5. Capital budgeting and fiscal sustainability
Sound capital budgeting processes ensure that projects can be delivered affordably, while ensuring there are steps in place to manage cost overruns and delays. It is also critical that financial reporting is undertaken in a way that is consistent across sectors, so that the performance of public investments can be compared across sectors. This chapter describes best practice capital budgeting, including examples of medium-term budget forecasting and the management of fiscal risks from leading countries.
The OECD Recommendation of the Council on Budgetary Governance establishes an overview of good practices, which give clear guidance for designing and managing budget systems in an effective manner, to make a positive impact on citizens’ lives. The Recommendation sets out ten principles of good budgetary governance in this regard:
“Manage budgets within clear, credible, and predictable limits for fiscal policy.
Closely align budgets with the medium-term strategic priorities of government.
Design the capital budgeting framework to meet national development needs in a cost-effective and coherent manner.
Ensure that budget documents and data are open, transparent, and accessible.
Provide for an inclusive, participative, and realistic debate on budgetary choices.
Present a comprehensive, accurate and reliable account of the public finances.
Ensure that performance, evaluation, and value for money are integral to the budget process.
Identify, assess, and manage prudently longer-term sustainability and other fiscal risks.
Promote the integrity and quality of budgetary forecasts, fiscal plans and budgetary implementation through rigorous quality assurance including independent audit.”
The Recommendation states that the capital budgeting framework should be designed to meet national development needs in a cost-effective and coherent manner, through:
“The grounding of capital investment plans, which by their nature have an impact beyond the annual budget, in objective appraisal of economic capacity gaps, infrastructural development needs and sectoral/social priorities.
The prudent assessment of (i) the costs and benefits of such investments; (ii) affordability for users over the long term, considering recurrent costs; (iii) relative priority among various projects; and (iv) overall value for money.
The evaluation of investment decisions independently of the specific financing mechanism, i.e. whether through traditional capital procurement or a private financing model such as public-private partnership (PPP).
The development and implementation of a national framework for supporting public investment, which should address a range of factors including: (i) adequate institutional capacity to appraise, procure and manage large capital projects; (ii) a stable legal, administrative, and regulatory framework; (iii) coordination of investment plans among national and sub-national levels of government; (iv) integration of capital budgeting within the overall medium-term fiscal plan of the government.” (OECD, 2015[1])
While the third principle directly relates to capital budgeting, it should be borne in mind that all the principles are relevant to capital expenditures, whether it be planning, executing, reporting or evaluation. The principles promote more effective public spending and as capital expenditure makes up a significant proportion of the overall budget, it must be subject to the same rigorous oversight as current or operational expenditure. Since public investment projects extend beyond the annual budget, it follows that they must be aligned with the government's medium-term strategic priorities and managed within an overarching medium-term expenditure framework.
A culture of strong appraisal, performance monitoring and evaluation is not sufficient. Several investment projects may each be justified by cost benefit analysis but there is a limit on the number of investment projects that can be undertaken within the overall budgetary framework and/or without adding to inflationary pressures in the economy. This is specifically recognised by the Recommendation of the Council on the Governance of Infrastructure, which states that an infrastructure governance framework should protect fiscal sustainability, affordability and value for money through a number of criteria including “ensuring that the overall infrastructure investment envelope is sustainable in the medium and long-term, considering the overall debt level and policy objectives, measuring, disclosing and monitoring multi-year spending commitments, including off-balance sheet commitments and contingent liabilities resulting from infrastructure projects” (OECD, 2020[2]).
Insofar as appropriations for capital investment in Bulgaria are allocated within an overarching top-down capital framework, it can be said to comply with the requirement to respect fiscal sustainability and affordability. However, ensuring value for money requires a more in-depth management process than providing a capital envelope in the budget without careful monitoring of expenditures throughout the year. Even if the budget users have the capacities to manage investments, there should be a strong reporting relationship to the Ministry of Finance (MOF) Budget Department so that cost overruns and delays can be tracked in a timely manner and factored into the medium-tern budgetary arithmetic. There should be a standard reporting structure so that reports are consistent, comprehensive and comparable which will enable the MoF to monitor capital expenditures effectively.
The government’s main capital investment priorities are set out in the Governing Programme of the Government of the Republic of Bulgaria 2017-2021, where individual sectoral policies are defined, and specific measures and objectives are set out for the implementation of the programme.
Table 5.1 shows the capital expenditure in the consolidated fiscal programme for the period 2021-2025.
Capital expenditure includes projects funded by the European Structural and Investment Funds. About 50% of expenditure is funded by the EU, with about three quarters of the remainder coming from central government and the rest from municipal budgets. Co-financing is a precondition for receiving EU financing. The planned expenditure amount is ambitious and significant. For that reason, it should be subject to robust planning, appraisal, selection, monitoring and review procedures. This cycle, therefore, is the basis for the review of capital budgeting.
Capital investments that are co-financed by European Structural and Investment Funds are subject to comprehensive monitoring and reporting requirements. The Management of Resources from the European Funds under Shared Management Act and the Council of Ministers Decree No. 162 of 2016 provide detailed rules for the award of grants under programmes financed by these Funds. While EU-funded expenditures are part of the consolidated fiscal program, the MOF’s National Fund Directorate must keep a separate account of these funds for transparency and reporting reasons. The Directorate includes all expenditures into a consolidated account and provides information to the Treasury Directorate and the Budget Directorate. At the same time, MOF monitors major investment projects and it does so using information provided by the managing authorities. If the Ministry has queries, the analysis is carried out by the managing authority.
Where investment projects are not EU co-financed, there is a procedure within the budget process for applying, reviewing, approving, and monitoring the implementation of these projects, financed by state loans or backed by state guarantees. Planning and approval for non-EU financed capital investment is regulated by an ordinance adopted by the Council of Ministers Decree 337/2015.2 This provides the regulatory framework for investment projects financed by state loans and projects applying for financing with a state guarantee, as well as the procedure for their consideration. This ordinance regulates the conditions to be met and the procedures to be followed before investment projects financed by state loans or with a state guarantee can be approved. It provides that, in general, capital expenditure is subject to the same scrutiny that applies to all public expenditure under the Public Finance Act.
The Medium-term Budget Forecasts (MTBF) present the capital expenditures of the Consolidated Fiscal Programme both on a sectoral basis and on an aggregated basis. They also present the capital expenditures by source of funding, namely national budget, and EU-fund accounts. The expenditures are presented also at the aggregated level in terms of capital transfers, gross fixed capital formation and other capital expenditure.
The MTBF includes calculations for capital spending in the upcoming budget year and the following two years. Furthermore, the programme budgets are drafted within the ceilings of the expenditures of the PBAs for the next three years, with capital expenditures being included in these programme budgets. These are, however, indicative, and subject to amendment each year, when it is necessary to provide additional funding for measures/projects complementing the policies conducted. Nevertheless, where capital expenditures are included in a programme budget, the information relating to these expenditures is presented in a three-year perspective, including for those ministries that have significant capital expenditure, such as the Ministry of Transport and Communications; the Ministry of Environment and Water; and MRDPW. For the Ministry of Defence, the Council of Ministers approves the allocation of investment costs over a period of seven years, although this is not published. Box 5.1 includes an example from New Zealand of how capital expenditure allocation has been recently reformed to be on a rolling four-yearly basis to take a longer-term view of capital commitments.
In New Zealand, capital expenditure on public investment in the budget is comprised of two components: an allocation of funds that the government uses to progress priority investments; and investment that occurs from depreciating assets that are already in use.
As with other OECD countries, New Zealand’s requirements for public investment extend beyond the annual budget cycle. In 2019, the capital expenditure allocation in the budget was set on a rolling four-year basis, which aligns to the medium-term expenditure framework. The multi-year allocation for capital expenditure allows the government to take a longer-term view of capital commitments. As such, the government can draw on the allocation and manage the impacts on budget spending in any given year.
New Zealand’s capital management approach has applied public-private partnerships selectively. They remain a vehicle for public investment, but they rely on the ability to articulate and value the risk of a public investment during each stage of the investment cycle, specifically from design to construction through to the operation of the asset.
Source: (The Treasury (New Zealand), 2022[4])
The annual State Budget Law presents capital expenditures at the level of the total state budget and at the level of the PBAs, as well as capital transfers from the state budget to non-governmental organisations and enterprises. It also shows the planned total transfer for capital expenditures to municipalities and at the individual municipality level. Capital expenditures financed by the state budget are planned under municipal budgets. More detailed information on capital expenditures and transfers by policy area, budget programme and project, including whether the source is national budget or EU funds, is shown in the programme budgets of the PBAs. These programme budgets are part of the budget documentation which, together with the Updated Medium-Term Budget Forecast, are submitted to the National Assembly with the annual state budget law). The Updated Medium-Term Budget Forecast usually contains new and priority investment programmes and projects, for which additional financing is provided, as well as projects with a multi-annual implementation period.
In recent times, highlighted capital measures have included the decision of the National Assembly to approve the acquisition of combat aircraft and combat equipment, and the decision for the introduction of a toll fee to fund the construction of first-class roads and highways. Significant investment projects are also included in the relevant expenditure programmes. This information includes non-financial information and key performance indicators. The threshold of what constitutes a significant impact is set at BGN 1 billion, which is very high. For investment projects below that threshold, certain projects may be highlighted but inclusion is not obligatory. For example, under the Defence and Armed Forces Act 2010, projects with a cost in excess of BGN 50 million must first be approved by the Council of Ministers. In addition, projects with a cost more than BGN 100 million must also receive the approval of the National Assembly.
Capital investment is prioritised according to the need for implementing sectoral development strategies that have been adopted by the Council of Ministers. In approving an investment strategy, the government takes account of the cost of large investment projects within the overarching financial constraint of the fiscal targets. Following on from this, the individual ministries determine the priority projects for financing within the framework of the funds provided by the State Budget Act. The sectoral development strategies include all sources of project funding, such as the state budget, own contribution by beneficiaries, EU co-financed programmes and other donors.
One of the most important criteria as regards the selection of investment projects is their anticipated contribution to achieving “key indicators” target values in the MTBF. Another criterion is the anticipated feasibility of the project, with projects already in train or in the preparation phase being prioritised to guarantee greater absorption of the available resources. To guard against underspending on capital projects, the PBAs are required to have some reserve projects in place. If reserve projects have not been evaluated and prepared, according to procedures which comply with those of the EU funds, they cannot be funded and consequently some funding sources may go unused.
Managing authorities also are required to assess the conformity of the investment project with the programme and financial framework. The selected investment projects should be appropriate and realistic for implementation; related to the development strategies in the respective sector; and consistent with the priorities, objectives and measures set out in the governance programme, in strategic documents and programmes. In selecting projects, PBAs must demonstrate how the projects correspond to priorities of high-level strategies such as Bulgaria2030 and the action plan for its implementation. Each project should consider the long-term benefits to society or to the targeted sector and the long-term social and/or economic benefits to which the project will contribute. But as noted in Section 3: Long-term Strategic Vision and Planning, it is not clear whether investment decisions are always being directed by Bulgaria2030 or other strategic direction in practice. The ministries and agencies decide about the lowest level of investment; there is no centralized mechanism on how to prioritize or choose specific solutions to the challenges that cut across several ministerial portfolios. Box 5.2 includes an example from the Slovak Republic of how capital expenditure is integrated in the budget process, how it is monitored and how the role of the Ministry of Finance is central to the monitoring process.
Capital expenditure in the Slovak Republic is well integrated in the budget process. Line ministries submit proposals based on their individual priorities and they are negotiated with the Ministry of Finance together with current expenditure. As one of the binding indicators that determine legislative approval, limits on capital spending for every line ministry are decided within the budgeting process. The integration between current and capital expenditure aims to improve budget planning, facilitate coordination and increase flexibility.
Under the Slovak budget process, requests from line ministries for capital funding include for the entire cost of a multi-year project. Carry-overs for capital are allowed within the period of two years. There is a register of every investment included in the state budget and separate modules, Register of Investments, for budgeting capital expenditures in the budget information system. This information system provides basic financial and non-financial information about the investment (name, current status, type, schedule, costs, budgeted expenditures etc.) for monitoring and evaluation purposes.
In 2016, the government reformed the process of evaluating significant investments. Slovakia has defined a methodological framework for the process and preparation of large investment projects and their evaluation according to the principles of value for money. This means that, for investment projects with a cost of more than EUR 40 million (and IT projects from EUR 10 million), following a feasibility study by the relevant Ministry, the Ministry of Finance is obliged to prepare and publish an evaluation. The evaluation provides recommendations of alternatives, cost-benefit-analysis and input values. Such systematic investment assessments are essential to help ensure that the projects are developed in a manner that is cost efficient, affordable, and trusted by users and citizens.
Source: (OECD, 2017[5])
Municipalities also incur capital expenditures, which are funded by a combination of their own revenue, transfers from the state budget, loans, donations, and EU funds. The amount of the targeted (earmarked) capital expenditure subsidy and the mechanism for distributing it per municipality is set out in the State Budget Act for the relevant year. According to the guidelines for the PBAs for the preparation of their budget forecasts, municipalities must plan the use of transfers from the state budget, at the same level as defined in the State Budget Act for the current year. The subsidy for a specific municipality must be allocated to construction projects and major repairs, acquisition of intangible assets and repayment of loans for capital expenditure under a decision of the municipal council. Therefore, their ability to plan for capital expenditure is restricted. Despite this restriction, the municipalities prioritise capital investments by drawing up a list after consulting with both citizens and business at local level. Every municipality has a four-year plan that includes a list of projects, which address the investment requirements of the municipality. Municipal investment is highly dependent on the national government and EU funds, and therefore quite volatile. The ability of municipalities to access EU funds is also highly polarised, with many municipalities having difficulty to meet co-financing requirements. (OECD, 2021[6])
Furthermore, as noted in Section 5: Project Selection, Prioritisation and Appraisal Processes, there is no clearly defined standard methodology for planning, monitoring, and reporting on capital investments, which would apply across all sectors equally. The primary basis for approving projects derives from (i) the need to draw down EU co-financing and (ii) the overall budgetary aggregates, which dictates what can be afforded. The guiding principle is that the individual PBAs are best placed to develop policies in their area of competence. The head of each budget organisation is responsible for managing the budget for each particular year and prioritising expenditures, including investment expenditures, if this complies with overall expenditure guidelines issued by the Ministry of Finance. Prioritisation for capital investment depends primarily on the relevant PBAs, with the MOF carrying out its monitoring and analysis role in the context of compliance with agreed policies and available resources. Any monitoring of capital expenditure is within the context of the overall budget of the PBAs. There is no specialist unit within the MOF charged with carrying out the monitoring of capital expenditures. In line with this decentralised approach, the focus on capital expenditures is about ensuring they remain within the overall budget of the individual PBA. A standard methodology would allow for prioritisation of projects across sectors in terms of return on investment. It would facilitate an approach that would provide better value for money on capital expenditures.
Beginning with the preparation of the 2020 Budget, the MOF’s guidelines instructed the PBAs to prepare their three-year budget forecasts for capital expenditures and capital transfers in more detail. Each PBA also was required to submit an explanation of its investment policy in general (including in the current year) and for investment projects with an estimated cost of more than BGN 500 000, they were required to provide specific information to the MoF under a form called “list of priority investment projects”. The form requires the PBA to justify the proposed project under 12 criteria. Since 2021, this threshold has been increased to BGN 1 million. This is a step towards better prioritisation and ensures that plans for new projects take account of the progress of existing ones.
There is no evidence to suggest that in prioritising capital investment, subsequent recurrent costs are considered even though one of the 12 criteria for priority investment projects is whether the implemented project will require maintenance costs. In Bulgaria, current expenditures are regarded as being separate from capital expenditures and are not bound to a specific investment project. Lifecycle costing of a project does not have to be considered. If recurrent costs are considered it is a matter for the managing authority because the MOF does not require this to be done in every case.
This view should be revised because some capital projects can have significant implications for current expenditures once the physical building is completed. If capital budgeting is an integral element of the budget, planned investments should take account of subsequent current expenditure commitments. Additionally, for large projects at least, the current costs should also be published alongside the initial capital investment.
The implementation of investment projects is often subject to delay. While some delay is inevitable owing to unfavourable weather conditions or the challenges that complex projects often present, in two of the three most recent years actual capital expenditure has been less than 80% of the planned allocation. It is possible, however, that this was exacerbated by the impact of Covid-19 and in 2019, the actual capital expenditure was only 11% less than the planned allocation. Table 5.2 demonstrates differences between planned and actual expenditure between the years 2019 and 2021.
Municipal bodies can carry forward unspent capital funds into the next year without changing the purpose of the funds. For central government bodies, however, there is no provision for the carry-over of unspent capital funds into the following year, which would make it easier to cope with delays. Neither is there a provision for virement between capital and current expenditures. Capital expenditures by first-level spending unit are adopted in accordance with the annual state budget law and amendments are made by the respective authority in line with the requirements of the Public Finance Act or the annual state budget law. Since the first-level spending units have a degree of flexibility for selecting capital projects as long as they remain within their respective total budget allocations, it is possible that a delay in one particular project could result in another project being initiated in its place. It also could lead to projects being selected in the first instance mainly to avoid underspend on the budget units’ capital allocation.
Changes in political priorities can also affect expenditures. A change in government can result in certain investment projects being deferred or cancelled. This tends to encourage planners to prioritize shorter projects over longer ones, at least where the funding is domestic rather than from the EU. Indeed, the guidelines for prioritizing investment projects encourage PBAs to select projects that can be completed within a projected 3-year period. As noted in Long Term Strategic Vision and Planning, it is important for governments to plan their investments for the long-term with minimal disruption because it delivers certainty of the investment pipeline for communities, businesses and the infrastructure market. As also noted in Long Term Strategic Vision and Planning, stopping unfinished projects to provide funding for new priority projects does occur but is reactive, costly and not in line with sound planning practices. Importantly, projects with EU funds do not have such a problem since the commitments are strictly set out in the Operational Programmes.
The State Expenditures Directorate of the MOF monitors the capital expenditures of state authorities and other units included in the consolidated fiscal programme. The Local Government Directorate monitors the capital expenditure of the municipalities financed by the earmarked subsidy and carries out the relevant analyses of their capital expenditure. Municipalities must submit to the MoF estimates for financing capital expenditures and monthly reports on their implementation. The estimates and the quarterly reports on the financing of capital expenditure are published on the websites of the municipalities.
The State Expenditures Directorate is responsible for the budgets of first level spending units; there is no separate unit responsible for monitoring capital investment. The expert responsible for each PBA reviews the overall budget of that entity and there is no specialist monitoring of the capital side of the entity’s budget. In effect, this means that only the National Fund Directorate carries out detailed monitoring of capital expenditures, in accordance with the terms under which EU funds are disbursed.
If cost overruns emerge on a project, the PBA can amend its budget. It can transfer funding from another project, or it can seek additional funds through a decision of the Council of Ministers. If the latter, the PBA must prepare a financial justification, which provides an impact assessment in a developed form. There is no requirement for the provision of a CBA.
The reporting on the implementation of large investment projects includes data on the overall costs and on whether projects are meeting their construction milestones. Data on capital expenditures are included in the quarterly, six-monthly and annual reports to the MOF. In compliance with the ministry’s guidelines, each PBA reports every quarter in a standard form on the capital expenditure under each separate project. Additional information on the implementation of investment projects by the PBAs is contained in their semi-annual and annual programme reports. These reports contain information to demonstrate that both the total cost and the physical progress of major investment projects are being monitored by the responsible government unit. These reports are in a programme format and contain detailed information on the degree of implementation and achieved societal benefits regarding KPIs for each policy area. Since 2021, the guidelines of the Minister of Finance3 requires the PBAs to submit detailed quarterly information on investment projects with an estimated value of more than BGN 50 million. This has increased ongoing monitoring of the financial performance of certain investment projects.
Units responsible for individual policy areas are also required to report to the minister and senior management regarding progress on major investment projects. In addition, each line ministry is required to report monthly on the implementation of projects funded by state investment loans, accompanied by an explanatory note. For projects funded by European Structural and Investment Funds and other international programmes and contracts, the reporting format and periodicity is regulated in the grant agreement. Financial statements are submitted quarterly to the Steering Committee. A request to the Steering Committee for payment is accompanied by a technical report demonstrating the physical progress of the projects in question.
Furthermore, although physical progress is reported, the MOF does not exercise on-site monitoring of physical performance. On-site control is carried out by the relevant ministry. Information is collected on standardized forms, attached to the guidelines, and the same information is collected from all PBAs. On the basis that the execution of the projects is the responsibility of the PBAs, the MOF considers that this is sufficient.
Despite the reporting requirements, the absence of a centralised methodology for appraisal and evaluation means that there is a greater concentration on the procedural part of the capital investment than on resource management. Across different budget units and different projects, there are different assessment procedures and different performance criteria. Furthermore, there is no established procedure for conducting reviews or evaluations of investment projects to determine whether the projects were delivered in line with expectations and/or to identify lessons that could be learnt with a view to improving capital investment in the future. The lack of such procedures has negative implications for the requirement to ensure value for money.
Weak oversight is reflected by the fact that internal audit units of the PBAs with high capital expenditure do not always seem to focus significantly on investment projects. The internal audit unit in one agency responsible for a major infrastructure network regularly focuses on capital projects and makes recommendations with deadlines for their implementation. The same agency also has a risk analysis directorate responsible for checking the physical progress on projects in the various districts. Similarly, in another agency responsible for a different infrastructure network, its internal audit unit undertakes audits of capital works. In other PBAs, however, it seems that the internal audit function is under resourced and/or does not consider that capital investment projects should be a priority for audit as they only focus on internal procedures within the entity. The attitude seems to be that the Financial Inspection Agency can carry out inspections or the National Audit Office (NAO), or the Audit of European Union Funds Executive Agency in case of EU co-financed projects, can carry out external audits so that any problems could be identified in this fashion. Even where internal audit units make recommendations for managers to improve internal controls subsequent to audit findings, the NAO has found that the recommendations may not be implemented.
The importance of internal audit is recognized in Guidance for the Management of Risk in the Public Sector, which was adopted by an order of the Minister of Finance in 2020. The guidance recognises that close interaction between an organisation's management and internal audit is key to the effectiveness of the risk management process because the internal auditor should assess risk management systems, identify and evaluate material risks, and assist the manager without assuming responsibility. Given the risk that can materialise with capital projects, it is vital that they are subject to risk management including the scrutiny of internal audit.
Capital expenditures can only be incurred in accordance with legislation, which provides the framework within which PBAs operate. Each PBA is provided with an agreed capital budget and it carries the main responsibility for the projects funded from that budget. It must report regularly to the MOF. Despite this legal framework, there are significant weaknesses in the system. The MoF is satisfied if the budget is not exceeded and reports are submitted. The concept of monitoring seems to be limited to the submission and receipt of reports and there is little discussion about the implementation of projects. There is almost no focus on physical progress of projects even though this is contained in reports. There is no consideration given to the operational costs once a project is completed and operational.
There is no overall coordinating body which is responsible for ensuring that capital investments are undertaken in a structured manner. Such a body would be expected to regularly consult with PBAs regarding the implementation of projects and the expenditure being incurred. It would ensure that projects are planned so that where they coincide or overlap to some extent, they are carried out in a coordinated way so that the total costs are minimized, as well as ensuring that delays do not occur owing to projects clashing with each other. It should also ensure that a multi-annual approach is adopted so that costs are accurately reflected in the medium-term expenditure framework and beyond where projects are long term. Where the cost of project changes, this should be tracked and recorded in a medium-term expenditure framework so the impact on the public finances can be clearly seen in a multi-annual context.
5.2.1. Fiscal Risks
The MOF is responsible for the identification of and reporting on contingent liabilities. The main budgetary documents (the Medium-Term Budget Forecast, the Convergence Programme, the Updated Medium-Term Budget Forecast which are among the documents underpinning the draft annual state budget law) contain information on fiscal risks, based on which the fiscal targets and parameters of the medium-term budgetary framework (fiscal policy) are defined. The MOF identifies mitigating measures or buffers based on the identified risks and the alternative scenarios developed.
An examination of the Budget Forecast 2023-2025 shows that the document contains a section entitled Fiscal Risks but that it is rather short. It identifies risks to the public finances posed by the war in Ukraine, Covid-19, higher energy costs, general inflationary pressures but does not quantify the costs of any of these risks. It rightly highlights Bulgaria’s low level of public debt as a mitigating factor and although it does not mention a contingency provision, there is a contingency reserve included in the budget to create a source of funding in the event of the realisation of some risks or other unforeseen expenditure. This contingency reserve is provided under Article 42.3 of the PFA, which also provides that the amount will be decided by the government on an annual basis.
Furthermore, some fiscal risks are quantified. For example, the Convergence Programme 2022-2025 provides quantified information on contingent liabilities comprising state guarantees and the guaranteed debt of the general government sector. Liabilities of state-owned enterprises are not provided although these were included in previous Convergence Programmes.
Box 5.3 shows the example of Latvia which has developed a sophisticated fiscal risk management framework that mitigates for a wide range of factors including capital investment and PPPs. Two key elements to fiscal risk management in Latvia are the Fiscal Safety Reserve, which is set at a minimum of 0.1% of GDP and the responsibility of line ministries in managing their risks. While fiscal risk is managed by the MoF at the overall level, there is no suggestion that the Safety Reserve should be automatically used in the event of a risk materialising. In a study of fiscal risk management in five OECD countries, the OECD has found that where countries maintain a fiscal reserve for unforeseen risks materialising, the reserve has no relation to the evolution of the stock of fiscal risks because the authorities want to avoid the perception that cost overruns will be funded unconditionally (OECD, 2020[8]). Even where a reserve exists, line ministries should be expected to fund overruns by offsetting savings elsewhere in their budgets.
Latvia’s fiscal risks management framework is well integrated into the processes for managing fiscal policy and the budget. The fiscal risks framework has a strong legal basis. The 2014 Fiscal Discipline Law requires regular identification, disclosure and mitigation of fiscal risks. A Declaration on Fiscal Risks is annexed to the Medium-Term Budget Framework Law published every year. The Law also sets a Fiscal Safety Reserve of at least 0.1% of GDP, which provides a pocket of financial resources that can be tapped if fiscal risks materialise. Government regulation No. 229 governs the management of fiscal risks by the public administration and the methodology to determine the size of the Fiscal Safety Reserve. Fiscal risks are monitored and managed by a well-specified and devolved management system. The Fiscal Discipline Council also carries out an external control function.
Latvia has developed a sophisticated methodology to identify and measure fiscal risks. It first classifies the sources of fiscal risks according to a modified version of a matrix developed by the World Bank, which includes risks associated with capital investment including future recurrent costs when the project is completed. Fiscal risks are defined by the nature of a government obligation (implicit or explicit) and the influence of the government on the materialisation of the risks. It defines two types of fiscal risks: quantifiable and non-quantifiable. A quantified fiscal risk is one where the probability of occurrence and the impact on the budget balance are assessed. Latvia’s Declaration of Fiscal Risks identifies and discusses both types of fiscal risk. Their measurement is then used to determine the Fiscal Safety Reserve.
Fiscal risks are measured both quantitatively and qualitatively. The impact on the general government balance is measured qualitatively on a three-point scale: the impact may be considered as significant (>0.5% of GDP), medium (between 0.01% and 0.5% of GDP) or low (below or equal to 0.01% of GDP). Where possible, the impact is also measured quantitatively. The probability of a fiscal risk materialising is assessed on a 5-point scale. Existing mitigation measures are taken into account in assessing this probability.
The Declaration on Fiscal Risks presents an assessment of the accuracy of past fiscal forecasts. Sources of deviations from past forecasts are examined from both the perspective of the structural balance and the nominal balance at the general government level.
Latvia’s fiscal risks management framework is also operationalised by a devolved three-tiered management system. The Fiscal Policy Department in the MoF handles the general management of fiscal risks. The Department maintains a register of fiscal risks and liaises with individual ministries and agencies to update it. The Department also provides methodological assistance to central administration institutions on a case-by-case basis. Central administration institutions such as line ministries are responsible for fiscal risks that are more specific to their functions. They coordinate with the MoF to keep the register up to date. They also elaborate their own fiscal risk management reports that are submitted to the MoF every year. In addition to quantifiable and non-quantifiable risks, Latvia distinguishes a third level of fiscal risk management: individual fiscal risks. Individual fiscal risks are those related to the execution of projects and policy. One such example is fiscal risks stemming from a state-owned enterprise (SOE) or a specific Public Private Partnership (PPP) project. Responsibility for these risks is devolved to the entity that directly supervises the corporation or policy.
Every year, the Declaration of Fiscal Risks that is annexed to the Medium-Term Budget Framework Law contains several elements. These are a descriptive summary of the Latvian management framework of fiscal risks, their classification, the methodology to assess how likely they are to occur and their budget impact, a presentation of each quantifiable fiscal risk and non-quantifiable fiscal risk, and the calculation of the Fiscal Safety Reserve.
Source: Information provided to the OECD by the Latvian authorities
Under the Concessions Act, concession contracts and public private partnerships (PPPs) are granted only on condition that the construction risk and the operational risk is borne by the concessionaire. The operational risk borne by the concessionaire is the risk of exposure to market fluctuations in the demand and/or supply of the object of the concession and/or the services The operational risk is borne because, under normal operating conditions, the concession contract does not guarantee the return of the investments made and the costs of operating the construction or services subject to the concession. Risks related to mismanagement, failure of the economic operator to fulfil contractual obligations and force majeure are not considered as operational risk.
All other risks are allocated between the government (or the mayor of a municipality) as the grantor of the concession and the concessionaire depending on the capacity of each party to better assess, control and manage the respective risk. The allocation of risks is part of the preliminary financial and economic analysis and justification of the concession, which are monitored on an ongoing basis by the responsible parties. In the event of an amendment to the concession contract, the allocation of risks set out in the original contract should be maintained.
What this means is that concessions and PPPs are potential fiscal risks that need to be managed and mitigated. There are currently no PPPs in Bulgaria but should any such projects become operational in the future, associated contingent liabilities will have to be considered.
Under the Financial Management and Control Act in the Public Sector, the heads of public sector organizations are responsible for achieving the organizations’ objectives by managing public funds in a lawful, economical, efficient and effective manner and this includes capital expenditure. While this may be legally correct (and indeed follows the internationally recognised COSO framework and its standards, as well as EU good practices regarding managerial accountability), the mitigation of fiscal risks posed by capital investment – whether through PPPs or direct procurement – is about anticipating what could go wrong despite the efforts of the managing authority. For example, in Spain, several road concessionaires, already suffering from low structural demand and construction cost overruns, went technically bankrupt after the 2008 global financial crisis when highway demand dropped 15–20% for several years, and ultimately had to be rescued by government. This report discusses concession contracts and PPPs in more detail in Section 7: Value for Money for Public and Private Investment in Infrastructure.
From a budgetary perspective, the key weaknesses can be summarized as follows:
EU-funded projects are well monitored but there is a less structured approach to domestically funded projects. There is regular reporting on capital expenditures but there is little analysis of the reports and there is little monitoring of physical progress. The lack of a rigorous public investment management system could be leading to wasteful spending.
Although the debt/GDP ratio is low and there is a contingency provision in the Budget, there is no fiscal risk management strategy in place. Although several fiscal risks are monitored and the Budget contains a short section on fiscal risks, there does not appear to be systematic identification of risks with mitigating factors specified.
Capital budgeting is very much on an annual rather than the multi-annual approach. There is a multi-annual budget framework, but this is top-down with little emphasis on the need to engage in realistic planning and costing of projects. There is often uncertainty regarding funding and consequently some projects may be halted or postponed to make way for other priority projects.
State bodies are not allowed to carry forward unspent funds from year to year. Municipal bodies can carry forward unspent funds into the next year, but State bodies must surrender these funds and agree with the MOF to spend as part of the following year's budget. Many countries allow carry-over of at least some unspent moneys to encourage line managers to manage the overall cost rather than an annual cost of a project.
Internal audit units of PBAs with high capital expenditure do not focus significantly on investment projects which means that risk associated with capital investment may not be receiving the scrutiny it merits. Internal audit units are often under resourced and in prioritizing internal audit activities, they may focus only on internal procedures within the entity. Given that capital projects can incur significant costs, it would be worthwhile focusing on the procedures for agreeing contracts and managing these types of projects.
References
[3] Ministry of Finance, Bulgaria (2021), Medium-Term Budget Forecast 2021-2025.
[7] Ministry of Finance, Bulgaria (2018), Consolidated Fiscal Programme.
[6] OECD (2021), Decentralisation and Regionalisation in Bulgaria: Towards Balanced Regional Development, OECD Multi-level Governance Studies, OECD Publishing, Paris, https://doi.org/10.1787/b5ab8109-en.
[8] OECD (2020), Managing Fiscal Risk, https://www.oecd.org/officialdocuments/publicdisplaydocumentpdf/?cote=GOV/PGC/SBO(2020)7&docLanguage=En.
[2] OECD (2020), Recommendation of the Council on the Governance of Infrastructure, https://legalinstruments.oecd.org/en/instruments/OECD-LEGAL-0460.
[5] OECD (2017), Getting Infrastructure Right: A framework for better governance, OECD Publishing, Paris, https://doi.org/10.1787/9789264272453-en.
[1] OECD (2015), Principles of Budgetary Governance, Recommendation of the Council on Budgetary Governance, https://www.oecd.org/gov/budgeting/principles-budgetary-governance.htm.
[4] The Treasury (New Zealand) (2022), Budgets and forecasts, https://www.treasury.govt.nz/information-and-services/financial-management-and-advice/budgets-and-forecasts.
Notes
← 1. Includes expenditure on the acquisition of computers and hardware, as well as the acquisition of software and software licences.
← 2. Ordinance on the conditions to be met by investment projects financed by government loans and the projects applying for financing under a state guarantee and the procedure for their consideration.
← 3. RD No. 3/15.09.2021.