Chart 1

Picture a country beset by burst sewers, "boil water" warnings, surging municipal debt, and discord on how to tackle these problems. Chances are you're not thinking of New Zealand. The antipodean island nation of waterways and mountains vaunts a clean, green image. But a years-long program to reshape the governance of water infrastructure in New Zealand now looks like a sinking ship.

A new National-led administration, elected in October 2023, promises to repeal its predecessor's signature Affordable Water Reform laws, which were rushed through parliament just months ago. Depending on what the government replaces them with, the abrupt reversal could add to recent downgrade pressure (see table 1 and chart 2) on the 25 councils we rate in New Zealand.

Councils face a trilemma of meeting higher water investment needs, reining in growing debt burdens, and keeping a lid on unpopular rates hikes. And proposals to simply shift council debt "off balance sheet," while maintaining council control of related assets, don't always stack up.

Table 1

Chart 2

From Gastro To Boiling Point

To understand why water is one of New Zealand's pressing public policy challenges, a refresher is crucial (see chart 3). Ownership and responsibility for New Zealand's "three waters" assets--drinking water, wastewater, and stormwater--sit primarily with 67 local councils. Two major reviews, the Havelock North Drinking Water Inquiry (2016-2017) and the Three Waters Review (2017-2019), both concluded that councils were struggling to maintain their ageing water infrastructure.

Chart 3

In response, the former Labour government initiated the Three Waters Reform program. It would strip responsibility for water management--including water-related assets, liabilities, revenues, expenses, and staff--from councils and amalgamate it into four new, publicly owned, statutory water services entities (WSEs) from 2024. This was to be the biggest shakeup of the local government sector since 1989.

In an election-year change of heart, the government later rebranded the program "Affordable Water Reform" and announced the formation of 10 WSEs rather than four (see charts 4 and 5).

Chart 4

Chart 5

Water Infrastructure Is Often Out Of Sight, Out Of Mind

Almost a quarter of New Zealanders receive drinking water that fails to comply with national standards (see chart 6). Several councils are forced to issue long-term "boil water" and "do not use" advisories as a result.

Chart 6

Nearly a quarter (73) of council-owned wastewater treatment plants operate on expired consents (i.e., regulatory approvals). Where consents are in place, regulation appears ineffective: in fiscal 2022, 412 non-conformances were reported but only 36 compliance actions were taken, according to Water New Zealand, an industry body. The average age of pipelines is about 33-37 years. Councilors often choose to "sweat" invisible, underground assets in favor of spending on popular above-ground facilities.

At some councils, asset replacement investment falls short of depreciation. This renewals gap is particularly big for stormwater (see table 2). And the shortfall is probably even greater than indicated in table 2 after factoring in recent upward revaluations of infrastructure assets, damage wrought by Cyclone Gabrielle, and under-delivery by councils relative to their budgets (see "25 Ratings In 25 Years: New Zealand Councils Prove Their Staying Power," published on RatingsDirect, Feb. 2, 2022).

Table 2

The cost to rectify these deficiencies is potentially huge. New Zealand needs to invest NZ$120 billion-NZ$185 billion (30%-47% of today's GDP) to maintain safe three waters infrastructure over the next 30 years, according to analysis commissioned by the former government from the Water Industry Commission for Scotland. (Note: these large sums are disputed. A competing analysis from consultancy Castalia, for example, found the government's assumptions "implausible".)

The former government judged that aggregating assets into new WSEs would result in economies of scale and better long-term planning. To finance the infrastructure deficit, the new WSEs would presumably be highly leveraged. They could be unconstrained by the debt covenants that the New Zealand Local Government Funding Agency Ltd. (LGFA) currently imposes on councils. Early modeling on the WSEs by the government assumed a debt-to-EBITDA ratio exceeding 9x over a 30-year horizon.

Institutional Settings May Be Under Pressure

New Zealand's council sector is already highly leveraged compared with municipal tiers of government in other advanced economies (see chart 7). And sectorwide debt is still rising. This is mostly due to a recent uptick in capital expenditure, by councils bringing forward water projects in anticipation of the Affordable Water Reform legislation or in response to natural disaster events.

Chart 7

In the absence of new policy to alleviate fiscal imbalances and restrain growth in debt, we may reflect the increased sectorwide risk by revising our institutional framework assessment (see "Institutional Framework Assessment: New Zealand Local Governments," May 17, 2023) down.

If we were to lower our institutional framework assessment by one notch to "2", this would prompt a roughly one-notch downgrade of rated councils, on average (see chart 8). We define the institutional framework to mean the set of formal rules, laws, practices, customs, and precedents that shape subnational governments' institutional arrangements and influence their policies in public finance.

Chart 8

The Affordable Water Reform Program Would Have Alleviated Debt…

Labour's reforms, if implemented, would likely have been credit positive or neutral for most councils. This is because most councils' three waters-related activities are more highly leveraged than their overall balance sheets. Relieving them of water-related debts therefore lowers their residual debt burdens. (The impact might vary depending on details of the debt transfer mechanism that were yet to be disclosed.) A handful of councils whose debt metrics worsen would theoretically receive "no worse off" grants as compensation.

As an aside, the Affordable Water Reforms shared some common elements with Social and Healthcare ("Sote") reform in Finland. Under its Sote reform, the Finnish government transferred revenues, expenditures, assets, and debts associated with healthcare and social services from Finnish municipalities to a newly created tier of government known as "wellbeing services counties" in 2023. This resulted in a higher relative debt burden for Finnish municipalities (see chart 7) but eased their future spending pressures.

…But It Became A Political Football

As Labour's reform program progressed, resistance hardened. Surveys by media outlets at the October 2022 local government elections revealed that an overwhelming majority of mayoral candidates, and newly elected mayors and councilors, were opposed (see chart 9).

Chart 9

This discontent climaxed with alternative reform plans put forward by Communities 4 Local Democracy (a lobby group of 30-odd councils) and the mayors of New Zealand's two biggest cities, Auckland and Christchurch, and a High Court challenge by a separate group of three councils.

Some of the objections are financial, but many are more political or ideological. The major recurrent arguments include:

• That water assets are "owned" by local communities and transferring them to WSEs amounts to unjust confiscation. (A subset of opponents also worries about the potential for creeping privatization.)
• That the proposed governance structure of the WSEs diminishes local voice. Regional WSEs might not prioritize the investments that ratepayers want and might not be held accountable in the same way elected councilors are.
• That proposed "co-governance" is socially divisive or undemocratic. Under co-governance, councils and Iwi (indigenous Maori people) are appointed to "regional representative groups" in 50:50 shares to help set WSEs' strategic direction.
• That councils with high-quality existing water assets will end up cross-subsidizing weaker councils that failed to properly invest in the past.
• That Labour may be overstating the proposed financial benefits or basing them on faulty assumptions. Economies of scale may not ensue, a risk exacerbated by the decision to establish ten entities rather than four.

The Next Phase Will Be Devolution And Evolution, Not Revolution

The Affordable Water Reform laws appear dead in the water. The new National-led government has promised to repeal them within 100 days.

What's next? There is bipartisan agreement on the need to retain Taumata Arowai as a water quality regulator. Beyond this, alternative plans are somewhat vague on how they would address the trilemma of bridging the water infrastructure deficit, reining in growing debt burdens, and keeping a lid on unpopular rates hikes, in our view.

National's pre-election "Local Water Done Well" manifesto would require councils to develop plans to meet new water standards, under monitoring from a new water infrastructure regulator. It also gives councils the option to form regional council-controlled organizations (CCOs) for water delivery. These CCOs would differ from the proposed WSEs in being voluntary and more tightly controlled by councils.

Draft legislation prepared by the Taxpayers' Union (and aligned to the Communities 4 Local Democracy model) contains some similar features. It calls for councils to shift drinking water and wastewater assets into subsidiary water companies (CCOs), with separate boards and separate financial accounts. Stormwater assets would be excluded.

Some politicians argue councils could raise debt "off balance sheet". This would presumably allow councils to finance massive new investment while remaining within LGFA covenants, self-imposed debt limits, or credit rating tolerances.

There is precedent here. A law passed in 2020, called the Infrastructure Funding and Financing Act, allows the establishment of special-purpose vehicles (SPVs) for financing and constructing infrastructure in high-growth council areas. The SPVs are wholly owned by a Crown (central government) entity. Under this scheme, SPV debts associated with Tauranga City Council's transport system plan and Wellington City Council's sludge minimization facility do not count toward our assessment of their respective councils' debts, though they count toward the Crown's.

However, we may not apply the same analytical treatment if future projects are structured in different ways. For instance, the counterproposal by the mayors of Auckland Council and Christchurch City Council called for lending from a new "Water Infrastructure Fund". It purported that these loans could be off balance sheet, without further explanation.

Balance Sheet Separation Is Oft Misunderstood

Would the Affordable Water Reforms have achieved balance sheet separation? A qualified "yes". But it isn't clear if the various counterproposals would, too.

"Balance sheet separation" or "financial separation" may mean different things to different stakeholders (see table 4 in the Appendix). The former Labour government wanted WSEs to be sufficiently independent from councils that they could borrow heavily, in their own names, without impinging on council credit quality. This meant that WSEs should not present either actual or contingent liability risks to councils. The government described this strong form of financial separation as a non-negotiable bottom line of its reform program.

Accountants may have their own definition. In a July 2022 submission, the Auditor-General noted that it was in ongoing talks about councils' level of influence and control over WSEs. The degree of accounting consolidation may in turn affect how councils are assessed against LGFA covenants.

In contrast, from a credit rating perspective, our measurement of a council's "tax-supported debt" usually includes the debts of any related entities (including CCOs) where we see a very high likelihood that the council will provide support in case of need.

For example, we already consolidate council-owned holding companies (e.g., Christchurch City Holdings Ltd. and WRC Holdings Ltd.), wholly-owned CCOs (e.g., New Plymouth Airport and Watercare), and funding arms (e.g., Dunedin City Treasury Ltd.). We consolidate all aspects of the balance sheet and cashflows, net of any intra-group transactions. Such consolidation is not necessarily credit negative. In situations where subsidiaries generate strong cash flows of their own, the debt-to-operating revenue ratio may in fact be lower at group level than at parent council level.

We typically do not consolidate commercial entities where councils don't possess a majority equity stake (e.g., Wellington International Airport Ltd. and Port Nelson).

Even in cases where we don't consolidate related entities, we may still treat their debts as contingent liabilities of councils. And, if these contingent liabilities become large enough or their risk of crystallization becomes great enough, we may apply a negative qualitative adjustment to our credit assessment (see "The Importance Of Contingent Liabilities: Low Probabilities But High Impacts," March 24, 2023). The former Labour government considered such an adjustment to be a deal breaker.

We assessed several hypothetical scenarios for the New Zealand government through our Rating Evaluation Service (RES) over 2021-2022. The outcomes of these RESs were released, in part, on the websites of New Zealand's Department of Internal Affairs and Treasury. For most (but not all) of the hypothetical RES scenarios presented to us, we determined that we would not count WSEs' debts toward councils' tax-supported debts, nor treat them as material contingent liability risks.

Breaking Up Is Hard To Do

What about the alternative reform plans? We would likely view a CCO where there is a high degree of political control or ownership, alongside a high level of indebtedness, as either part of its parent council's tax-supported debt or at least a material contingent liability. This would hold true even if the CCO is deconsolidated in an accounting sense. (Note: CCOs, by definition, are public companies where one or more local authorities hold at least 50% of the equity or appoint at least 50% of directors.)

On the flipside, if a CCO could somehow be formed 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 (see chart 10). Nor would it have access to LGFA.

Chart 10

Therein lies the rub. An entity can't 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. From the hypothetical RES scenarios presented to us in 2021, we determined that the proposed WSEs would have standalone credit profiles in the range of 'bbb-' (low investment grade) to 'bb+' (high speculative grade). Only in one scenario did the final rating on a WSE reach 'AA+', with credit uplift thanks to access to a liquidity facility from the Crown government.

One guiding consideration for assessing financial support may be clauses like section 166 of the Water Services Entities Act 2022. This section expressly prohibits councils from providing WSEs with any financial support, capital, or loans.

To be clear, the formation of water CCOs could still yield other benefits. These include sharper commercial discipline and delineation between activities so that every dollar of water investment needn't compete for internal funding against every other council service. Some councils already have CCOs for water maintenance or operational management, and these could be expanded to be asset owners, too.

In addition, subjecting water infrastructure to economic regulation might ensure that higher tariffs can be set free of political influence. Such regulation already applies to other network industries in New Zealand like electricity lines, and in several other countries. (At present, many councils charge customers flat rates for water services, and some lack metering that would even allow for volumetric pricing.)

What about economies of scale? Without the big stick of central government, the level of voluntary amalgamation of water assets into regional CCOs could vary dramatically across the country. And there may be little incentive for stronger councils to join with financially weaker ones, thereby failing to address the problem of infrastructure shortfalls in poorer pockets of the nation.

It's Uncertain If New Money Is On The Table

Apart from councils (or their CCOs) borrowing more or doing things more efficiently, another mooted solution is for the Crown government to flex its own substantial balance sheet and funding tools (see chart 11). The National manifesto, for example, hints at "limited one-off" funding for struggling councils during the transition phase.

Chart 11

In recent years we've observed a proliferation of time-limited, ad hoc funding schemes. These include the Provincial Growth Fund, Housing Infrastructure Fund, Infrastructure Acceleration Fund, and the Infrastructure Reference Group's shovel-ready grants program. The challenge for councils is that these contestable schemes take time and effort to apply for, and uncertain outcomes make budgeting difficult.

The incoming government has also talked up so-called city deals and regional deals. These are long-term, bespoke partnerships between different tiers of government, like those employed in the U.K. and Australia.

Again, the devil is in the detail. At its simplest, a city deal might be little different to the plethora of existing schemes where a council receives capital grants in exchange for unlocking development. Some city deals overseas have simply bundled up a shopping list of projects that were already in the planning pipeline. More innovative models might bestow on councils new funding tools, such as value capture mechanisms or "earn backs" of windfall tax revenue.

Without new funding tools, councils will remain heavily reliant on rates revenue. We regard rates as efficient and transparent. However, rates are also highly politically visible and less progressive than income taxes. Consequently, elected officials may be reluctant to lift rates in proportion to their growing spending needs. Operating margins compressed in 2022-2023 as cost inflation (as measured by CPI or by a widely used local government cost index) caught up to growth in rates (see chart 12).

Chart 12

Debt-Shifting May Equal Credit Quality Erosion

As one councilor quipped: everyone wants to get to heaven, but nobody wants to die. It ultimately isn't clear if whatever replaces Affordable Water Reform will allow councils to afford the necessary upgrades without recourse to ever-burgeoning debt. If debts (past and future) are merely shifted into entities that remain under the control of councils, local government credit quality may continue to erode.

We emphasize the distinction between our credit ratings and hard borrowing caps (see table 4). The desire by councils to retain strong credit ratings is merely a behavioral choice. In contrast, LGFA covenants and Local Government Act regulations firmly constrain borrowing by some high-growth councils that are already heavily indebted.

Some of the alternative reform options discussed in this report could result in weaker credit quality without necessarily affecting headroom under the official borrowing limits. But even if the average sectorwide rating of councils declines from its current level of around 'AA', it is still likely to remain high in a global context.

The next few months could be arduous for council officers. Many will need to draft their 2024-2034 long-term plans (LTPs) based on existing legislation passed by the former Labour government, while potentially preparing a second set of shadow plans to roll out in the event of repeal. It's possible that the new government pushes back the repeal date, extends the statutory deadline for the triennial LTPs beyond June 30, 2024, or later requires councils to publish an LTP variation.

Finally, we note that much of the public debate in New Zealand about water reform seems to overlook an uncomfortable truth: regardless of which body incurs the debt for new water infrastructure (whether it be local or central government, CCOs, water utilities, or even SPVs), the group of people responsible for servicing that debt is often overlapping.

You can't make dirty water clean by stirring it. Either ratepayers, taxpayers, levy-payers, or tariff-payers look set to face steeper bills in the future to address New Zealand's water woes.

Related Research

• The Importance Of Contingent Liabilities: Low Probabilities But High Impacts, March 24, 2023
• Pipedream Or Panacea: New Zealand's "Three Waters" Reforms Pt. 2, Feb. 28, 2023
• Pipedream Or Panacea: New Zealand's "Three Waters" Reforms Pt. 1, Feb. 28, 2023
• Institutional Framework Assessment: Finnish Municipalities, Dec. 14, 2022
• Credit FAQ: Lifting The Lid On New Zealand's "Three Waters" Reforms, Oct. 13, 2022
• Bulletin: Credit Implications Of New Zealand's Proposed "Three Water" Reforms, May 10, 2022
• Institutional Framework Assessment: New Zealand Local Governments, April 28, 2022
• 25 Ratings In 25 Years: New Zealand Councils Prove Their Staying Power, Feb. 2, 2022

Editor: Lex Hall

Digital Design: Halie Mustow, Evy Cheung

Table 3

Table 4