments have had no choice but to apply accumulated depreciation and other reserves (e.g. leave provisions) to short-term capital priorities and political requirements. Some decisions to apply cash reserves to short-term priorities (such as improving levels of service) would have been made by Ministers and central agencies irrespective of any long-run cash deficit implications identified at the time.

Maybe the challenge in this is as much about the operating models for many agencies being unsustainable as it is about an (increasingly obsolete) capital funding model for departments.

We think there is an ‘elephant in the room’: the expectation on departmental chief executives to fund future capital needs from depreciation flows is difficult if not impossible to achieve.

A fundamental rethink of the capital funding model is long overdue.