Water service entities will end up loading balance sheets with debt for projects that have nothing to do with core business, and everything to do with satisfying local political imperatives. Eric Crampton explains how taxpayers could wind up footing the bill.
Comment: Among the problems leading to the Government’s proposed Three Waters reforms were councils loading up their balance sheets with dubious debt.
So it seems odd that the Government plans on loading up the balance sheets of amalgamated water service entities with dubious debt.
The Government provided a lot of sweeteners to councils to encourage them to sign on to the water reform agenda. The first tranche of that 'better off' funding came from central government and has been covering all manner of community projects, from swimming pool upgrades to walking trails.
The second tranche of funding will have no greater tie to water infrastructure but will turn into debt that has to be paid off by the new amalgamated water providers.
So part of what got us into the current mess is being imposed on the new water service providers. It seems a rather bad idea.
Let’s recap.
Councils at or near their debt limits have enormous difficulty funding the infrastructure necessary to accommodate urban growth. Pipes that might live for 50 or 80 years are effectively required to pay themselves off over three years.
Why?
Suppose a council is at its debt limit, with debt at or near 280 percent of council revenues. Any new debt cannot exceed 2.8 times the annual revenue that comes from the infrastructure supported by that debt.
It is one of the underlying reasons for the housing shortage, and ongoing fights between central and local government. If it is too difficult for council to figure out how to cover the infrastructure necessary to enable either greenfield expansion or an upzoning, council will use zoning rules and consenting practice to prevent new development.
It didn’t have to be like this. Nobody forced councils to load up their balance sheets with debt for white elephant projects like convention centres and stadiums that can never hope to cover their construction cost. And nobody forced councils to underfund maintenance work for years, holding rates down and diverting rates revenue into vanity projects.
But now too many councils’ balance sheets are loaded up with financial debt while a more tangible kind of debt buried underground is coming due. Something had to give.
And so the Government proposed amalgamating council water assets into four large water service entities.
The new entities have incredibly complex governance structures, designed in part to make sure that the debt they take on will not be tied to council balance sheets. Without balance sheet separation, the debt would effectively be council debt. If councils would be likely to bail out a water service entity, if it came to it, council debt limits would still apply.
Convoluted governance structures and a Crown backstop guarantee should mean that the entities' debt does not turn into council debt. The water service entities, with clean balance sheets backed by water assets and revenues from water users, would be clear to take on debt to fund maintenance, renewal, and extension of water networks.
Except their balance sheets will not be quite as clear as we might have expected.
Last year, central government set two funding programmes to encourage councils to engage with the water reforms. 'No worse off' payments of $500 million were intended to make sure that councils weren’t left financially worse off after water service amalgamation. 'Better off' funding of $2 billion was set as investment “into the future for local government and community wellbeing, consistent with the priorities of both central and local government”.
Last week, the Waikato Times reported on a set of projects being proposed for funding through the 'better off' programme. The projects include a cycleway, social housing upgrades, a river walkway, a public art programme, passenger rail business case development, swimming pool renovations and more.
None of it has any relation to water infrastructure, but that wasn’t the point of the programme. It always had very broad objectives providing flexibility for communities to use the funding as they saw fit; the point seemed more to be about getting councils onside with the proposed reforms.
A bribe from central government to local councils is one thing - and perhaps justifiable if the reform programme made sense.
But there is a neat trick in the funding. $1.5 billion of the $2.5 billion comes not from the Crown, but from the future water service entities, which will end up carrying the debt.
Each council can apply for funding up to a maximum determined by its population, relative deprivation, and land area. And every council has rather strong incentive to apply for the maximum amount of funding.
It is a classic pork-barrel politics problem. The costs of 'better off' projects will be spread among water users across a very wide amalgamated area. If one council’s residents decided to be more cautious in their levels of spending, most of the benefits of their prudence would be enjoyed by water users in other parts of the amalgamated water area.
It would be like deciding to save money by having only a small meal while dining out with a large group that splits the bill evenly at the end of the evening. You wind up hungry while saving little.
If second-tranche projects had to be dedicated to improving water infrastructure so that councils could address specific water issues in preparation for amalgamation, debt financing through the water service entities might be justified.
But as is, those entities will open with the sin that contributed to the fall of the old model: loading up balance sheets with debt for projects that have nothing to do with core business, and everything to do with satisfying local political imperatives.
Standard & Poor's already warned that the water service entities will be aggressively leveraged and that the Crown’s backstop guarantee will matter considerably in their credit rating. Taxpayers more broadly could yet wind up footing the bill if a bailout proves necessary.
It seems an unnecessary risk and a poor precedent.
