Minute ddi to chief secretary c 2bn mod cash increase over sr2002

Ed Balls Spencer Livermore Shriti Vadera cE2bn MOD Cash Increase over SR2002 Issue: MOD seek to exploit RAB unfairly and ignore agreed SR2002 cash forecasts, to increase their cash spend uplift by over 40% over SR2002. An additional £2bn cash spend would have a big impact on the fiscal position. We should initially rebut 100% of the Recommendation: switches: they are neither legitimate nor affordable and contradict the whole ethos of RAB. Timing: ASAP - MOD is already spending the money DECLASSIFIED In February 2003, MOD's forecast non-cash requirement fell substantially from the SR2002 figures. This was due to a mixture of delayed procurement projects, changes in accounting treatment and a surge in write-offs in the Spring Supplementary Estimate. MOD unilaterally re-allocated the reduced non-cash costs into increased cash spending - totalling up to £1bn a year by year 3. This was on top of the significant increase in cash, already agreed in SR2002. Over the last 3 months senior officials have met, Permanent Secretaries have written to each other and you have discussed with Mr. Hoon on the telephone. The main arguments put at various levels are summarised below. Officials have worked co-operatively and refined the figures downwards c30%, but still remain poles apart - or c£2bn over 3 years. In the meantime, for practicality's sake, MOD's Main Estimate last year included a limited switch from non-cash into cash of £200m pa, on the understanding that it would not prejudice any future decision. RESTRICTED DECLASSIFIED MOD view: MOD keep their argument very simple: • they are working within the existing RAB framework which rightly rewards them for lower non-cash costs, delivered by extracting value from their assets. • they claim HMT has focused them on DEL totals, and that they were lead to believe that cash was irrelevant. • MOD point to their Settlement letter that specified unlimited flexibility to move funds between sub-programmes. HMT argument: The big picture is that MOD have acted in bad faith. RAB sets out guidelines and principals, but cannot cover every eventuality. There are no hard and fast rules in some areas and they can be open to interpretation. Treasury is ultimately responsible for refining the guidelines over this transitional phase. Equally, we need to be able to trust departments to work within the spirit of RAB and check with us where clarification is obviously required. If we cannot trust departments to behave in a co-operative manner, we will have to consider tighter controls - undoubtedly a backward step. RESTRICTED DECLASSIFIED between RAB Stage I and Il, and ineffective management of procurement contracts. Thus this cash windfall has nothing to do with the RAB principles of efficiency or improved asset utilisation. Allowing it would set a costly precedent. • MOD have constantly reassured us, until the very last minute, that non-cash forecasts in SR2002 were understated, not overstated. It would appear that they have misled us. • The sub-programmes referred to in the Settlement letter are clearly MOD's internal budget holders, as they very well know. It was always understood (although admittedly not put in writing) that significant movements in cash / non-cash would have to be agreed with HMT. • The quality of MOD's forecasting has remained poor and does not instil confidence. NAO are yet to confirm some of the accounting changes. Even more reason why they should protect us both against future swings in the other direction by adding these non-cash reductions to the non-cash DUP we prompted MOD to create in SR2002. • It is not credible that MOD can really have believed that cash was not relevant. We disagree that RAB lead them to this conclusion. RESTRICTED 4 DECLASSIFIED As the table shows, the switches break down into 4 main subcategories, and our logic is laid out below on each: 2003-04 2004-05 2005-06 % SR2002 TOTAL 211 281 229 Changes in Accounting 721 35% 160 181 Procurement Slippage 127 23% 468 Misc -127 83 45 1 0% Accounted for 437 262 491 1190 Unforecast 1.97bn write-down 252 225 202 679 33% Not accounted for 200 10% -24 -31 255 Total 490 631 948 2069 100% Changes in Accounting Treatment - 35%, or c£240m pa These have been presented by MOD as rectification of accounting errors, mainly in the way they depreciate assets. In actual fact, MOD instructed their Top Level Budget holders to seek ways to free up cash. One way they found was to depreciate certain assets more slowly. The fact that these "corrections" were cash-driven is of concern, in that it could be storing up future movements in the other direction. MOD feel they can manage these risks, but on recent performance we don't share their confidence. This will increase future pressures on a budget that is already under strain (see 3 below). We cannot agree to these changes. RAB was intended to reward better asset utilisation, not rectification of basic accounting errors. RESTRICTED DECLASSIFIED Astute, Typhoon) tend to slip to the right. This also means that large R and D costs will not hit their balance sheet and be depreciated as expected. We think this is where MOD have the strongest point. Under RAB departments should legitimately benefit from the lower non-cash costs of a smaller asset base. Indeed, MOD's calculations show that they will incur an additional £100m of expenditure to compensate for procurement delays. However, there is still a reasonable argument that this rewards MOD for poor supply chain management and inaccurate forecasting. Additional £2bn write-offs - 33%, or c£225m pa Last year write-offs went through AME; this year they go through DEL. MOD took advantage of the transitional phase between RAB Stage I and Il to write off £3.6bn of assets in the Spring Supplementary Estimate. This has recently been adjusted to closer to £3bn - but this is still cf2bn above the forecast figure of £1. 1bn upon which their SR2002 non-cash forecast was inaccurately based. The key question here is one of symmetry. In RAB Stage II, departments feel the pain of write-offs as they go through their DEL, but then are rewarded with lower non-cash costs from reduced assets. MOD have sought to transfer the pain to HMT by stuffing un-forecast write-offs into AME at the end of last year, but still want to reap the rewards. This is a transitional issue, where we must reserve the right to make sure that anomalies between RESTRICTED DECLASSIFIED legitimate. Hence we should disallow these switches. So having assessed MOD's proposed switches on a purely legitimacy basis, our view is that at a push, a maximum of c£150m pa, or 23% of the proposed switches are acceptable to us. These stem from the procurement slippage category. 2) Consideration of affordability Any switch from "non-cash" to "cash" spending has a direct impact on Public Sector Current Expenditure and is broadly equivalent to granting a Reserve Claim. In the current fiscal situation and in light of known spending pressures (including those from MOD - see below), there is very little headroom to accommodate increases in PSCE without significantly threatening the achievement of the Golden Rule - on the cautious case over the economic cycle. In this context, DDI/GEP judgement is that £200m pa is the maximum that HMT could afford to concede in this area. 3)Wider pressures on MOD baseline If we do concede at any point, we will need to stress that any switches are one-offs. As in the case of a Reserve claim, MOD should not see this as a permanent step increase to their near- cash baseline for SR2004. The danger is that MOD will transfer this spend into steady state activities. RESTRICTED DECLASSIFIED • Post-Iraq recuperation: early estimates to replenish equipment are around £1bn over the SR period. To protect the reserve we could push MOD to re-prioritise other capital spending, but this will go against precedent. • MOD's Equipment Programme: MOD's equipment programme is also under immense pressure and this has been exacerbated by the decision to buy the Hawk 128 aircraft. As you are aware, the Hawk 128 will cost around £1.75 billion more than MOD has budgeted through-life (including at least {53M/£45M/55M in SR2002 years) and MOD must now find ways of accommodating this additional cost from within the defence budget, as agreed by No10." 4) What MOD might accept MOD have been ruthless in seeking to exploit any perceived loopholes in RAB and in misleading us on the risks of non-cash costs moving downwards. They now sense a clear opportunity, and will seek to maximise political leverage. Their need will be increased by our recent wins in forcing them to absorb the additional costs of pensions and Hawk within existing baselines. We should not expect them to accept our opening position if it is less than 50%. They will fight to get as much as they can. Our best guess, is that they could live with 20-30%, but would set their sights higher. RESTRICTED DECLASSIFIED they should be able to make good use of their non-cash allocation. Indeed, this will protect us from future MOD non-cash pressures, which they have always lead us to believe were building up. We can ease the pain by offering them EY on non-cash. If MOD push further, and you are persuaded to compromise, we should focus on switches occurring due to procurement slippage. These make up c£150m pa and are the only changes that we can see any possible justification for. If push comes to shove, we could then compromise further and concede on a % of the write-off related switches, to take the total up to a maximum of £200m - the limit of affordability. Because this transitional issue is a one-off, conceding here would not set any precedent. This would allow us to stick to our line on disallowing switches stemming from simple changes in accounting treatment. Handling: The ball is firmly in our court - if we do nothing then MOD will continue to spend the cash. We have not replied sooner because it was agreed that Hawk needed to be resolved first. We feel the next step would be for you to write a strong letter to Mr. Hoon, rebuffing the switches. RESTRICTED DECLASSIFIED both politically and in the media. They label the Treasury view as equating to "cuts in defence" and "re-opening the SR2002 Settlement", ", and have said as much to the Prime Minister. Clearly neither are true: their cash uplift in SR2002 led to the biggest increase in Defence spending for 20 years and this remains intact; only MOD are deviating significantly from agreed SR2002 figures., MOD allocated the cash windfalls to their key budget holders such as the Army, Navy, RAF and Defence Logistics Organisation in January 2003. They did so without HMT agreement, knowing that their senior military will see any subsequent reductions as cuts and cry foul to the media. However, we understand that if MOD do have to revert to the agreed SR2002 figures, the main reductions will be in the procurement and logistics areas ie: manning and training should not be affected MOD military will talk to the Daily Telegraph. We will have to work closely with No. 10 and MOD centre to present a strong case. There are a range of arguments we can deploy, depending on how strong we need to be, and these are included in our defensive lines (Annexe A). DDI RESTRICTED 10 DECLASSIFIED Secretaries have also exchanged correspondence. I have also noted Peter Watkins' letter to Matthew Rycroft of June 12th. While our officials have resolved some issues that have reduced the size of the switch, I understand that you are still proposing to norease your cash spending by £490m / £631m / £948m over and above the increases we agreed in SR2002 - ie a £2 billion increase over the three years. After careful consideration, I am unable to agree to any of the proposed movements. As you know, we negotiated the 2002 Spending Review settlement on a near-cash basis, adding in your department's forecast non-cash requirement only at the very end. The outcome represented the biggest increase in planned defence spending for twenty years. The extra increases in cash spending you are now proposing would add about 70% to the planned increase in your near-cash budget this year, and around 40% in each of the next two years. Given the current very tight fiscal position, we simply cannot afford these extra increases. They would impact very significantly on the risk around the golden rule. We could never have contemplated a spending review settlement on this scale a year ago, and in the meantime the fiscal pressures have increased substantially. To allow an unplanned increase of this magnitude now would have a material impact on the integrity and prudence of the public finances, on which so much else is based. As you will recognise, we are in a transitional phase with Resource Accounting and Budgeting. The new budgeting system is RESTRICTED DECLASSIFIED Unfortunately, the Ministry of Defence has not engaged the Treasury effectively during its internal budgeting process. From the end of the Spending Review period until January 2003 your officials consistently led mine to believe that you were struggling to manage a lack of non-cash resources, not the opposite. In consequence there was no discussion about the implications of a such a fiscally significant switch from non-cash to cash until your internal budgets had been set and allocated to your Top Level Budget holders. Given the tight fiscal situation, it was never credible that such a significant and unexpected increase in public sector net expenditure would be something that Treasury could allow your department to unilaterally decide on. RAB is designed to incentivise departments to manage their asset base more efficiently and it is right that departments are rewarded for better asset utilisation. However, it is my firm view that the cash windfalls that occur due to windfalls from accounting changes and the transitional effects of the move from Stage I to Stage Il RAB, do not fall into this category. I do want to underline two key points. First, there is no question of Treasury re-opening the Spending Review Settlement. The underlying "near-cash" (ie: Resource + Capital DEL) SR2002 settlement remains exactly as agreed - the best defence spending settlement in twenty years. Second, I want to reaffirm my support for the magnificent work our armed forces are doing in Iraq, and to underline my commitment to the continued effective funding of the operation. RESTRICTED 12 DECLASSIFIED already. I would be grateful for your confirmation that these budgets will be adjusted downwards accordingly. I am copying this letter to the Chancellor and the Prime Minister. PAUL BOATENG RESTRICTED DECLASSIFIED There is no question of cutting the MOD Resource DEL control total. The underlying "near-cash" (ie: Resource + Capital DEL) SR2002 settlement remains as agreed: the best Defence planned spending settlement for 20 years. But we do need departments to seek our approval for significant deviations from agreed cash / non-cash totals. Treasury lead us to believe that DELs are what matters, not cash Simply not the case. Treasury has sought to get departments to focus more on Resource spend, but cash is still crucial to the fiscal balance - we can't spend what we haven't got. Don't forget that RAB stems from the private sector - do they ignore cash? You are denying us the full benefits of RAB We are happy for MOD to benefit from improved asset utilisation and disposal of surplus assets, but technical changes in accounting treatment and taking advantage of the transitional phase of RAB do not fall into this category. The changes you propose go against the ethos of RAB. We are working within the rules of the RAB framework We RAB does not have a hard and fast rule for every occasion. expect departments to work with us refining them over this transitional period, rather than unilaterally seeking to unfairly exploit perceived loopholes. RESTRICTED 14 DECLASSIFIED