Napier is one of several councils that have acknowledged a need to dramatically increase their investment in Three Waters infrastructure. Photo: Supplied

When Malcolm Alexander was appointed chief executive of Local Government NZ in 2012, he was almost immediately struck by how the regulatory settings for water infrastructure were significantly behind similar network industries.  

He had previously worked in electricity and telecommunications infrastructure. “I worried – rightly, as it turned out – that the incentives to invest in, and maintain, water networks were poor.”

Voters and politicians “pilloried” local councils for quite modest debt levels, he says, failing to acknowledge that inter-generational debt should be used to fund inter-generational assets.

He worried that if the problem wasn’t fixed, any significant problem might cause a knee-jerk reaction – or as he puts it, vast government over-reach. “Then Havelock North happened.”

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The Havelock North campylobacteriosis outbreak in 2016 was traced to contamination of drinking water supplied by two council bores. About 5500 of the town’s 14,000 residents were estimated to have become ill; 45 were hospitalised and at least three died. This, in a developed nation.

While at Local Government NZ, Alexander had begun work to move the Three Waters sector into a standard utility regulation model, like power companies. But he says there was little interest from the Government, its officials or the sector.

It was only after Havelock North happened that the Government suddenly sat up and paid attention. According to a ministerial briefing obtained by Newsroom, Bill English’s National-led Government commissioned preliminary work to address wider system-level issues with water supply, wastewater and stormwater systems. When Labour was elected to Government in 2017, Internal Affairs officials warned its incoming minister that the recommendations would be “wide-ranging and controversial”. 

That proved to be an understatement. Unable to corral all 67 city and district councils into the big regional water providers that were believed to be necessary, the Labour Government abandoned its voluntary approach in 2021, in favour of its compulsory four-entity model.  

“I don’t care what it is called but I want the assets off the councils and into a new organisation, with the quality and price regulation in our model.”
– Chris Bishop, National Party

Councils mutinied and 33 of them (Christchurch, Dunedin and Queenstown Lakes have since left) set up a grouping in opposition, named Communities 4 Local Democracy. They contracted Malcolm Alexander to lobby for a locally controlled Three Waters solution.

But the critical problem is that for the vast majority of councils, investment in water infrastructure has fallen well behind depreciation and population growth. Most will struggle to play catch-up and get their water supplies and wastewater services up to the standard demanded by new regulation, post-Havelock. Their alternatives are to raise rates or water charges (Auckland Council says charges will have to double) or borrow heavily.

Despite the Labour Government increasing the number of entities from four to 10 this year, to ensure greater local control, many councils remained unhappy. The National Party campaigned against “seizure of local assets” and promised to restore council ownership and control.

Now, it’s crunch time. Christopher Luxon promises to repeal Labour’s water reforms in his first 100 days as Prime Minister – but he and his advisors must come up with an alternative that is also acceptable to the Act Party and New Zealand First, and to as many councils and ratepayers as possible. 

National’s Local Water Done Well policy pointedly avoided making any commitments about restraining increases to water charges or slowing borrowing – but Luxon and his ministers won’t want to go into the next election being blamed for massive hikes to water charges.

As more and more councils climb closer to their hard debt ceiling (290 percent of revenue) contracted with the Local Government Funding Agency, an incoming National-led government wants to move the assets off ratepayers’ books.

Councils’ net debt to revenue ratios

Labour discovered that's very difficult without sheeting the liability to taxpayers as effective guarantors – that's why the previously Government trod such a fine line in setting up its 10 new incorporations.

National too, despite its criticism of big regional entities, acknowledges it's preferable to put the assets in entities separate from council. At its heart, that's much the same strategy as that pursued by Labour, but without the compulsion that first provoked the council blowback.

National's policy says: "It is our expectation that most councils will choose a model that gives them the ability to access long-term borrowing, where the cost of infrastructure investments can be paid down over the life of the asset rather than funding them from existing revenue. This is widely accepted as the best-practice approach to financing long-term infrastructure of this sort."

It depends on individual councils – but National's infrastructure spokesperson, Chris Bishop, likes the council-controlled organisation model, owning the water assets and charging ratepayers for their use, controlled by one or more councils.

He draws a contrast with the example of Wellington Water, where six councils have set up a regional organisation but retained ownership of the assets, debts and revenues. "I don’t care what it is called but I want the assets off the councils and into a new organisation, with the quality and price regulation in our model," he tells Newsroom.

"Wellington Water exists now and they pretend it’s a council-controlled organisation but Hutt Council owns its pipes, Upper Hutt owns its pipes, etc." 

Given the tight timeframe National has set itself, it has been canvassing for alternative models that can be enabled by new legislation to replace the laws passed by the last Parliament. 

It is understood such a solution as that described by Bishop would be broadly acceptable to key councils including Auckland. And Christchurch mayor Phil Mauger says he too is looking forward to sitting down with the new Minister, once they are settled in. "We have got to make sure we keep investing in these vital services, so balancing that need with the cost paid by ratepayers is key to any model," he tells Newsroom. "That’s still the big challenge, regardless of who is looking after the pipes."

National emphasises the status quo is not sustainable, in which every council independently runs its own Three Waters infrastructure. But National has allowed itself more than just the 100 days to draft replacement legislation, by challenging councils to deliver a plan for how they will transition their water services to a new model that meets water quality and infrastructure investment rules, while being financially sustainable in the long-term.

There are three that broadly fit within the policy principles upon which National campaigned: a framework designed by economic consultants Castalia on behalf of Communities 4 Local Democracy; a finessed version developed by Malcolm Alexander and a technical working group commissioned by the Taxpayers' Union; and a regional model championed by five Hawkes Bay councils.

All three return the decision on the new structure to local authorities; all three propose a degree of regional collaboration to best-use local expertise and achieve economies of scale; and all three contemplate placing assets in the ownership of council-controlled organisations.

The Hawkes Bay model is an asset-owning council-controlled regional organisation, in partnership and co-design with Māori underpinned by the Treaty of Waitangi. 

The Castalia model offers councils five years to meet water quality and economic regulation; if they're not able to do that on their own, it offers alternative pathways for councils to choose between – either regional merger or collaboration, or outsourcing to a specialist services provider.

The Alexander model proposes stand-alone water entities, each controlled by one or more councils. With a consumer-based monopoly, Alexander says these should be able to raise debt easily. This model would transfer just the drinking water and wastewater assets – the stormwater assets would stay with councils.

All three models acknowledge the importance of better regulation, and to that end, would embrace the new Taumata Arowai water quality regulator the Labour government established.

They also support an economic regulator run out of the Commerce Commission, that would ensure water entities were run in a financially sustainable manner and imposed fair water charges. That was passed into legislation in the final days of the last Parliament, but it's likely some changes would be required for it to regulate council-controlled companies rather than Labour's 10 big water incorporations.

These models and the incoming government's vision for Three Waters do raise several critical questions. These are difficult challenges around whether the assets should be shifted from councils to the ownership of council-controlled organisations, about the need for balance sheet separation from councils, and about using alternative financing in place of council borrowing, such as public-private partnerships, revenue bonds or the new Infrastructure Funding and Financing Act.

Because, as almost everybody acknowledges, the status quo is not sustainable.

Balance sheet separation

For former Prime Minister Jacinda Ardern, balance sheet separation was a bottom line. She and her local government minister Nanaia Mahuta accepted officials' advice that with councils hitting their borrowing limits, the only way to raise the necessary capex for water assets (and to free up councils to build roads and libraries) was to separate the two.

Many councils resented this blanket approach; they argued that different councils faced different challenges. Some like Whangārei said they owned their water treatment plants and reticulation networks debt free; by transferring the ownership to independent entities they would lose the revenue off assets they owned, without the new entities taking on any of their debt.

The Government argued all councils would be freed of the fiscal constraint and risk of debt (new or old) needed to build and maintain water networks. And indeed, that balance sheet separation was the only way New Zealand could provide the investment needed.

That is moot. Malcolm Alexander and Castalia managing director Andreas Heuser both point to alternative structures like the 20 elected energy trusts that own some of the country's electricity distribution networks on behalf of local consumers and communities. They say those provide an example of how community ownership of water assets can be retained, separate from councils.

Heuser says that's an option – but he also argues it's not always necessary to separate the balance sheets, because the capital cost is far lower than Internal Affairs officials and consultants had projected – most councils can afford it through rates or water charges, or through borrowing.

That depends on one's definition of balance sheet separation.

Internal Affairs relied on the rating agency S&P Global Ratings' definition, which sources says is narrowly correct but unnecessarily conservative. S&P provides ratings for 25 councils; its competitor Fitch provides ratings for eight councils. There's an argument that councils could loosen the borrowing constraints simply by switching to another agency like Fitch, which does not necessarily consolidate all subsidiary debt up to the council that owns the crown-controlled organisations.

Fitch declines to comment for this article, while New Zealand is between governments, but S&P Global Ratings analyst Martin Foo is willing to discuss the different meanings and impacts of balance sheet separation.

Foo says part of the confusion is that 'balance sheet separation' and 'financial separation' mean different things to different stakeholders.

"The former Labour government wanted its proposed water services entities to be sufficiently independent from their council owners that they could borrow heavily, in their own names, without impinging on council credit quality," he explains.

"Accountants may have their own definition of balance sheet separation. But from a credit rating perspective, our measurement of a council’s 'tax-supported debt' will include the debts of any related entities (including council-controlled organisations) where we see a very high likelihood that the council will provide support in case of need."

In other words, if they get in trouble, creditors expect the council will bail them out; water services are too big to be allowed to fail. As examples, S&P already consolidates council-owned holding companies like Christchurch City Holdings and WRC Holdings, and wholly-owned council-controlled organisations like New Plymouth Airport and Auckland's Watercare, in the financial metrics of their parent councils.

"Even in cases where we don’t consolidate related entities, we may still treat such entities as contingent liabilities of councils. And, if such contingent liabilities become large enough or their risk of materialisation becomes great enough, we may reflect this through a negative qualitative adjustment to our credit assessment."

"We are completely transparent about the modelling and assumptions in our work, and happy to share spreadsheets with government agencies."
– Andreas Heuser, Castalia

On his initial reading of alternative proposals from Communities 4 Local Democracy and the Taxpayers’ Union, Foo says S&P might view a proposed water council-controlled organisation (whether owned by one or more councils) where there is a high degree of political control or ownership, alongside a high level of indebtedness, as weighing on the credit quality of its parent council or councils.

So structurally separating the organisation from the council doesn't give either a get-out-of-jail-free card; each may still be constrained by the other's borrowing. That's why, for instance, Watercare is warning that Auckland's water charges may have to double – because the parent council is so indebted that Watercare can't borrow to upgrade assets like the aged sewer that has collapsed in Parnell.

On the flipside, Foo says, even if a water organisation could theoretically be established in a way that restricts control, ownership, or financial support from parent councils, it’s unlikely to be able to borrow as cheaply as councils, and nor would it have access to borrowing from the Local Government Funding Agency. That's because the agency, by design, can lend only to local councils or to council organisations that are "explicitly backstopped" by local councils, in the form of a guarantee or uncalled capital.

"Together, these points highlight a fundamental tension at the heart of the reforms," Foo says. "An entity is unlikely to borrow on terms as competitive as the government (central or local) can, unless, well, it’s part of the government – or at least backstopped by the government. It is difficult to disentangle ownership of water-related assets from ownership of water-related debts."

Capital costs of renewal

If balance sheet separation is difficult or impossible to achieve, is there any other way councils on their own can retain control of their water assets and pay for their upgrade and renewal over the next 30 years?

That's a cost that the Water Industry commission of Scotland (consultants to Internal Affairs) projected to be $120 to $185 billion dollars.

Engineering firm Beca, asked to peer review the Water Industry Commission's work, said if anything that number was conservative – and that projection was thought by officials to have risen even further with accelerated cost escalation, and the loss of efficiencies of scale by moving from four entities to 10.

Rubbish, says Heuser, Alexander, the National Party, and many mayors and councils. They – and some senior figures involved in financing council assets – believe the $185b to be enormously inflated, and to be working from an assumption that future infrastructure could be gold-plated.

"I think the $185b number was definitely inflated ... I don't think it would have reached anywhere near the levels being being stated by central government."
– Kirsten Wise, Napier mayor

It's difficult to know what they base their scepticism on. Councils, after all, have insight only into the renewal needs of their own water assets, not the other 66 councils. And both Alexander and National have cited Heuser when they say the necessary capex is far lower.

So it all comes back to Heuser's work. He argues that the actual capital investment needed is (just) $97b – and that at that lesser level, councils can finance it off their balance sheets, without raising water charges or breaching their debt ceilings.

Again, if balance sheet separation is so difficult to achieve through transferring the water assets to a council-controlled organisation, then the only way these new alternative models can be made to work is if the incoming government believes Heuser's argument that the necessary capital expenditure is manageable within council balance sheets.

Given that the Water Industry Commission's numbers use, as a starting point, infrastructure renewal projections collected by Internal Affairs from the 67 city and district councils, what makes Heuser think his numbers are better?

He essentially reverse engineers the commission's calculations, and concludes that nearly half the $185b would not be spending, but would be savings on spending otherwise required. If the four entities could make those savings, he argues, then so too can the councils through mechanisms like council-controlled organisations.

He says his Communities 4 Local Democracy model could finance the actual capital expenditure the government claims is necessary for the first 20 years, without changing any settings. 

"Castalia’s simple financing model uses the same capex profile for councils, using the same assumptions as the Water Industry Commission for investment timing, population growth, local government debt cap, interest rates and opex," his model says.

"We assume that a debt cap of 2.8 times council revenue applies for the 30-year period (as it currently does under Local Government Funding Authority covenants). We also assume that the government’s commitment of $2.5b toward councils (so-called 'better off funding') is made available to councils to invest in water investments.

"This is a better use of scarce public funding for the water sector than the government’s current proposal to permit councils to spend the $2.5 billion on any matter."

(It's worth noting that the previous Government has already withdrawn $1.5b of that Better Off funding, most of which was to have been borrowed against the water assets; Heuser's model would require the incoming Government to reinstate it).

Heuser's report says: "The Castalia modelling assumes no changes to water rates/charges. If water rates/charges were increased at a modest 0.6 percent per year, the Water Industry Commission claimed $97b capex would be financeable under the Communities 4 Local Democracy model without changing council debt caps for the whole 30 year period."

Given that so much depends on them, are his numbers credible? "We are completely transparent about the modelling and assumptions in our work, and happy to share spreadsheets with government agencies," he tells Newsroom.

One mayor who does think the $185b is overblown is Kirsten Wise, from Napier City Council. And her analysis meaningful, because Internal Affairs officials cited Napier as an example of a council that had reassessed its early infrastructure projections, and concluded the council would need to spend more.

Napier mayor Kirsten Wise says councils are facing across-the-board cost escalations – but nowhere near the extent projected by Internal Affairs officials. Photo: Supplied

Napier City Council carried out a comprehensive revaluation of its infrastructure assets as at June 2020. This resulted in a 66 percent increase in the replacement costs of its pipes from $555m to $919m. And since there, there has been significant additional capital price inflation. 

The Water Industry Commission compared Napier's projected capital expenditure with the cost efficiencies it could achieve as part of a bigger grouping. "Even if the top of the range of investment for Napier City is halved, there is still no chance that the average cost per household is less than the worst possible outcome under the amalgamated entity,” it said, in advice submitted to Parliament last year.

Wise says Napier's revaluation is a wake-up call about the amount of capital investment needed. "It really is. And it's not just water infrastructure, it's across the board. We, like any other sector or industry faced with ever-increasing costs, have to find ways to fund it."

And yet, even she doesn't agree with the Water Industry Commission's $185b projection.

"I think the $185b number was definitely inflated," she says this week. "And acknowledging that what we had originally been forecasting ourselves will have changed now – but I don't think it would have reached anywhere near the levels being stated by central government.

"What you'll find is that most councils, like us, are in the process of actually reassessing their expenditure position, particularly in light of the fact that with the incoming government, we've been provided with an opportunity to approach them with alternative models."

To that extent, even as a critic of the previous government's reforms, she acknowledges one important benefit of the past three years' detailed Three Waters work. "The reforms being led by central government have ensured that councils all over the country have gone through their own process," she says.

"We need to ensure that we're having that conversation with accurate information. So we should, at a national level, have a much clearer picture of what that total cost across all councils looks like, in the very near future."

Newsroom Pro managing editor Jonathan Milne covers business, politics and the economy.

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