Managing and Controlling Second-Level Organisations: The Responsibilities of the First-Level Organisation

Abstract

What are called second-level bodies exist in probably all public sectors. They can perform very useful roles, although they can be used to avoid the controls that apply to fist-level organisations. However, they do need to be managed by their equivalent first-level or controlling body. Unfortunately in many developing and transition economy countries they are not managed and, in effect, have a life of their own. What is often a cause of this situation is an asymmetry of information; the second-level body knows far more about its business than the controlling body. This may be inevitable but the operations of a second-level body should be always within a context and to a standard and level of performance set by the first-level body. Also second-level body performance should be subject to periodic review. This chapter addresses the problems arising with the management of second-level bodies within the context of a PFM/IC managerial framework and provides advice about reform arrangements. A feature of many public sector organisations is the existence of ‘second-level’ organisations. In considering the introduction of PFM/IC regard should be had to how these organisations are managed by the controlling or first-level body.

A feature of many public sector organisations is the existence of ‘second level’ organisations. In considering the introduction of PFM/IC regard should be had to how these organisations are managed by the controlling or first level body. There are different types of second-level organisations and the focus in this chapter is on those that have delegated powers from the central or local government. Second-level organisations are widely used by central and local governments with many different types of organisational arrangement. There is no single model which can be regarded as appropriate for all countries and all types of second-level organisation operating with a delegated power structure. Included in this chapter is a reference to private finance initiative (PFI) arrangements, which although do not strictly fall into the category of a second-level organisation, but can have similar characteristics from a control perspective.

There are different reasons for establishing second-level organisations, not all of which may be appropriate. Specific regulations should be issued indicating when such organisations can be established. These regulations should specify a formal process of approval which for central government should involving not only the ministry concerned but also the ministry of finance. Second-level organisations with delegated powers can be used for commercial and non-commercial purposes and sometimes they provide both types of services or activities at the same time. The evidence from several developing and transition economy countries is that such organisations may not be well managed by their owning or controlling first-level organisation and they may set their own agendas rather than have them set for them, as they should, by the controlling or owning first-level organisation. Regular reviews of such organisations, including whether their continued existence can be justified, do not happen but again such reviews ought to occur.

This chapter describes the actions that first-level controlling or owning organisations should take to properly exercise their responsibilities towards their second-level organisations operating under delegated powers and towards PFI arrangements.

Examples are also included of how two developed economy countries manage the establishment and control of second-level organisations. They both require tight oversight by the controlling or owning first-level organisation to be exercised over the second-level organisations.

12.1 An Overview of the Control of Second-Level Organisations with the Development of PFM/IC

12.1.1 The Context for Establishing Second-Level Organisations

Second-level organisations also come in various forms. These have been classified by Cohen and Peterson¹ into three types of decentralisation, that is, devolution, de-concentration, and delegation:

• 1. Devolved decentralisation is autonomous local government although the interpretation of the term ‘autonomous’ can vary widely and heavily depends upon the financial relationships between central and local governments. Local governments can issue their own laws and regulations within defined limits, prepare budgets, raise local taxes, publish annual financial statements and be subject to external audit. They may or may not be able to borrow. They may be able to develop their own chart of accounts but in some countries, they may be required to utilise the one available through a central government Integrated Financial Management Information System (IFMIS).

• 2. De-concentration: This is where a central ministry retains what it regards as the most significant powers, particularly over the development of policy and finance for a service but delegates to regional or branch offices responsibilities for the implementation of the service.

• 3. Delegation: This refers to circumstances where a central government, or a local government, delegates responsibility for defined areas of policy to organisations which are under its direct or indirect control or in some circumstances may be autonomous such as non-governmental organisations. Delegation may sometimes include power to develop particular areas of policy, as well as being responsible for the implementation of certain areas of policy. This usually occurs where a central government (or ministry or local government) feels that a service can be provided more efficiently, effectively, and accountably. It may also occur where a particular service or activity is revenue raising. Delegation can sometimes lead on the privatisation.

In this chapter the definition of second-level organisations is limited to the third category of organisations, that is, those which have delegated powers. The problems that arise for governments to address is why have such delegation arrangements been made, how to ensure the highest level of effectiveness and efficiency are delivered and how to decide whether those arrangements should continue?

Other questions may arise, for example, about the desirability of pushing accountability downwards, about privatisation and limiting the size and role of the central state or indeed of local government. Consequently, a discussion about second-level organisations may not be simply limited to organisational issues but can develop into a discussion about how public services are to be delivered. Should they be retained fully under the control of the public sector or should they be delegated to the private sector through arrangements such as those associated with private finance initiatives (PFI). That is a question which can follow on from the examples taken from two developed countries described later in this chapter.

Second-level organisations can be responsible for almost any aspect of government, from delivering public services, to collecting taxes, to providing advice and to undertaking regulatory activities.

A primary question to be considered is the funding of second-level organisations. The ultimate guarantor of the financial resilience of a second-level organisation is likely to be either the central or the local government, that is, the provider of public money. Public money is not just that provided from the budget but it can include foreign aid as well as income earned by second-level organisations themselves, particularly trading second-level organisations. In some countries where foreign aid is important it can also include non-monetised support provided in various forms.

PFI arrangements have been defined as a system in which private companies build and sometimes manage large projects such as hospitals or roads, and then the government pays to use them.² The assets that are provided in this way very often are ultimately returned to the public sector at the end of the contract period.

12.1.2 The Criteria for Establishing Second-Level Organisations

Second-level organisations with delegated authority can be grouped into three types depending upon their financial objectives. One type is those which are wholly funded from the budget of the first-level organisation. A second is those that provide services and activities for which they charge a fee although they may not actually be trading organisations with the budgetary contribution essentially being a residual payment to cover those costs which cannot be recovered through fees. The third type is those which operate essentially as state owned enterprises and which may or may not be ‘profitable’. Ideally, criteria should be set which would define whether establishing a second-level organisation would be appropriate. The criteria should apply, in principle, to all second-level organisations. These criteria could include:

• By providing a service or activity through a second-level organisation it can be demonstrably proved that the service or activity will be provided more efficiently and effectively than it would by being delivered directly by the controlling organisation.

• The controlling organisation has a strong internal control and financial management capability along with a policy capacity to set the objectives, monitor the performance of the second-level organisation and to exercise effective oversight.

• There is a sufficient ongoing demand for the service or activity, which means that the proposed second-level organisation does not represent simply an immediate response to a short-term situation.

• The proposed service or activity is unique in that the same or a similar service or activity could not be provided by another second-level organisation, by the controlling organisation itself or by another first-level organisation.

• If the service or activity is to be delivered on a cost basis there are specific reasons why it should be provided by the public sector, rather than by the private sector and if provided by the public sector that it will be a service that can be expected to ‘break-even’ financially within a budget period or if a market based activity, that it will be a profitable activity according to conditions specified by the ministry of finance.

• A business case and rationale for the delegation of responsibility to a second-level organisation can be made, demonstrating that there is a clear benefit for a delivery function to be carried out by a second-level organisation rather than directly by the controlling organisation or by another second-level organisation: this business case should be reviewed by an organisation other than the controlling organisation, such as the ministry of finance.

• The service or activity proposed is a technical function for which external experts need to be employed rather than civil servants.

• The service or activity needs to be, and be seen to be, delivered with absolute political impartiality, such as a regulatory service.

• The second-level organisation will be of sufficient size that it can employ the appropriate staff and operate economically. That appropriate staff should include not only technical and financial expertise but also staff expert in personnel management because effective personnel management is essential to attract good-quality employees, to develop them and to retain them.

• There is an acceptance that the need for the continued existence of the second-level organisation will be subject to periodic review.

Proposals to establish second-level organisations should be measured against this set of criteria, along with any others that may be added to meet local circumstances.

Important features of the relationships between controlling and second-level organisations are:

• A clear separation exists of the management of the controlling organisation from that of the second-level organisation to avoid any conflict of interest emerging.

• The controlling organisation must have a capacity to determine the conditions of any performance or service-level agreement and to effectively monitor those conditions, taking corrective actions as necessary.

• Governance arrangements should be established including where appropriate governing boards for second-level organisations with the authority to ensure that the managers of those second-level organisations do achieve what they are expected to achieve.

• All second-level organisations should be subject to external and internal audit with the external auditor’s report being submitted to the controlling organisation.

Where assets are provided through PFI-type contracts the reasons are usually financial, that is, off-balance sheet financing arrangements and not to do with efficiency and effectiveness. The public sector pays a charge (often monthly) for the asset and that charge covers the costs of building the asset, financing it, and operating it for the whole length of the contract.

Because operating circumstances do not remain the same for second-level bodies there should be a systematic review process, perhaps every 3 or 5 years (depending upon the service or activity being provided), so that whether the second-level organisation should continue is tested. That review process should involve the controlling organisation and at least the ministry of finance. For local government there should be a similar review process. With contractual arrangements such as those for PFI-type schemes the opportunity for review during the contract period depends entirely upon the terms of the contract but those opportunities are likely to be much less than with conventional second-level organisation arrangements.

12.1.3 Purpose of Establishing Second-Level Organisations and the Problems That Exist

There are some organisations such as an ombudsman or the state auditor or organisations with a judicial-type function which should be excluded from this discussion even though they depend upon public money for their effective functioning. They may also receive their funding through the ministry of finance rather than directly through parliamentary decision.

For second-level organisations with delegated powers, in general the main stated purpose of establishing them in developing and transition economy countries is usually to enhance efficiency and effectiveness through the development of a specialist management and by giving them more autonomy. There can be other reasons as well, often unspecified, including, for example, providing an opportunity to avoid budgetary controls or to create mechanisms to provide additional rewards to certain officials.

Very often though, the identification and measurements of efficiency gains and the effectiveness of second-level organisations does not occur, even with this being the raison d’être for the establishment in the first place. Experience shows that unless second-level organisations have clear objectives and there is clarity about the anticipated improvements in efficiency and effectiveness, that managements have the financial and performance information necessary to enable them to judge efficiency and effectiveness, and that they are properly supervised by the controlling first-level organisation, the likelihood is that they will pursue their own interests in their own way. The result will be that the controlling organisation will have difficulty in ensuring that the interests of the second-level organisation and those of the controlling organisation coincide and that what the second-level organisation is expected to achieve will in fact be achieved. One of the reasons for this will be an asymmetry of information. The second-level organisation will know more about all its activities and policies than the controlling organisation. However, the principle should be that the objectives and interests of the controlling and second-level organisations should be compatible.

Governments should have a developed policy, rather than ad hoc arrangements, towards the creation of second-level organisations. This developed policy should cover such issues as:

• Initiation of the proposal: who should be the initiator of proposals for the establishment of a second-level organisation and the approval processes? What are the approval processes: is there any role for an assessor other than the organisation making the proposal, such as the ministry of finance?

• Size: should there be a minimum size before any second-level organisation can be created?

• Governance arrangements: who should appoint the chairman, board members and the chief executive?

• Personnel policies: should these be specified covering, for example, the level of the personnel establishment and the reasons and arrangements for appointing staff as well as changing the level of staffing, the salary structures?

• Justification: what is the justification for separating the functions of the proposed second-level organisation from those of the controlling organisation?

• Periodic review: should there be an automatic process of review to determine whether the second-level organisation should continue in existence after a specified period?

• The arrangements of the controlling organisation: will the controlling organisation retain sufficient expertise to enable it to set objectives and performance standards including targets for the improvement of efficiency and effectiveness, to determine an appropriate budget and to ensure that it remains in effective policy control over the second-level organisation including that it meets the objectives and performance standards set by the controlling organisation?

• Performance measurement arrangements: how will the second-level organisation performance be measured in delivering its objectives and performance standards and how is it proposed that the efficiency and effectiveness of the second-level organisation will be monitored?

• Accountability arrangements: what will be the accountability arrangements to the controlling first-level organisation?

Establishing a second-level organisation is not ‘cost free’. There are the costs of establishing and managing the organisation itself as well as the additional costs incurred by the controlling organisation in supervising the performance of the second-level organisation. Where there are several (or sometimes many) such organisations these costs are multiplied. Proposals to establish second-level organisations should be carefully reviewed, not just by the controlling organisation but also by others involved in the development and management of public services, not least the ministry of finance. (In local government there should be also a third party involvement in the assessment. Who it should be would depend upon how a local government was organised.) However, any such second-level organisation should be required to be subject to audit by the local government auditor.

Unless countries are clear about why they agree to the establishment of a second-level organisation and that they keep second-level organisation performance under review, a significant risk is that a second-level organisation will not only develop a ‘life of its own’ but the quality of performance may also deteriorate. A second-level organisation will generally want to justify its own existence and the continuation of its own programme of activity. If the controlling organisation is not either able or willing to exercise its control responsibilities the budget that the second-level organisation presents to the controlling organisation will be driven by the interests of the second-level organisation rather than by the interests of the controlling organisation. The controlling organisation, in effect, risks becoming subservient to the interests of the second-level organisation and therefore ineffective as a supervising organisation. This is inappropriate and the controlling organisation should be determining the policy and the strategy for the implementation of that policy by the second-level organisation. It should also be agreeing the performance standards and efficiency and effectiveness targets and hence the budget of the second-level organisation. This is a serious risk and the impact should not be underestimated.

12.1.4 The Responsibilities of Controlling Organisation

Controlling organisations as they represent the principal in the principal/agency relationship which exists between a controlling organisation and a second-level organisation, have several responsibilities. As the principal, the controlling organisation with PFM/IC should specifically determine the objectives and performance standards and objectives which second-level organisations are to achieve and should identify and agree the performance measures that are to be adopted to demonstrate whether they have been achieved in practice or not. These arrangements should be specified in some form of ‘contract’ or oversight agreement such as a performance or service-level agreement (see below). In legal terms an organisation cannot contract with itself and that agreement would need to be a memorandum of understanding or equivalent unless the second-level organisation was a separate legal entity. These documents have been used in developed economy countries.

Success in delivering objectives and performance standards will depend upon the accompanying financial settlement. (A risk with these types of arrangements is that the controlling organisation may seek to ‘offload’ its responsibilities onto a second-level organisation and not provide sufficient finance.) The controlling organisation should also specify in the ‘contract’ the standards of governance and of internal control that are to apply in the second-level organisation. An important activity of the controlling organisation is to monitor their second-level organisations to ensure that they comply with those standards of governance and of internal control and meet any regulatory and legislative requirements. The ‘contract’ may specify the monitoring arrangements. Performance monitoring should be a positive activity of the controlling organisation. Exactly how it is undertaken will depend upon local circumstances but it should include regular written formal reports as well as personal meetings between representatives of the controlling organisation (which for normal business relationships should be representatives of the operational management of the controlling organisation) and the chief executive and operational management of the second-level organisation. The head of operational management of the controlling organisation (e.g. the state secretary) should then report to the political level of management including his/her own observations on the performance of the second-level organisation. In normal operational circumstances the political level of management should not become involved in the management of second-level organisations. Where the political level of management should become involved is in the setting of the policies, objectives, and performance standards of the second-level organisation, in acting upon reports of the controlling organisation operational management, or where some unusual or inappropriate event or actions have occurred, such as a failure of governance or the making of inappropriate payments to senior executives. Such ‘unusual’ events anyway should have been reported upon by the controlling organisation operational management. This arrangement makes possible the development of political accountability without a minister (or mayor) becoming involved in the detailed operation of the second-level organisation.

Consequently, controlling organisations should have these capabilities, to:

• Prepare the ‘contract’ with the second-level organisation.

• Set the objectives of the second-level organisation along with the performance standards they should be expected to adhere to, whether they are trading or non-trading second-level organisations.

• Ensure that appropriate standards of corporate governance and internal control are applied in the management and organisation of the second-level organisation.

• In the application of the internal control standards approve the risk appetite proposals.

• Systematically monitor the activities of the second-level organisation requiring periodic reports about their performance.

• Determine the budget for the second-level organisation and the financial returns that should be expected if they are trading second-level organisations (subject to any ministry of finance specifications). That determination should include whether any subvention from the budget is gross or net and if net and fees or other earnings are expected to make up the balance what is to happen if there is a surplus: is it to be handed over to the ministry of finance or retained but only for specified purposes? Similarly, where goods are imported and costs include import duties the costs of those imported goods should be shown gross rather than net of import duties.

Unless these types of arrangement are made the controlling organisation loses effective control over the second-level organisation. If controlling organisations do not follow this procedure this is an unsatisfactory situation and not compatible with the principles of PFM/IC. This is because some portion of the budgetary expenditure (or income) for which ultimately the controlling organisation should be responsible, will fall outside its financial management and internal control requirements.

To enable a controlling organisation to properly undertake these responsibilities the controlling organisation will need to include within its own organisation a specific department or unit responsible for the management of second-level organisations. (Where the second-level organisation is small the controlling organisation responsibilities may be exercised by a specific individual such as the head of finance.) That department or unit should be able to define the objectives, performance standards, financial returns (where appropriate), the operating budget and expected efficiency gains of the second-level organisations for which the department has a responsibility and to then monitor what is happening. These are effective preconditions for the establishment of a second-level organisation and if they cannot be met then such an organisation should not be established.

The reality, in this author’s experience, is that in practice the objectives of second-level organisations can be vague and are often described, but only in general terms, in the legislation establishing the organisation in the first place. Very often too that legislation has not been changed since its initial approval. Objectives are not usually linked to budgets, but they should be. (Where the objectives have been defined in the legislation establishing the second-level organisation, by definition, they cannot be linked to current budgets and to argue that this is an adequate arrangement, as has occurred in this author’s experience, is inappropriate.) Those objectives can also be inconsistent with the objectives of the controlling organisation. Again, in some countries, the agreement of the annual budget and the consequential budgetary control arrangements are regarded as a sufficient form of control. However, these are nowhere near enough as a form of control for the following reasons:

• Political and operational circumstances change as does the operational environment: a single statement of objectives set out in the originating law does not necessarily reflect current operational circumstances or the environment in which the organisation is operating.

• Current objectives of the second-level organisation should be consistent with the current objectives of the controlling organisation which will also change as political and operational circumstances change. The management arrangements may also need to change to reflect any changes in the objectives.

Second-level organisations can be a potential source of mismanagement, fraud, and corrupt behaviour. There are many causes of this, not least ineffective management by the controlling organisation. But another cause is poor internal control and poor corporate governance. Good corporate governance is potentially an effective anti-corruption tool. Corporate governance promotes transparency and accountability, so that clarity exists about how decisions are made and why. Consequently, a requirement should be that second-level organisations meet the standards of internal control and corporate governance (see Chap. 1) that apply to first-level controlling organisations. To ensure that this does occur, effective supervision of second-level organisations by the controlling organisation is essential. Other steps may be taken to limit the possibilities of corruption including, for example, that second-level organisations may be restricted to procuring only low value items with high value items only being procured by the controlling first-level organisation or with the specific authority of the controlling organisation. The first-level organisation should always maintain an effective capacity to properly supervise the policies and activities of the second-level organisation. In practice this does not always occur.

A requirement should be that the internal control arrangements that apply to controlling organisations should apply equally to second-level organisations although they may need to be adapted to the second-level organisation’s operational circumstances and management. Even so they should still follow the basic procedures of internal control that apply to the controlling first-level organisation. This means that the internal control arrangements, essentially managerial disciplines (see Chap. 11), should be designed, inter alia, to ensure that the second-level organisation delivers its objectives to time and standard, observes the approved performance standards and operates efficiently and effectively within approved budgets and the law and regulations and meets the specified standards of transparency and accountability. The delegation and accountability arrangements should also ensure that a second-level organisation does not enter into commitments or take on fiscal risks which could prejudice its future financial resilience and potentially that of the controlling organisation.

The point is that second-level organisations should not be ‘free-standing’ and should be subject to active engagement with the first-level controlling or supervising ministry. In general, under no circumstances should a second-level organisation negotiate its budget separately with the ministry of finance from that of the controlling organisation but in some countries this does occur. (The only examples where this could be appropriate would be, for example, the budgets of an ombudsman, the supreme audit organisation, and judicial bodies. The supreme audit organisation should not be regarded as a second-level organisation in any event.)

In many countries and especially in developing and transition economy countries the reality is that the essential control and review features of second-level organisations do not exist. Often the controlling first-level organisation does not have the capacity (or see the need) to exercise policy control (believing that the originating law is all that is required). The only advice that the controlling organisation very often receives about the operations of a second-level organisation is from the second-level organisation itself, so it is hardly impartial. There are no arrangements for independent assessment. Yet a controlling organisation should always have a policy capacity, even if this requires the employment of a specialist independent organisation, to enable it to challenge the management of a second-level organisation.

Second-level organisations can also become permanent features of management in transition and developing countries. They may even report directly on their performance to the parliament rather than through the first-level organisation. This effectively bypasses the controlling first-level management. This is an inappropriate arrangement. Also, no arrangements for periodic review of the continued existence of a second-level organisation exists.

The establishment of clear lines of accountability is crucial for controlling organisations. If the controlling organisation believes, through the exercise of its supervisory role that the second-level organisation is not performing as it should, then the responsibility of the controlling organisation is to take corrective action. Failure to do so leaves the controlling organisation exposed to adverse criticism. That corrective action may be taken directly by the head of operational management or by the political head on the advice of the head of the controlling organisation operational manager, depending upon the circumstances.

In some countries the only form of control exercised by a controlling organisation is budgetary control. This makes control one-dimensional and is not sufficient to ensure that objectives and performance standards are being achieved. This limited form of control also does nothing to ensure that there is any year on year improvement in performance or that the second-level organisation has responded to changing circumstances.

An important aspect of control is that the controlling organisation does not become part of the management of the second-level organisation. This does not mean that staffs cannot be interchangeable or that the rules that apply to the appointment of staff to first-level organisations should not apply to the appointment of staff to second-level organisations. Ideally, they should be the same. However, controlling organisations in some countries do feel that to exercise control their officials have to be appointed to the board of the second-level organisation (or other executive body) and approve the day to day managerial decisions of the second-level organisation. In this way the controlling organisation becomes part of the second-level organisation management. Very importantly it also places those staff in a position where conflicts of interest can occur. This is entirely wrong and can result in a failure of control by the first-level controlling organisation. This is contrary to the principles of corporate governance and would prevent the controlling organisation exercising an independent assessment role of the performance of the second-level organisation. (This author has come across examples of where controlling ministry civil servants have been appointed as members of the board of second-level commercial organisations, as have ministers. This arrangement creates opportunities for such appointees to receive additional remuneration and other benefits, which of course may also be a motivation for appointment and such officials and such appointments may occur even though the appointee may have no specific expertise. But in such circumstances the controlling ministry’s ability to supervise and to independently assess the managerial performance of the second-level organisation can be heavily circumscribed.)

Overall, the responsibilities of the controlling organisation are to ensure that the second-level organisation:

• 1. Has strategic clarity—that is, agreeing with the vision and/or mission of the second-level organisation and ensuring all its activities either directly or indirectly, contribute towards those of the controlling organisation and that the second-level organisations have a properly funded mandate with appropriate powers.

• 2. Is set and meets objectives and performance standards that are consistent with those of the controlling organisation.

• 3. Is results focussed and has the skills, resources, and plans to achieve those objectives.

• 4. Has established performance measures and information systems which enable the second-level organisation to demonstrate that it is meeting the objectives and performance standards set by the controlling organisation.

• 5. Meets the corporate governance and internal control standards specified by the ministry of finance including any specific budgetary and financial control requirements.

• 6. Agrees the second-level organisation’s risk appetite and satisfies itself that the second-level organisation management has controls in place to manage risk, that is, both the risks which may prevent objectives and performance standards being achieved and those inherent in the activities and services being provided.

• 7. Has established the appropriate managerial structures to secure delivery of the objectives and performance standards efficiently and effectively: this includes a high-quality financial management process, human resource management arrangement, with the appointment of appropriately skilled managers which together will make it possible to achieve the objectives of the organisation.

• 8. Does not accept any fiscal risks without the specific approval of the controlling organisation.

• 9. Follows the relevant legislation and administrative rules.

• 10. Informs the controlling organisation when approval is required to particular actions proposed by the second-level organisation or where circumstances arise not envisaged in the ‘contractual’ arrangements between the controlling and second-level organisation.

• 11. That reporting arrangements exist which enable the controlling organisation to effectively monitor the performance of the second-level organisation during the year.

Second-level organisations should also be required to prepare an annual report, including a statement of internal control, audited financial statements, that is audited by the state auditor, about their performance and activities. The controlling organisation should approve the publication of that annual report including the audited financial statements along with the statement of internal control. A consequence of this is that the activities of second-level organisations should, in the normal course of events, be subject to parliamentary scrutiny.

The focus of the controlling organisation should be on results not processes, on obtaining good and timely strategic management information, gaining strategic clarity about objectives and trends in performance, and ensuring that the second-level organisation has the management structure and staff capability to deliver its objectives and envisaged performance.

The controlling organisation should recognise that a second-level organisation will always find activities or reasons to justify its existence but this does not necessarily mean that those activities or reasons are compatible with the interests or objectives of the controlling organisation or are indeed necessary. Therefore, the process of periodic review, referred to above, should exist which will require the second-level organisation to justify its continued existence.

These requirements mean that the controlling organisation must have available to it sufficient knowledge and operational information about the second-level organisation to enable it to assess the performance of that organisation and whether it should continue in existence. Unless these requirements exist, there is a risk that because of an asymmetry of information developing between the second-level organisation and the controlling organisation this exposes the controlling organisation, and hence the minister (or mayor), to the charge that it is not actually in control of the second-level organisation.

12.1.5 The Information That a Controlling Organisation Should Have

A controlling organisation must have available to it sufficient knowledge and expertise to set objectives for the second-level organisation, to define appropriate performance standards as well as the financial parameters for budgetary purposes, and to monitor performance during the year. A significant risk, pointed out above, for the controlling organisation, is that because the second-level organisation has detailed operational knowledge of the area of operations, the controlling first-level organisation will not be able to properly exercise its control responsibilities. However, the existence of a ‘contract’ assuming that it is properly drawn up by the controlling organisation should ensure that the controlling organisation has the key information it requires to exercise effective control. With such ‘contracts’ the goals, targets, and financial resources should be agreed between the controlling first-level organisation and the second-level organisation. The second-level organisations should be held accountable for their achievement. The controlling first-level organisation, as has been indicated above, should systematically monitor the performance of the second-level organisation with the extent of the monitoring being determined by the conditions included in the ‘contract’. Adopting a performance basis for control adds to the focus on compliance, a focus on results and their achievement efficiently and effectively. However, to achieve these benefits requires capacity building both in the controlling organisation and in the second-level organisation.

12.1.6 Oversight Arrangements by Controlling Organisations: Service-Level Agreements—Examples of Arrangements in Ireland and the Netherlands

Set out below are example arrangements which countries ought to consider in the establishment and management of second-level organisations. These arrangements are based upon a model published by the Irish Republic and regulations published by the Government of The Netherlands. The underlying principle is that the control arrangements and performance of second-level organisations should be carefully monitored by the controlling organisation.

A particular feature of the Netherlands arrangements is that the regulations governing the establishment of second-level bodies (called agencies in the regulations) specify different financial arrangements for agencies which are income earning from those which rely upon budgetary finance. There is no specific reference in the regulations to state owned enterprises.

In the Netherlands an agency is treated as a service part of a ministry that operates with its own management model and financial administration. It may be an income earning agency or an expenditure based agency. The aim is to establish a management model which facilitates a more efficient operational management but one not adversely affecting the overall control of public expenditure. The agency model is described as ‘a form of internal independence in which the ministerial responsibility for the agencies is fully maintained’.³ There are different financial regulations affecting the two types of agencies. The income earning agency, which is not a state owned enterprise, is required to prepare its financial accounts on an accruals basis of accounting and the expenditure based agency on a cash basis of accounting. This means that an income earning agency in determining the charges for its services, costs such as depreciation would be incorporated into the cost structure which they would not be were a cash basis of accounting employed. It also means that charges for the services provided by an income earning agency would be largely stable irrespective of the levels of capital expenditure incurred. An income earning agency is expected to earn sufficient income to meet its outgoings.

One important feature specified in the Irish government arrangements is that all second-level organisations whatever their type should implement good corporate governance standards. Those standards would be specified by the Ministry of Finance. A second important feature is summarised in the following extract from the Irish code: ‘The oversight agreement should reflect the State bodies legal framework; the environment in which it operates (e.g., commercial, non-commercial, regulatory body); the purpose and responsibilities of the State body; the State body’s level of compliance with this Code; details of the Performance Delivery Agreement (e.g., outputs to be delivered); and arrangements for oversight, monitoring and reporting on conformity with Government policy including those actions and areas of expenditure where prior sanction from the parent Department and/or the Department of Public Expenditure and Reform is required.’⁴ The starting point for clarity of accountabilities is a service-level or performance agreement (referred to in the Irish guide as an ‘oversight agreement’) between the relevant controlling organisation and the second-level organisation. This Code demonstrates that clear objectives, delegation, and accountability arrangements should exist which underpin effective managerial relations between controlling organisations and the second-level organisations for which they are responsible. Effective accountability depends upon the roles and responsibilities being clearly defined and understood by the controlling organisation and the second-level organisation.

The ‘oversight’ agreement ‘demonstrates that clear objectives, delegation, and accountability arrangements exist which underpin effective managerial relations between controlling organisations and the second-level organisations for which they are responsible. Effective accountability depends upon the roles and responsibilities being clearly defined and understood by the controlling organisation and the second-level organisation.’

The contents of such agreements typically should contain the following sections (and these are based largely, but not wholly, upon the Irish and Netherlands requirements):

• 1. Introduction: which sets out the background to the agreement; the parties involved; it also clarifies the statutory tasks of the second-level organisation.

• 2. Corporate governance: this covers the underlying framework including the legislative context, compliance with relevant statutory and corporate governance obligations; as well as compliance with meeting good practice in public expenditure, not least in securing good value for money.

• 3. Management arrangements: this should include a requirement that the top management of the second-level organisation should be required to incorporate into the managerial arrangements the standards of internal control applying throughout the public sector, adapted as necessary for commercial second-level organisations.

• 4. Objectives of the agreement: this focuses on the key priorities/objectives of the second-level organisation. There must be a clear link between the second-level organisation’s goals and objectives and those of the controlling organisation.

• 5. Mutual commitments: this is that an effective agreement should acknowledge the mutual relationship in terms of responsibilities and obligations between the controlling organisation and the second-level organisation. Therefore, the agreement should include a section clearly setting out the controlling organisation’s commitments, for example, the controlling organisation will provide a range of operational supports X, Y, and Z, to enable the second-level organisation fulfil its mandate and that the level of funding is compatible with the second-level organisation’s ability to achieve its objectives and performance standards.

• 6. Inputs: in order to provide a comprehensive picture and to allow for ready comparison with previous/future agreements, the inputs/resources of the second-level organisation in terms of income and expenditure (capital and current), including pay allocations/staffing for the period of the agreement together with any specific allocations for specific purposes, should be clearly set out. This should include whether funding is to be on a gross or a net basis after income earned and what happens to any surplus income which ideally should be transferred to the ministry of finance.

• 7. Performance/service levels and performance measurement: the agreement should specify the performance/services and outputs/service levels, based on the agreed inputs outlined in point 5 above, to be provided by the second-level organisation as well as the performance monitoring and measurement indicators. Performance/service actual levels and expected levels, including minimum levels, should be explicitly detailed, and agreed upon in order to avoid misinterpretation or misunderstanding between the controlling organisation and the second-level organisation.⁵

  The measurement indicators of outputs (what actions the second-level organisation carries out) and impacts or results (what the second-level organisation achieves) should be credible and reliable.

  As second-level organisations may carry out many functions/services, the focus should be on those functions/services which are central to delivering the strategic objectives of the controlling organisation, that is, the focus of control should be on the core activities. (This is to avoid overwhelming the agreement with bureaucratic requirements). Therefore, in selecting appropriate indicators, the aim should be on the quality of the information/indicators as opposed to quantity. Baselines should also be identified from which targets for improvements could be measured.

• 8. The financial accounting arrangements depending upon whether the second-level organisation is income earning or not and if it is income earning that accrual accounting should be applied (this would not apply if the income earning element was only marginal).

• 9. Potential risk factors: potential risk factors or other likely constraints, both internal and external, that might impact on expected performance/service levels over the duration of the agreement should also be highlighted. As the resources for the period of the agreement should be agreed and included in the agreement, resource constraints ought not to be a potential risk factor.

• 10. Flexibility and amendment of targets: on occasion performance/service targets may require to be changed or modified or added to during the period of the agreement, due to unforeseen circumstances. Where amendments become necessary, the controlling organisation should agree with the second-level organisation on the amended targets and the agreement should include a procedure for agreeing such changes.

• 11. Major new investments and policies: a requirement should be included for the second-level organisation to consult with and seek approval of the controlling organisation where major new investment projects or new policies are proposed: such large projects and new policies should be fully evaluated and consistent with the strategic vision of the organisation.

• 12. Monitoring arrangements: the specific monitoring and reporting arrangements of the agreement should be identified, as well as procedures for dealing with variations in performance against targets. For example, the arrangements may include reporting information on the operation of the agreement in annual reports, officials meeting on a regular basis to review performance against the agreement; and implementing an internal system to monitor performance against the activities outlined in the agreement. The successful monitoring of the agreement will be in large part dependent on how well defined the performance/service levels are set out. A feature of the monitoring arrangements should be agreement about the internal audit arrangements. Although a second-level organisation should have its own internal audit arrangements, whether by its own staff or through other arrangements the controlling organisation internal audit should have access to the management and records to support the monitoring arrangements specified in the service-level agreement.

• 13. All service-level agreements should include a requirement that each second-level organisation should publish an annual report and financial statements. The latter should be audited by the state auditor. The contents of this report should vary depending upon whether the second-level organisation is an income earning organisation or receives its finance from the budget or is a commercial organisation. These reporting requirements should include:

  • (a) An annual report signed by the chairman of the board responsible for the management of the second-level organisation or if no board, by the chief executive which should cover:

    • i. A review of the operational environment including changes that have affected the performance of the organisation.

    • ii. An affirmation that controlling organisation policy is being complied with and if not the reasons for non-compliance.

    • iii. The actual operational performance of the organisation against the objectives incorporated into the service-level agreement with an explanation for any differences.

    • iv. An explanation of any policy changes or major initiatives during the year.

    • v. The prospects for the next and future 3 years.

    • vi. Any particular information that may have a political or public resonance in the country.

    • vii. The statement of internal control (see Chap. 13).

  • (b) The financial statements which taken as a whole, should be fair, balanced, and understandable and:

    • i. Provide the information necessary for an assessment of the organisation’s financial position and its financial performance analysed over main activities compared with the budget forecast (i.e. over main activity/objective headings and not the subjective headings usually required for budgetary control purposes).

    • ii. The income of the second-level organisation from all main sources and analysed over those different sources along with the costs of generating that income.

    • iii. Any loans or other forms of financial support provided by the controlling organisation, or any other government ministry or agency or any commercial loans (which should be approved by the ministry of finance) and how such finance has been used.

    • iv. The extent of liabilities including liabilities outstanding at the year-end.

    • v. The extent of revenues due but not yet collected.

    • vi. The cash position at the year-end including deposits with all banking institutions (this will be affected by whether a treasury single account process exists).

    • vii. A forecast of the extent of any fiscal risks accepted by the second-level organisation or which potentially could occur.

    • viii. A statement about the longer-term financial resilience of the organisation taking into account the longer-term commitments (including contracts) of the organisation together with any other factors which could affect the future financial resilience of the organisation over at least the next 12 months, including inflation and other changes in market conditions or anticipated demands for the service.

    • ix. A statement about ‘sensitive’ information (with the term ‘sensitive’ being defined as including any particular items that the controlling organisation and/or the ministry of finance specify as necessary to be disclosed) but could include such items as remuneration, bonuses, and other payments to senior executives, termination/severance payments to employees, travel and subsistence payments analysed between national and international travel, hospitality expenditure, legal costs, and compensation paid.

  • (c) If the second-level organisation operates in a market place, then the range of financial information to be provided would need to be considerably extended. As the financial accounts should be prepared on the same basis as commercial organisations operating in the country the information provided should include such additional factors as:

    • i. The overall profitability, taking into account the cost of capital, depreciation, and an appropriate share of overheads.

    • ii. Information about losses on any business activities after appropriate allowances for depreciation, the cost of capital and overheads.

    • iii. The rate of return on assets employed and other appropriate commercial measures of performance.

    • iv. Market share, changes over time and prospects for future periods.

  (Other examples of information that may be required by the controlling organisation of a state owned enterprise are included in Annexes 1 and 2 to this chapter.)

• 14. Duration and signatories to the agreement: this section should highlight the duration of the agreement and the commencement date. The period covered by the agreement will depend on the nature and services to be provided by the second-level organisation.⁶

This is a lengthy list of requirements which it would be inappropriate to expect to be completed where small second-level bodies are involved. However, this then raises the question as to whether such small second-level bodies should exist and whether it would be more appropriate for the functions of such bodies to be absorbed into the functions of the controlling first-level body. As has been pointed out above establishing second-level bodies is not ‘cost free’.

In Annex 1 an example from Ireland of the requirements to be included in the chairman of a commercial state body statement is shown. Although this statement is designed primarily to reflect the circumstances of commercial state bodies much of the content would be equally relevant to a non-commercial state body. Annex 2 shows the Irish financial information requirements for shareholders in commercial second-level state bodies. Again, the approach adopted here would have direct relevance to commercial second-level bodies in developing and transitional economy countries.

The annual report and financial statements of all second-level organisations should be available as part of the accountability process to parliament, to users of the second-level organisation services and to civil society. Publication should be the normal practice and only withheld in exceptional circumstances.

The approach of the Government of the Netherlands has these particular features:

• To establish an agency the relevant minister is required to apply to the minister of finance for the designation of a service unit as an agency. In other words, an individual minister must seek the approval of the minister of finance to a decision to establish a second-level organisation.

• An important condition in obtaining approval to the creation of an agency is that the centralised state audit service (a technically advanced internal audit service), has not found any relevant deficiencies in the financial management arrangements.

• As part of the application for the establishment of an agency, the relevant minister must submit an agreement with the agency describing the structure and expected functioning of the agency.

• The relevant minister must prove that the proposed agency:

  • Will have an expected turnover or expected revenue of more than €50 million on an annual basis⁷;

  • Will have a result-oriented management model⁸;

  • Will work more efficiently than as a regular service unit of the controlling organisation concerned and indicate how the service unit will further develop efficiency as an agency during the next 5 years;

  • Can establish a link between expenditure, costs, and performance in such a way that funding based on performance is possible;

  • Can guarantee a sufficient level of quality of the financial function and financial management;

• Provided these conditions can be met the relevant minister in conjunction with the Minister of Finance, submits the proposal to establish the agency to the council of ministers. If the council of ministers approves the establishment of the agency, the relevant minister notifies the parliament and provided the proposal is approved the decision establishing the agency will be signed by the relevant minister and the minister of finance. The decision to establish the agency is published in the government gazette and the Supreme Audit Institution (state auditor) is informed.

• The controlling ministry is responsible for supervising the policy of the agency and the quality of its management. The controlling ministry is also expected to establish a high-quality system for monitoring the budget of the agency, the continuity of the agency and the quality of the products. In addition, the controlling ministry is annually required to assess the financial management arrangements and to approve the annual report. The agency has a responsibility to ensure that the quality of financial management is maintained.

• The agency must promptly inform the controlling ministry of proposed policy changes.⁹

• Reporting arrangements should exist that will enable to controlling ministry to monitor the performance of the agency

12.1.7 Arrangements for the Systematic Review of Existence of a Second-Level Organisation: A Netherlands Example

As has been explained above whether a second-level organisation should continue in existence should be subject to systematic review. The Netherlands Ministry of Finance reviews the necessity for the maintenance of the status of second-level organisations. This provides an example for other countries.

In the Netherlands, at least once every 5 years, the controlling minister and the minister of finance have a responsibility to jointly assess the efficiency and effectiveness of an agency. The relevant minister is required to publish the resulting report.

The review is undertaken by the state audit service (which is a different audit service from the State Auditor, the Supreme Audit Institution) and the purpose of the audit is to form an opinion on the functioning of the agency in the areas of (a) governance, (b) funding, (c) efficiency, (d) financial management, and (e) the future of the organisation.

Should a decision be made to close an agency, or to merge it with another agency, parliament should be informed and the Supreme Audit Institution.

On closure a financial audit is undertaken and the assets and liabilities of the agency are transferred to the organisation taking over the functions of the agency. (There are also special provisions relating to finance but these are specifically related to the Netherlands financing arrangements for agencies.) This provides a model arrangement which other countries could well follow. Without arrangements for regular review the possibility is that a second-level organisation could continue in existence when the underlying need for it has disappeared or it is not achieving its objectives or the standards set for it, assuming that they have been.

12.1.8 Questions to Be Asked About Second-Level Organisations When PFM/IC Is Introduced

Introducing PFM/IC creates the opportunity to re-examine the relationships between controlling ministries or local governments and their second-level organisations. This re-examination should be regarded as an integral part of the application process of PFM/IC and the following questions about second-level organisations and the control arrangements should be asked by the ministry of finance or the head of the ‘driver’ organisation responsible for the application of PFM/IC:

• 1. Have criteria been set to provide a basis for the establishment of second-level organisations (perhaps along the lines of those described above by the Netherlands Ministry of Finance and the Irish government), whether income earning, budget funded or commercial and if they have been set are those criteria being met by the second-level organisations?

• 2. If those criteria have not been set, then should they be? Importantly the controlling organisation should be satisfied that second-level organisations will have sufficient resources to enable it to employ the expert staff required and a management structure capable of delivering the objectives and performance standards and objectives set for them by the controlling organisation.

• 3. Does the controlling organisation itself have the capability to set clear managerial objectives and performance standards and objectives required for the second-level organisations (this is not simply about agreeing the budget), and to then monitor their performance and secure improvements systematically in the efficiency and effectiveness of the service delivery and related activities provided by second-level organisations?

• 4. Does a process exist allowing the controlling organisation and/or the ministry of finance to periodically review the need for second-level organisations to continue should operational or other circumstances change?

• 5. Has a results oriented management model been introduced in second-level organisations, irrespective of whether the objectives are commercial or not (because a results oriented model is consistent with the aim of improving efficiency and effectiveness)?

• 6. Have service-level or performance agreements been entered into and is the coverage of those agreements sufficiently comprehensive to ensure that the objectives and standards for the second-level organisations are clear? Do those agreements follow requirements specified by the ministry of finance?

• 7. Do clear performance targets exist and is performance information available to management and do appropriate monitoring and reporting arrangements exist?

• 8. Is the level of discretion available to the second-level organisations clear and when they must refer proposed decisions to the controlling organisation?

• 9. Are the governance and internal control arrangements robust and is there clarity in the separation of the roles of the management of the controlling organisation and of the second-level organisations? (This may include rethinking how the second-level organisations are governed such as should they have a governing board, who should be members of that board, what is the role of the chairman, who is the chief executive and to whom does the chief executive report, how are these different individuals to be appointed and removed? A separate section below discusses the appropriateness of a board structure.)

• 10. If the objectives of a second-level organisation are income earning or commercial then does a financial structure exist which ensures that the second-level organisation fully recovers all its costs and if operating commercially is effectively not subsidised in such a manner that it can unfairly compete with private sector competitors? Examples of subsidy would be that capital is provided free of charge whereas a commercially oriented second-level organisation should be charged for the cost of the capital that it is employing; public organisations may not include a charge for depreciation in their cost structure but if operating in a market place depreciation should be allowed for in costs; it should not be allowed to ‘cross-subsidise’ commercial activity from non-commercial activity and therefore accounting arrangements agreed with the controlling organisation should be employed to prevent this. A commercially oriented second-level organisation should be required to follow the accounting principles used by commercial companies in the country and not public sector accounting arrangements; second-level commercial bodies also should be expected normally to achieve a ‘market rate of return’ on the capital employed.

• 11. Can the first-level organisation demonstrate that by delegating responsibility to a second-level organisation management that the service and activities to be delivered will be more efficiently and effectively delivered than if those services and activities remained part of the controlling organisation?

• 12. Are the second-level organisations able to demonstrate how the service or activity they provide at least over the period of any performance or service-level agreement, will improve their efficiency and effectiveness?

• 13. Does the controlling organisation determine the second-level organisations budgets rather than a direct negotiation occurring between the second-level organisation and the ministry of finance? If the latter is the current arrangement, this should be changed.

• 14. Where new investment or activities are to be undertaken does the second-level organisation have the capacity to undertake an appropriate level of project analysis (depending upon the size of the project) and associated business planning, including considering the business risks that may arise?

• 15. Can the management of second-level organisations demonstrate an adequate quality in the finance function and of financial management in support of the management, so that the management is able to demonstrate how it is delivering improvements in efficiency and effectiveness?

• 16. Will those finance functions have the technical capability to assess and report on the financial resilience of the organisation over the medium to longer term?

• 17. Will a governance and reporting structure be established which will secure these characteristics:

  • (a) ensure that the management of second-level organisations acts in accordance with the objectives set by the controlling organisation;

  • (b) that the resources of the second-level organisations are used only for the approved purposes;

  • (c) that the standards of internal control specified by the ministry of finance are fully applied throughout the second level organisations demonstrate the effectiveness of the internal audit function whether provided directly by the second level organisation or by the first level organisation (see also below);

  • (d) that the management structure of the second level organisations evolves as the operational environment and objectives of the organisation evolve; and

  • (e) that the accountability arrangements between the second-level organisations and the controlling organisation properly present the operational and financial performance, including the end of year financial statements and annual reports, of the second-level organisations?

12.1.9 Questions to Be Asked Where Private Sector Organisations Are Asked to Deliver Public Services

Where public services are to be delivered through private sector organisations using private finance initiative-type (PFI) arrangements other questions need to be asked of the organisation responsible for this type of arrangement, including:

• If the objective is to improve efficiency and effectiveness through introducing private sector market disciplines does the initiating contract allow for any form of assessment and if so, what mechanisms have been established to demonstrate that such improvements are occurring?

• What is the process for following up the evidence of improvement?

• The market place usually encourages providers to focus on the most profitable areas of activity, so where public services are to be delivered universally what steps have been taken to ensure that the least profitable areas of activity are still being covered (this can be particularly important in the provision of social and health services using PFI arrangements)?

• Profit maximisation does not automatically mean that services are being delivered efficiently and effectively: consequently, what actions are being taken to ensure that an appropriate proportion of resources are being utilised for public service delivery compared with reward to shareholders and senior executives?

• Has the PFI-type exercise simply been adopted for ‘financial engineering reasons’ such as to contain the level of public sector debt, and if so, has this been agreed with the ministry of finance?

The United Kingdom National Audit Office looked at the quality of the management of PFI contracts in the UK National Health Service. Its overall conclusions included:

Most [Health] Trusts are managing their contracts well day-to-day and understand the risks to value for money. However, risks remain and, while many Trusts have recently increased the resources they dedicate to managing PFI contracts, some Trusts are not devoting enough resources. About 12% (9 of the 76) operational PFI contracts have no-one from the public sector assigned to contract management.

It is likely that Trusts will be expected to make efficiency savings over the next few years, but their ability to make savings from their PFI contracts is very limited. Because Trusts pay an index-linked fixed sum, it is difficult for them to make savings without cutting back on services. Contractors who secure economies of scale through managing multiple PFI contracts are rarely required to share these efficiency gains with Trusts.¹⁰

The National Audit Office also looked at the problems which can emerge with all types of PFI contracts at the end of the life of a contract¹¹ and there are lessons to be learnt from this. These included the following:

• 1. The public sector does not take a strategic or consistent approach to managing PFI contracts as they end and risks failing to secure value for money during the expiry negotiations with the private sector.

• 2. There is a risk of increased costs and service disruptions if authorities do not prepare for contract expiry adequately in advance.

• 3. Some authorities have insufficient knowledge about the assets’ condition, which risks them being returned to the public sector in a worse quality than expected.

• 4. Many authorities start preparing for contract expiry more than 4 years in advance but there is a risk this is not enough time.

• 5. Authorities recognise that contract expiry will be resource intensive and require unique skills, and expect to fill gaps with consultants.

• 6. A misalignment of investor and authority incentives at contract expiry creates a potential for disputes.

• 7. Early PFI contracts are likely to contain significant ambiguity around the roles and responsibilities of the parties at contract expiry.

This illustrates the complexity of PFI contracts and why great care is required before they are entered into.

12.1.10 An Example of the Risks That Can Exist with Second-Level Organisations

12.1.10.1 Introduction

An example from a developed economy country, South Australia, of the problems that can emerge with the delegation of responsibilities from a controlling organisation is described below. This example also illustrates the significance of many of the issues that are relevant to the effective introduction of PFM/IC and the control of second-level organisations. In Australia private sector has been used to support the provision of technical and further education (TAFE) for young people. This example also demonstrates that a market solution requires regulation to secure the benefits as the quality review report¹² referred to below shows: ‘The early response by registered training organisations (RTOs) to the new market opportunities, and by students to the improved access to subsidised training, far outstripped expectations, with the consequence that government expenditure on VET [vocational education and training] ballooned and students were exposed to low-quality profit-seeking training providers.’¹³ The response of the Australian government was to give a sharper focus to regulation; to introduce higher barriers to entry for the subsidised market; to provide incentives for students to enrol in courses with a higher public value; to provide improved information for prospective students so they could make better judgements about which course to choose.

12.1.10.2 The example:

The public authority in South Australia responsible for the organisation of the delivery of tertiary technical and further education in that State had come under criticism for being slow-moving, inefficient, and overly protected in a market place where there were both public and private sector providers. The quality of the educational outputs was, at that time, not contested. However, a quality review by the Australian Skills Quality Authority (ASQA) resulted in ASQA giving notice of its intention to suspend the registration of ten qualifications from the Technical and Further Education (TAFE). The shock of this finding was such that the then Government of South Australia (SA) sought the resignation of the Board chair and accepted the Chief Executive Officer’s offer to step down. The purpose of this quality review was to ‘make recommendations to ensure the quality, sustainability, and reputation of the state’s public vocational and education training provider’. The criticisms included

• Insufficient attention was paid to the impact on volume of delivery.

• The amount of training declined overall and costs per hour did not improve (in fact, the TAFE SA’s efficiency has steadily worsened since 2013).

• Most of the focus of an economy drive was on staff reductions, which could have been better targeted. Many high-cost staff left, there did not appear to be strategic consideration of how to realign organisational resources to improve efficiency and cater best to market demand.

• The governing board, in particular, lost sight of the importance of quality both as an end and as a means. The board’s single-minded focus on cost-cutting (and to a lesser extent, revenue generation) meant that quality issues were de-prioritised. Not only did this increase the risk of becoming non-compliant, it overlooked the need for TAFE SA to maintain a reputation for quality in order to compete effectively. The absence of a more balanced and strategic approach pointed to systemic issues. These weaknesses reflected in part the board’s leadership and positioning of TAFE SA under the then chair, who was seemingly insufficiently challenged by either his colleagues or the then TAFE SA chief executive officer (CEO). In terms of systemic issues, the roots of these problems lay in the articulation of TAFE SA’s strategy, and the governance arrangements as they pertain to the board and senior executives.

• On strategy, this report concludes that TAFE SA’s strategic plan ‘on paper’ was generally sound but was communicated and executed in a way that unintentionally downplayed the importance of maintaining quality and training output. Improving TAFE SA’s commercial performance was seen primarily in terms of an imperative to reduce costs.

• On the question of governance, board membership was unbalanced, the wrong structures were in place to effectively monitor risk to regulatory compliance and reputation, and performance metrics for executives were skewed. The most concerning finding, and an indicator of both the poor support provided to the Board and the limited sense of responsibility of its members, was that internal quality auditors (i.e. not financial auditors) had made discoveries similar to those later made by ASQA. They reported TAFE SA’s noncompliance ‘up the line’, but these internal audit findings revealing a high degree of exposure were not given proper consideration at either the executive or the board level. Several aspects of organisational effectiveness and efficiency went unattended.

• Resource alignment—there was an apparent skew towards more staff in corporate functions that emerged as a result of the voluntary redundancy process and the potential need to review the spread of responsibilities at senior levels. The implication is that relatively fewer resources were dedicated to quality teaching and assessment.

• Internal governance—responsibilities and accountabilities within TAFE SA seem unclear, delegations needed an overhaul, and the performance management system required improvement.

• Capability—there has been a commendable effort since December 2017 to upgrade the formal training and assessment qualifications of staff and provide more professional development, particularly with respect to assessment processes.

• Culture—this presents both an opportunity and a risk for TAFE SA. There is large contingent of highly motivated and loyal staff who want to help restore confidence in the institution of which they are very proud, but who have felt alienated from and unclear about the overarching strategy and role of TAFE SA in the wider system. They have also been inculcated into a culture of fixed rules and entitlements that arguably diminishes a sense of trust, responsibility, and ability to ‘lead from below’.

12.1.11 Controlling Ministries and Boards for Second-Level Organisations

There are different views on the appropriateness of boards to be responsible for overseeing the management of a second-level organisation. The lack of a board structure makes the controlling organisation management dependent entirely upon the most senior official (chief executive) of the second-level organisation. The advantage of a governing board is that it should be prepared to act independently of the most senior official. But it can only do this if the board includes independent experts, including the chairman. The advantage of independent experts is that they should be impartial and can bring an expertise to the oversight of the management of the second-level organisation. (Independent does mean ‘independent’ and that means no political or family or other types of relationship to other key government officials should exist.) This arrangement lessens the risk caused by the asymmetry of information existing between the second-level and the controlling organisation. The involvement of persons independent of the chief executive in the top-level decision making of the second-level organisation is a potentially very significant governance benefit! A board also provides in the second-level organisation governance structure a facility or feature able to challenge the chief executive of the organisation and therefore test out the plans, objectives, and assurances of that chief executive. This provides a degree of independent assurance to the controlling organisation.

However, appointing a board for every second-level organisation may not be appropriate where they are small or have a limited role (although this itself should raise questions about whether it is appropriate for such small second-level organisations to exist rather than their functions be undertaken directly by the controlling organisation), but for some and certainly for larger second-level organisations and especially for those that are commercially oriented the existence of a board would be entirely appropriate.

Where a board is created, particular attention should be given to its role, composition, and functioning. Governing boards should not interfere with the daily management of the second-level organisation. Their role is the strategic control and supervision of the organisation, that is, the oversight of the management. Many countries have taken initiatives to introduce corporate governance models to optimise the relationships between board and heads of second-level organisations. But corporate governance calls for a clear delineation of responsibilities between those responsible for daily management (the chief executive and operational staff) and the board. The board should be responsible for strategic decision making in terms of planning, overall budgetary envelopes, strategic tasks, reporting, and control of management. Board members should include persons with a range of expert knowledge, including in the subject matter of the second-level organisation activity, as well as in finance, and where appropriate commercial and legal expertise. The board should hold the executive head of the second-level organisation responsible not just for the quality and operational performance of the organisation but also for the way in which ethical and other control standards are introduced and applied. The existence of a board provides in practice a counterweight to the authority of the executive head of the second-level organisation and this reduces the chances of inappropriate action on the part of that executive head.

However, if a board structure is to be effective the board members should be appointed for their specific skills and this is especially important for the role of chairman. A risk that a ministry of finance and the PFM/IC driver department should be concerned about is that the appointments made to a board are simply made for political reasons, that is, to reward political friends and or to provide opportunities for rent seeking. Where such is the situation, the likelihood is that the board appointments will be entirely cosmetic and may well serve to disguise the reality of the power structures that exist.

An example of the responsibilities of board members is described in the Irish government publication on second-level bodies as follows¹⁴:

Principle:

Each State organisation should be headed by an effective Board which is collectively responsible for the long-term sustainability of the organisation.

Non-executive Board members should bring an independent judgement to bear on issues of strategy, performance, resources, key appointments, and standards of conduct.

Fiduciary Duty: All Board members have a fiduciary duty to the State organisation in the first instance (i.e. the duty to act in good faith and in the best interests of the State organisation).

The principle fiduciary duties are (NB the references to ‘company’ below, should be interpreted as to the ‘second-level organisation’):

• 1. To act in good faith in what the Board member considers to be the interest of the company;

• 2. To act honestly and responsibly in relation to the conduct of the affairs of the company;

• 3. To act in accordance with the company’s constitution and exercise his or her powers only for the purposes allowed by law;

• 4. Not to benefit from or use the company’s property, information or opportunities for his or her own or anyone else’s benefit unless the company’s constitution permits it or a resolution is passed in a general meeting;

• 5. Not to agree to restrict the Board member’s power to exercise an independent judgement unless this is expressly permitted by the company’s constitution;

• 6. To avoid any conflict between the Board member’s duties to the company (i.e. second-level organisation) and the Board member’s other interests unless the Board member is released from his or her duty to the company in relation to the matter concerned;

• 7. To exercise the care, skill, and diligence which would be reasonably expected of a person in the same position with similar knowledge and experience as a Board member. A Board member may be held liable for any loss resulting from their negligent behaviour; and

• 8. To have regard to interests of the company’s member stakeholders.

The arrangements described above in Sect. 1.7 designed to monitor the on-going performance of the second-level organisation would remain even with the existence of a board.

12.1.12 Audit and Second-Level Organisations

All second-level organisations should be subject to internal and external audit. External audit may be by the state auditor or could be both by the state auditor and by a commercial audit firm if the organisation is operating in the marketplace. Internal audit may be undertaken by either the second-level organisation’s own internal auditor or the internal audit of the controlling organisation. However, even where the second-level organisation has its own internal audit the controlling organisation still has an obligation to satisfy itself about the effectiveness of the control activities and therefore any agreement between the first and second-level organisations should provide for the controlling organisation internal audit to undertake its responsibilities on behalf of the management of the controlling organisation. External audit should also encourage, for larger and commercial second-level organisations the establishment by the organisation of its own independent oversight organisation through, for example, the establishment of an audit committee. In some countries there already is a requirement that audit committees or audit and risk committees should be established by both controlling and second-level organisations with authority to:

• Evaluate management strategy and operations.

• Oversee and co-ordinate financial audit work.

• Report to the board (where there is one).

To whom the external auditor should report will depend upon local circumstances but where a board has been appointed to oversee the activities of the second-level organisation, the external auditor should normally report to that board, rather than to the chief executive and the report should be available to the controlling first-level organisation. If the second-level organisation is managed only by a ‘head’ or ‘chief executive’ the external auditor should always report to the controlling organisation with a copy to the head or chief executive of the second-level organisation. Usually, the external auditor will also provide a ‘management report’. A question that each controlling organisation should consider is whether the external auditor should also be required to submit that management report to the controlling organisation.

Where responsibility for a service or activity is delegated to the private sector via a PFI-type arrangement that arrangement ought to include a recognition that the state external auditor should have access to assess performance under the PFI contract arrangements as well as ensuring that the PFI contract itself contains the appropriate range of controls and that those controls are being properly exercised.

12.1.13 Using ‘Performance’ as a Basis for Control

‘Performance’ ought to be used as one of the factors in the controls by the first-level organisation. The extent of the ‘performance’ information required will depend upon the service or activity in which the second-level organisation is engaged. The information required for managerial control purposes will also be different from that required for public accountability purposes and it will be more extensive.

Using ‘performance’ as a basis for control, places the focus heavily upon the drafting of the service-level or performance agreement and the results or outputs of a second-level organisation. However, ‘performance’ can be very difficult to define in precise terms for some organisations, and consequently some countries have combined input and output controls.

Service-level agreements should describe the basis for defining the financial and statistical information systems to be used. An example, would be whether a cash or accrual accounting basis should be adopted (and this will depend mainly upon whether the second-level organisation is engaged in commercial activities). For statistical reporting purposes, sometimes it may be appropriate to require the use of definitions developed by such recognised organisations as the World Health Organisation (WHO). The agreement should also specify which control bodies (e.g. external audit or some other regulatory agency depending upon the service being delivered) should be involved in measuring or checking performance where that is appropriate, as, for example, with some medical or educational performance.

Whether ‘performance’ can be defined also depends upon whether the objectives for the second-level organisation have been clearly defined and linked to budgets. Where objectives are difficult to define proxy indicators may need to be devised. For example, the performance of a second-level organisation responsible for improving health care cannot necessarily be precisely defined because almost every activity influencing healthcare, such a diet, housing, and lifestyle, would not be under the control of the management of a second-level organisation (or first-level for that matter). But it can take a range of actions designed to address specific areas of healthcare such as programmes of vaccination, encouraging residents to adopt less sedentary lifestyles, or healthier eating, encouraging the stopping of smoking, and such actions can be measured. This would mean that the controlling organisation, sets out more specific requirements than an overarching objective. These resulting performance measures though should be agreed between the controlling organisation and the second-level organisation and their impacts should be measured against objectives set by the controlling organisation. (The problems with using performance are discussed in more detail in Chap. 5.)

Because of these difficulties and sometimes the costs of obtaining detailed performance information for accountability purposes, the performance or service-level agreement should focus on the key performance information rather than try to incorporate every aspect of performance. However, for purely internal management purposes much more detailed performance information may be needed and especially given a requirement that an objective of management is to secure improvements in efficiency and effectiveness.

All these factors point to a need for a close management dialogue between the first and second-level organisation with the first-level organisation having the knowledge and capacity to set the performance standards and objectives it expects to be achieved, whatever the form of performance (i.e. financial and/or physical performance) and then having the capacity to monitor whether those performance objectives have been achieved.

12.2 Summary of Issues Concerning Second-Level Organisations and PFI-Type Schemes

The mere act of creating a second-level organisation, or of delegating responsibility for the delivery of a service or activity to the private sector via a PFI arrangement does not of itself guarantee improved performance (of whatever kind). Management action must be taken by the controlling organisation. PFI arrangements are usually entered into in order to bring forward investment activity, such as the advanced provision of a hospital rather than for any other reason. Autonomy alone for a second-level organisation is an insufficient condition to improve the quality of second-level management and performance. Improvements require constant vigilance by a controlling organisation to avoid the onset of management complacency and the pursuit by the second-level organisation of its own agenda. This is particularly true where there are no external incentives, such a competition, to drive improvements in performance, that is, in quality and in efficiency and effectiveness and no threat of operational financial risk.

An important feature of controlling organisation management of second-level organisations is that there should be consistency between the objectives and policies of the controlling first-level organisation and those of all second-level organisations. Controlling organisations should be organised in such a manner as to ensure this occurs. They should retain a capacity to set policy objectives for second-level organisations and a capacity to systematically review performance. The operational heads of controlling organisations (state secretaries or equivalent) should ensure that second-level bodies are well managed, have objectives and performance standards which are consistent with those of the controlling organisation, adopt internal control policies which are also consistent with those of the controlling organisation and that systematic monitoring arrangements are established.

In countries which have well established arrangements for PFM/IC the evidence is that there is active management of second-level organisations and this extends to regular reviews not only of performance but also to whether the need for a second-level organisations remain. Active management also asks questions about whether new second-level organisations should be established at all. Establishing them is not ‘cost free’.

An important element in establishing a managerial relationship between first- and second-level organisations is the existence of agreements between the two levels of organisation setting out what each is expected to contribute and to achieve as well as how monitoring will be undertaken. The agreements (performance or service level or an equivalent term) do not need to just exist but they should be actively monitored by the first-level organisation.

A usual stated reason for establishing second-level organisations is to improve efficiency and effectiveness. However, there is little evidence that such a benefit is achieved in many countries and with some arrangements challenge to the managements of second-level organisations is difficult to mount unless the conditions to do so are established from the outset.

Second-level organisations should be subject to both internal and external audit. The specific arrangements may depend upon whether the second-level organisation has commercial or non-commercial objectives. The fact that audit arrangements exist does not mean that the controlling organisation should not directly engage in its own monitoring activities or in some way modify them. However, it should be clear about the role of its own internal audit organisation and ensure that it has access to the external auditor’s report.

All second-level organisations should be expected to publish an annual report, a statement of internal control and financial statements.

Annex

12.1.1 Irish Government Agency Report Requirements

12.1.1.1 Chairperson’s Comprehensive Report to the Minister

• 1. The Chairperson’s report to the relevant Minister regarding the system of internal control. This statement should be reviewed by the external auditors to confirm that it reflects the audited body¹⁵‘s compliance with the requirements and is consistent with the information of which they are aware from their audit work on the financial statements. The external auditors should include their report on this matter in their audit report on the financial statements.

• 2. The Chairperson’s report to the relevant Minister should include a statement on the system of internal control in the format set out below and include, in cases where a breach of this system has been identified, an outline of the steps that will be taken to guard against such a breach occurring in future.

• 3. Outlining all commercially significant developments affecting the state body in the preceding year, including the establishment of subsidiaries or joint ventures and share acquisitions, and major issues likely to arise in the short to medium term.

• 4. The Chairperson’s comprehensive report should provide summary details of all off-balance sheet financial transactions of the state body that are not disclosed in the annual report and financial statements of the state body, including information on the nature, purpose, and financial impact of the off-balance sheet financial transactions. The contents and format of this section of the report should be agreed in advance with the relevant Minister/designated Departmental officials.

• 5. Affirming that all appropriate procedures for financial reporting, internal audit, travel, procurement, and asset disposals are being carried out. For example, details of and explanations for the disposals of assets or grants of access to property or infrastructure for commercial arrangements with third parties above the threshold of €150,000 which have not been subject to auction or competitive tendering process should be included.

• 6. Affirming that Codes of Conduct for the Board and Employees have been put in place and adhered to.

• 7. Affirming that Government pay guidelines on the pay of CEOs and all state body employees are being complied with.

• 8. Affirming that Government guidelines on the payment of Board members’ fees are being complied with. The Chairperson’s comprehensive report should also include a schedule of the fees and aggregate expenses paid to each of the Board members.

• 9. As part of the Chairperson’s comprehensive report, the Chairperson should affirm that the Government pay guidelines are being complied with in respect of such appointees who serve on the main Board and any subsidiaries of state bodies.

• 10. Explaining failure to comply with any of the above and stating any corrective action taken or contemplated.

• 11. Outlining significant post-balance sheet events.

• 12. Confirming that the appropriate requirements of the Public Spending Code are being complied with.

• 13. Confirming that procedures are in place for the making of protected disclosures in accordance with section 21(1) of the Protected Disclosures Act 2014 and confirmation that the annual report required under section 22(1) of the Act has been published;

• 14. Certifying that Government travel policy requirements are being complied with in all respects.

• 15. The Chairperson’s letter should include the confirmation that the state body has complied with its obligations under tax law.

• 16. Providing details of/information on legal disputes involving other state bodies.

• 17. Confirming that this Code has been adopted and the extent to which the state body is in compliance with the Code.

• 18. Stating that any subsidiary of the state body (or subsidiary thereof) continues to operate solely for the purpose of which it was established, remains, and continues to remain in full compliance with the terms and conditions of the consent under which it was established.

• 19. Along with the unaudited six-monthly financial statements, the Chairperson should also provide an interim report to the relevant Minister and, where appropriate, on significant commercially sensitive developments in the preceding 6 months and likely developments for the rest of the year.

• 20. The Chairperson should, in the comprehensive report to the Minister affirm adherence to the relevant procurement policy and procedures and the development and implementation of the Corporate Procurement Plan.

• 21. Non-competitive procurement should be reported in the Chairperson’s comprehensive report to Minister.

12.1.1.2 Statement on System of Internal Controls in a State Body

A statement on the system of internal controls in a state body should include the following items:

• 1. Acknowledgement by the Chairperson that the Board is responsible for the state body’s system of internal control.

• 2. An explanation that such a system can provide only reasonable and not absolute assurance against material error.

• 3. Description of the key control procedures tailored to reflect the size and complexity of the organisation in order to provide a full understanding of the procedures, which have been put in place by the Board, to provide effective internal control.

  • (a) A statement in relation to when the annual review of the effectiveness of control was conducted or where such a review was not conducted, a statement that it was not conducted.

  • (b) Disclosure of details regarding instances where breaches in control occurred—such breaches might include non-compliance with procurement rules or instances where other elements of the control system (e.g. internal audit, Audit and Risk Committee or other committees) were not operational.

  • (c) Disclosure of details of any material losses or frauds.

  • (d) Statement on System of Internal Controls is to be reviewed by the Audit and Risk Committee and the Board to ensure it accurately reflects the control system in operation during the reporting period.

  • (e) Statement on System of Internal Controls is to be reviewed by the external auditors to confirm that it reflects the audited body’s compliance with the requirements of paragraph 1.9 (iv) and is consistent with the information of which they are aware from their audit work on the financial statements and where this is not the case, the external auditor should report on this in the audit report on the relevant financial statement.

  • (f) the steps taken to ensure an appropriate control environment (such as clearly defined management responsibilities);

  • (g) processes used to identify business risks and to evaluate their financial implications;

  • (h) details of the major information systems in place such as budgets, and means of comparing actual results with budgets during the year;

  • (i) the procedures for addressing the financial implications of major business risks (such as financial instructions and notes of procedures, delegation practices such as authorisation limits, segregation of duties and methods of preventing and detecting fraud); and

  • (j) the procedures for monitoring the effectiveness of the internal control system which may include: Audit and Risk Committees, management reviews, consultancy, inspection, and review studies, the work of internal audit, quality audit reviews, and statements from the heads of internal audit.

• 4. Confirmation that there has been a review of the effectiveness of the system of internal control.

• 5. Information (if appropriate) about the weaknesses in internal control that have resulted in material losses, contingencies, or uncertainties which require disclosure in the financial statements or the auditor’s report on the financial statements.

• 6. The information relating to weaknesses in internal control should be a description of the action taken, or intended to be taken, to correct the weaknesses, or an explanation of why no action is considered necessary.

• 7. Confirmation that the state body is in compliance with current procurement rules and guidelines as set out by the Office of Government Procurement.

12.1.2 Irish Government: Model Shareholder Expectation Letter

Strictly Private and Confidential

SAMPLE LETTER TO COMMERCIAL SEMISTATE BODY FOR CORPORATE GOVERNANCE COMPLIANCE AND SHAREHOLDER EXPECTATIONS.

[On Letterhead of Relevant Line Minister]

Author’s Note: This is an illustrative example of a shareholder expectation letter setting out what typically should be included. Please note that the shareholder expectation letter should be tailored to meet the particular circumstance of the commercial State body.

[Date]

Intended Recipient:

Dear []

Introduction

The Minister for Public Expenditure and Reform and I have given consideration to the way in which Government objectives for [insert name of entity] are formulated and shared with the Board of Directors (the ‘Board’). Arising from that consideration, we are now proposing a more structured approach to confirming Government’s objectives for [insert name of entity] over the short and medium term with a view to assisting the Board in its operations and in complying with its obligations under the prevailing governance framework.

This letter is intended to provide guidance to the Board with respect to Government’s current objectives for [insert name of entity] and the primary considerations which will be taken into account in respect of matters for which consent may be required under legislation, [the entities Constitution] and/or the Code of Practice for the Governance of State bodies (the ‘Code’). We believe that this letter will be helpful to the Board, particularly in its corporate and strategic planning processes, and it is our intention that we would in future issue a similar letter on an annual basis.

The specific objectives outlined in this letter should be considered in the context of the Government’s overall policy objectives for [insert name of entity], namely that:

• [Insert name of entity] should continue to deliver on its corporate strategy, [including]

• [Insert name of entity] should maintain financial policies and a capital structure, taking account of future obligations (including pensions), that facilitate the payment of dividends to the Shareholder(s).

12.1.2.1 Dividends

It is our view that a new Dividend Policy, tailored to the specific circumstances of each commercial semi-state body, should apply in the commercial state sector, with a view to facilitating management in prioritising objectives and providing greater clarity on dividend payments over the medium term. We therefore request that the Board of [insert name of entity] would now develop a new formal dividend policy for [insert name of entity], which would take into consideration the following principles:

• (a) an appropriate balance should be struck between payment of dividends and reinvestment in the business; in this context it is the strong objective that a robust medium-term framework for the calculation of dividends be put in place which will reflect the imperative that [insert name of entity] remain strong financially and in a position to invest commercially whilst also delivering an appropriate return to the Shareholder(s);

• (b) the policy and its implementation should ultimately be comparable with peer companies within a period of 5 years, taking into account structural, ownership, regional and other relevant differences; and

• (c) the policy should also be related to an agreed proportion of cash flow as well as net profit after tax (NPAT).

In this regard, it is proposed that a list of appropriate peer companies be agreed between our respective Departments and the Board. A suggested list of peer companies is set out in Appendix II.

As indicated above, the objective of formulating a new dividend policy is to assist the Board by bringing clarity to the Government’s objectives as regards future dividend payments over the medium term, thereby avoiding the uncertainty created by special dividends potentially being requested from time to time. It may still be necessary or appropriate for special dividends to be paid from time to time (e.g. in event of sales of assets, windfall gains, etc.). However, to the extent that any special dividend is paid, it is our expectation that the likely impact of such payment on the policy would be reviewed at the time. We also believe that greater certainty on dividend policy will assist in enabling informed decisions to be made on financial management and investment, while providing an appropriate, regular, and predictable return to the Shareholder.

We ask that you engage with the Departments with a view to developing an appropriate new dividend policy, with a target of having this finalised no later than [deadline].

12.1.2.2 Return on Capital

A key focus for the Shareholder(s) in the commercial state companies is the return generated on capital invested. We propose to augment our monitoring and measurement of [insert name of entity] investment returns and in this regard Appendix [see below] includes financial performance measures in respect of profitability and investment return which we propose to use to assess company performance. While acknowledging that returns will vary from year to year, sometimes due to temporary or non-controllable factors, it is, however, a key Government objective that [insert name of entity] delivers investment returns over the relevant period that are in line with peer companies, while also having regard to the cost of capital.

This proposed approach to developing a perspective on shareholder return will be reviewed on an on-going basis and may be adapted as necessary.

12.1.2.3 Sectoral Policy Objectives

In addition to the overall policy objectives of [insert name of entity] listed above, we wish to ensure that [insert name of entity] continues to work actively to support general Government policy in the XXX sector [including … This will require an appropriate level of on-going investment by [insert name of entity], with care being taken to ensure that core areas of activity are prioritised within the resources available to the company for reinvestment.

12.1.2.4 Governance Arrangements

12.1.2.4.1 Corporate Plan

The Code of Practice for the Governance of State bodies (the ‘Code’) sets out the governance framework for the internal management, and the internal and external reporting relationships of commercial and non-commercial State bodies. As you know, the Code requires State bodies to prepare a rolling 5-year corporate plan, which should be submitted to the relevant parent Department within six months of the year end. We would propose to engage with you early on in the process of preparing/updating this corporate plan, in order that we can provide feedback to you on the plan in a timely fashion.

12.1.2.4.2 Reporting

The Business and Financial Reporting Requirements document, appended to the Code, sets out the reporting requirements to which State bodies should adhere, including the provision of interim and final financial statements. We would propose to enhance the existing reporting arrangements by introducing regular three-monthly review meetings between [insert name of entity] and the Departments, to review progress in relation to the financial performance measures referred to above (as set out in Appendix) and other key performance indicators.

12.1.2.4.3 Board Evaluation

Consistent with the requirement in the Code, we expect that the Board constantly reviews its own operation and performance and that of its committees and individual members and that the Board undertakes an evaluation of its performance on an annual basis.

12.1.2.4.4 Engagement

Our expectation is that you will engage with the Department in the near term to discuss the matters set out in this letter in more detail. Please make arrangements with your usual contacts in the Department.

Yours sincerely.

Minister for…

12.1.3 Financial Performance Measures

Shareholder Return

Measure	Calculation
Dividend pay out	1. Dividends paid/adjusted net profit after tax (prior year) 2. Dividends paid/net cash flow from operating activities 3. Dividends paid/(net cash flow from operating activities less capex)
Return on equity	Adjusted net profit after tax/average equity
Earnings growth	Compound annual growth rate in adjusted net profit after tax

Profitability/Efficiency

Measure	Calculation
Return on capital employed (ROCE)	1. Adjusted EBIT/average capital employed (EBIT = earnings before interest and tax) 2. adjusted EBIT/adjusted average capital employed

Wages & Salaries

Measure	Calculation
Average pay	Wages & Salaries cost/average no. of employees
Average pay incl. employer contributions	Wages & Salaries plus employer pension contributions/average no. of employees

Leverage/Solvency/Credit Metrics

Measure	Calculation
Gearing ratio (net)	1. Net debt/net debt plus equity plus minorities  2. Net debt/net debt plus pension liabilities plus employee related liabilities plus equity plus minorities
EBITDA interest cover (DA = depreciation amortisation)	Adjusted EBITDA/net interest payable
Interest cover	PBIT/net interest payable
FFO/debt (FFO = funds from operations)	Funds from operations/gross debt,
Financial covenant metrics	e.g., net debt/EBITDA, others

Definition of Key Terms Used in Calculations

Term	Definition
Adjusted EBIT	Earnings before interest and tax adjusted for exceptional items and IFRS fair value movements
Adjusted EBITDA	Earnings before interest, tax, depreciation, and amortisation adjusted for exceptional items and IFRS fair value movements
Adjusted net profit after tax	Net profit after tax adjusted for exceptional items and IFRS fair value movements
Adjusted capital employed	Net debt plus equity plus pension liabilities plus employee related liabilities
Capital employed	Net debt plus equity
Dividends paid	Dividends paid during the financial year per the cash flow statement (excl. special dividends)
Equity	Total shareholder(s) equity taken from the balance sheet
Funds from operations	Net cash flow from operating activities (post interest and tax paid and pre-working capital changes)
Gross debt	Interest-bearing debt such as loans, bonds, and commercial paper plus interest-bearing finance leases
Fair value adjustments	Includes unrealised fair value gains/losses on derivatives or all fair value gains/losses on derivatives where the entity does not separately identify unrealised items.
Net cash flow from operating activities	Taken directly from the cash flow statement—ensure interest paid is included
Net debt	Interest-bearing debt such as loans, bonds, and commercial paper plus interest-bearing finance leases less cash