There will be winners and losers under New Zealand's "three waters" reforms. For some local councils, no longer having to manage and pay for drinking water, stormwater, and wastewater infrastructure will lighten the debt load. For others, handing control to four publicly owned "water service entities" or WSEs may crimp operating margins and increase debt-to-operating ratios.

A two-part S&P Global Ratings scenario analysis finds that up to 18 credit ratings could change between now and 2027. The key driver of this trend is not the reforms but rather financial forecasts in the long-term plans. Only three credit ratings would change under the reforms.

Plumbing The Problem

New Zealand's water infrastructure isn't up to scratch. On that the country's political parties agree, even if they haggle over the way to fix the situation. Our two-part report highlights key findings and trends from a high-level scenario analysis of the reforms on the 25 local councils we rate in New Zealand.

We base this scenario analysis on public information and a wide range of assumptions. An information void means we have made assumptions surrounding the revenues, expenses, assets and liabilities that will be transferred, the timing and mechanism of the transfer, and stranded overheads. Some of these are outlined in the appendix and in part two.

We have public credit ratings on about one-third of New Zealand's 78 local councils. These councils account for 83% of the loan book of the New Zealand Local Government Funding Agency (LGFA) and 78% of the country's water-related debt. Our rated portfolio includes two regional councils--Bay of Plenty Regional Council and Greater Wellington Regional Council--which don't generally deliver water services.

Greater Wellington, unlike many regional councils, has some responsibilities for water activities. We nevertheless exclude Greater Wellington from our analysis because the underlying information provided by the Department of Internal Affairs doesn't cover the council. This makes it difficult to forecast the impact of the reforms.

Some Key Assumptions

We have modeled the potential impact of the three waters reforms compared with policies and infrastructure budgets outlined in the 2021-2031 long-term plans. Importantly, this scenario analysis assumes the transfer of all water-related activities including revenues, expenses, assets and liabilities (such as debt) to WSEs on July 1, 2024.

It also assumes councils do not use the financial relief provided by the reforms to simply increase spending and infrastructure elsewhere thereby altering their long-term plans. In many cases, the analysis assumes debt relief (cash settlements) received by councils are immediately used to repay borrowings.

The hypothetical outcomes that this simplified analysis generates should not be construed as S&P Global Ratings' view of the likely future scoring or ratings trajectory; rather, they illustrate the potential impact of the reforms on councils' financials after applying a large set of assumptions.

Many Winners, Some Losers

Our scenario analysis shows that the three waters reforms are likely to improve financial outcomes relative to the status quo. Our analysis begins with councils' published 2021-2031 long-term plans. These long-term plans indicate that councils were already planning to rein in their deficits and pay down debt over 2026-2031. The structural improvement is particularly apparent in New Zealand's two largest councils--Auckland Council and Christchurch City Council.

While we consider financial forecasts of the long-term plans unlikely to occur to the degree presented, we use the long-term plan figures simply as a baseline from which to illustrate the relative impact of reforms.

Our view that 18 credit ratings could change between now and 2027 is based on the financial forecasts in the long-term plans, not the reforms. We find that trends presented in long-term plans could result in up to 15 credit ratings improving, all else constant. This analysis assumes liquidity, economic, and financial management assessments were unchanged.

In contrast, we find only three credit ratings would change purely because of the reforms. Of these, one credit rating could weaken, without "no worse off" funding.

All of this could see the average credit rating for New Zealand councils to improve to 'AA+' from 'AA' today. A word of caution on these findings: about half a dozen of these potential rating improvements are borderline; in some cases ratings may not improve.

Chart 1

We indicate the potential winners and losers, from solely a financial perspective, of the reforms (see chart 1). We compare the movement in key financial ratios under the reforms against the status quo. The scenario analysis finds that many councils will be better off from the reduction in debt and lower capital expenditure (capex) requirements. Many, however, will have narrower operating margins because of the reforms (see chart 2).

Fiscal Implications: After-Capital Account Deficits Could Improve As Infrastructure Burden Ease

Water Activities Equal Robust Margins

Our scenario analysis finds that across the board operating margins are likely to remain very strong on a global scale following the reforms--albeit about 15%-20% lower than without the reforms. This is because water activities are more profitable. In other words, they generate a higher margin than other services provided by councils such as roading, regulatory, and economic activities. For nearly 90% of councils we rate, operating margins from water activities are larger than the operating margins of other activities.

Across our rated portfolio, water-related activities account for 21% of operating revenues and only 17% of total operating expenditure. Our analysis shows only Whangarei District Council and Horowhenua District Council's operating margins would meaningfully reduce under the reforms.

Chart 3

The balance after-capital account (BACA) is our estimate of the underlying borrowing needs of a council. Our analysis finds that the initial improvement in after-capital account deficits from the reforms could be short-lived, appearing to last for about three years (see chart 4). This is because water-related capex in long-term plans rises to about 40% of total capex during this period from 30% in 2024. The key reason the improvement in this measure doesn't appear to be structural is because the loss of water-related capex for councils is offset by the large loss of water-related operating margins.

Chart 4

Still, there are variations across the sector. Closer examination reveals some councils are likely to be better off whereas some are much worse off (see chart 5). The biggest winner would be Palmerston North City Council. This is because it is likely to shift its yet to be built wastewater treatment plant--Nature Calls--which could cost several hundred million dollars--to one of the water services entities.

In contrast, the after-capital account deficits of Whangarei and Horowhenua are likely to be much worse off. This is in light of the previous findings that their operating margins are likely to suffer more than other rated councils. Interestingly, Wellington City Council's deficits are likely to widen substantially in the first few years before improving relative to the long-term plan toward the end of the decade.

Chart 5

Combining the outcomes of both weakening operating margins and improving after-capital account deficits could, under our criteria, shift budgetary performance assessments of up to 11 councils once the reforms take place in 2025.

Our modelling shows that seven councils could reduce their after-capital account deficits sufficiently to improve their budgetary performance assessment. Four could see a meaningful increase in these deficits, which may weaken their budgetary performance assessment. The remaining 12 councils are unlikely to experience a meaningful change in their fiscal outcomes.

It is unclear at this stage if the changes will last. Looking out to 2027, it appears the initial benefit of the reforms will ease, with only three councils likely to retain stronger budgetary performance than under the status quo. Meanwhile, three could also maintain weaker budgetary performance over this timeframe. The remaining 17 councils are unlikely to experience a meaningful change in their fiscal outcomes. This is consistent with chart 6.

Chart 6

Our findings do not fully incorporate the "no worse off" funding arrangements of the New Zealand central government (the Crown) because the timing and amount of such cash flows is not yet clear. We believe a large share of this funding will go toward Whangarei District Council and Wellington City Council to offset some of the weakness we have identified.

Our analysis finds that following the reforms, some councils' after-capital account deficits will be much higher. The inclusion of these capital revenues should improve the initial after-capital account position of some councils; however, these funds are unlikely to structurally benefit the recipients from a budget perspective.

Local Councils To Remain Highly Leveraged

Our analysis shows high debt levels are likely to remain a key vulnerability of the local council sector. This is despite the reforms potentially reducing the overall leverage of the sector, which will provide some additional headroom at the current rating levels. It is only toward the end of the long-term plan forecasts that the sector's debt materially declines (see chart 7).

We estimated the entire council sector's debt, including council-controlled organizations, was about 180% of operating revenues in 2022. Rated councils are even more leveraged given only councils with a certain amount of borrowing seek credit ratings.

We estimate debt levels of our rated portfolio will climb to about NZ$25.7 billion or 230% of operating revenues in 2024. About NZ$7.75 billion of this is water-related. The leverage of the rated portfolio is skewed because four key borrowers--Auckland, Christchurch, Wellington, and Hamilton--have very high debt burdens set to average 245%. These four councils account for more than 75% of our rated portfolio's debt.

Water assets tend to be more leveraged than other council assets. Therefore, offloading them to water services entities should improve the sector's debt measures. Across our portfolio, we estimate water-related debt will be about 325% of water-related operating revenues in 2024, when the reforms are set to take place.

On a global scale, the debt of New Zealand's local councils is an outlier relative to similar rated systems. The sector's weakness is offset by strong predictability, including the process surrounding key reforms, and very high standards of disclosure and transparency.

Chart 7

Debt remains high on a global scale, but there will be winners at an individual council level. As stated above four key borrowers account for 75% of our rated portfolio debt; therefore, the remaining 19 councils within this analysis only account for 25% of debt.

Our analysis finds that the handover of water assets would reduce most, but not all, councils' debt-to-operating revenue ratios. That is, if all debt and revenues are transferred on day one. On average, the reforms would provide additional debt capacity compared with long-term forecasts equivalent to about 25% of a council's annual operating revenue.

Under our scenario, 15 of the 23 councils' debt burden assessments could improve whereas two could be weaker, without offsetting "no worse off" funding (see chart 8).

Chart 8

An Uneven Debt Load

The proportion of total debt related to water assets is uneven across the sector (see chart 9). In 2025, we forecast, based on long-term plans, water-related debt to make up anywhere from 0%-80% of a council's total debt. Changes in the debt burden metric reflect several things:

• The initial debt burden relative to our thresholds (i.e., councils with debt at the lower end of our thresholds, say 130%, are likely to receive a larger improvement in their assessments than councils at the top end of our threshold, say 230%)
• The proportion of debt related to water assets; and
• The proportion of operating revenues in water-related activities.

Chart 9

Councils with lower debt-funded water assets or higher proportions of water-related revenues are likely to incur weaker debt burden assessments because debt-to-operating revenues rise under the reforms. This is the case with Whangarei and Wellington, whose debt rises substantially relative to operating revenues after the reforms. Whangarei has chosen to fully fund its water assets and therefore has no debt associated with them.

Crucially, these findings do not incorporate the full "no worse off" Crown funding. This funding should counter some, if not all, of the weakness identified here from a debt perspective, especially for Whangarei, which is slated to be a key recipient of "no worse off" funding.

The effect of the reforms on interest expenses is not material. Given the reduction in debt, our scenario analysis estimated that interest costs would be between 0.7% and 1.1% of operating revenues lower under the reforms. This is assuming councils can access capital markets at the same rate with or with the reforms. This would see average interest costs, relative to operating revenues, across our portfolio remain within the 5%-10% threshold in our criteria.

The Transfer Mechanism Is Crucial

Our analysis assumes all water-related activities including revenues, expenses, assets and liabilities occur on July 1, 2024. If this wasn't the case, outcomes could differ greatly. Any mismatch between the timing of debt and revenue transfer would likely inflate gross debt metrics during that period.

Chart 10 shows the difference in debt-to-operating revenues if the transfer of revenues, expenses and assets occurred on July 1, 2024, while the transfer of debt was delayed. Consider a scenario whereby debt was retained by local councils while revenues were vested to water service entities. Such a situation would likely weaken individual councils' debt assessments, potentially the credit ratings, and even our view of the sector's creditworthiness via the institutional framework.

Chart 10

We understand from draft legislation that as part of transitional arrangements, allocation schedules will be prepared to transfer assets, liabilities and other matters relating to water service delivery. Water assets and the accompanying revenue streams identified in these schedules will be vested in the WSEs on the establishment day. However, there may be flexibility in the debt transfer. Councils and the relevant WSE must individually agree to a payment schedule for water-related debt.

Muddy Waters

A dearth of quality information muddies analysis of the "three waters" reforms. On the surface, the reforms appear to accelerate underlying improving trends in 2021-2031 long-term plans; however, we believe financial forecasts within existing long-term plans are rosy. Lack of detail on critical elements such as the transfer mechanism clouds the picture. What really matters to the sector is the New Zealand LGFAs' creditworthiness. We examine this in part two.

Appendix

Related Research

• Credit FAQ: Lifting The Lid On New Zealand's "Three Waters" Reforms, Oct. 13, 2022

Editor: Lex Hall

Designer: Halie Mustow