A lack of quality information muddies analysis of New Zealand's water infrastructure reforms. The forecasts contained in the long-term plans appear overly optimistic, in our view.

What's also key is the creditworthiness of the body that funds New Zealand's local councils, the New Zealand Local Government Funding Agency (LGFA). Relieving councils of water activities may affect the credit ratings on the councils, and in turn that on the LGFA. We don't envisage this, but uncertainties abound, particularly around the transfer of debt.

A Costly Bit Of Plumbing

The background to the project indicates why it will have financial and rating implications. The New Zealand government (the Crown) pegged the cost of investment needed to fix the country's water systems and to build and maintain the infrastructure at between NZ$120 billion and NZ$185 billion over the next three decades--a colossal investment for which the Crown devised a potential solution known as "three waters."

To assess the potential effects of the reforms on credits rating we conducted a scenario analysis. Our analysis unearthed several key challenges. These include:

• Long-term plans and infrastructure profiles vary over time. This makes accurate financial analysis of the reforms difficult. To undertake the scenario analysis out to 2031 we were required to form a financial baseline from which to compare the financial impact of the reforms to. This proved challenging due to the questionable quality of financial forecasts within 2021-2031 long-term plans.
• The lack of information on critical elements, such as the transfer mechanism. Importantly, this element could have rating consequences.
• The creditworthiness of the LGFA is what really matters to the sector.
• Someone must pay, and it will always be residents. While general property rates and council targeted charges are likely to be lower under the reforms, overall costs for New Zealanders will be much higher given the perceived scope of investment required.
• Amalgamation debates could reignite as some councils will forgo many of their responsibilities.

Long-Term Plans And Infrastructure Profiles Vary Over Time

Financial forecasts in long-term plans rarely come to fruition. While the trend and themes may persist to some degree, profiles and financial strategies within long-term plans change regularly. Nevertheless, to undertake our scenario analysis, we required a baseline from which to illustrate the relative impact of reforms, so we used the long-term plans as a starting point.

To undertake this analysis, we have attempted to build baseline forecasts to 2031 based on long-term plans. In our credit ratings, our bespoke base case spans two to three years into the future to ensure better visibility.

We consider long-term plans as a baseline for the direction of councils. Plans, however, regularly change. Long-term plans are updated every three years with the next iteration due by June 30, 2024. Changes can occur because of a deliberate decision of the council (such as changing the timing or scope of projects), unforeseen events (such as natural disasters or the pandemic), or simply optimistic planning. In any case, it means broad-based financial analysis of the sector is difficult, particularly beyond the next two to three years.

Too Rosy A Forecast

The key reason behind these variations is optimistic planning, in our view. The delivery of annual capital expenditure (capex) undershoots budgets by 20%-30% each year on average. Unspent capex is then reprofiled to future years. These carryforwards are, in many cases, simply added to future budgets, which in turn drives them higher. Because of this, we believe financial outcomes in the first two to three years of long-term plans will be better than the long-term plan forecast.

In contrast, in outer years capex budgets are ratcheted up to account for carryforwards and new projects, which means financial outcomes beyond the next two to three years can be worse than forecasts in long-term plans.

Other factors that affect long-term plans and forecasting include:

• Proliferation of various government schemes such as Crown Infrastructure Partners, Infrastructure Financing and Funding, Housing Infrastructure Fund, Freshwater Improvement Fund, and shovel-ready grants during the pandemic, to name a few.
• Changes in standards by the Crown that impose additional spending on councils.
• Except for Auckland Council, plans are only published at parent council level--there is little publicly disclosed long-term planning for council-controlled organizations.
• While the above paragraph around optimistic planning is generally correct, sometimes councils will add big new projects between the long-term plan cycle, which require new community consultation via a long-term plan amendments.

As highlighted in part one of our scenario analysis, a consolidation of long-term plans of the councils rated by S&P Global Ratings indicates that councils were planning to rein in their deficits and pay down debt over the period 2026-2031. We challenge this trend and believe it is overly optimistic. This is because councils regularly increase their capex budgets in each successive long-term plan, driving debt higher.

Structural Deficits And A Steady Rise In Debt

Improving financial outcomes at the consolidated level is rare given the high indebtedness of the country's largest councils. When including capex, the New Zealand local council sector runs large, structural deficits compared with many systems globally. This has led to a steady rise in debt relative to operating revenues, despite large general property rate increases, and the promise of long-term plans to improve trends.

This is despite increased focus in the past decade to improve the reliability and accuracy of long-term plan forecasting. For instance, the Crown introduced new reporting requirements, such as 30-year infrastructure strategies and financial benchmark reporting. Many councils have doubled, if not tripled, capex plans in the first two to three years of a long-term plan even though the 30-year strategy shows no such investment or large new projects. This casts doubt on the quality of long-term plans and infrastructure planning of some councils.

While our scenario analysis assumed council policies and investment decisions would remain consistent with the 2021-2031 long term plans, we expect infrastructure profiles for non-water activities to change. This is because of planning delays and the addition of new projects once councils relinquish responsibility for water activities.

The handover would obviate the need for councils to invest in maintenance and upgrades of water assets, which are pressure points in many council budgets. Councils with favorable movements in budget and debt metrics would need to decide whether to explore new projects that aren't budgeted for or pass the savings to ratepayers in the form of lower increases in rates, or rate reductions.

In the long-term plans, councils assumed they would retain ownership and management of water-related assets for the life of the plan given the uncertainty around the reforms in 2021. Councils also knew, however, that the reforms could relieve them of all water-related debt. We believe there are instances where this has incentivized councils to accelerate water projects or "gold plate" some projects.

We've seen further examples of this in 2022-2023 Annual Plans. Should the reforms proceed, these councils know the new water services entities (WSEs) will bear the ultimate cost. Further, it would be difficult for the new WSEs to change the timing or scope of these projects if they begin before July 1, 2024.

LGFA Creditworthiness Matters For Councils

How the reforms affect the LGFA is crucial. The LGFA is the key borrowing authority for New Zealand local councils. All councils with material levels of debt borrow via the LGFA. Many borrow solely via the LGFA with the main exceptions of Auckland and Dunedin. Therefore, the credit rating on LGFA is what matters to them.

The LGFA credit rating is related to the underlying creditworthiness of the councils. This creditworthiness comprises both its loan book and are joint-and-several guarantors of the LGFA's own obligations. A weakening of the average council rating could have consequences for the LGFA. While our analysis didn't envisage this across the sector, there remains substantial uncertainties including the transfer mechanism.

The Debt Transfer Conundrum

The debt transfer mechanism poses a further complication for the LGFA. On one hand, it could affect the credit rating on individual councils as outlined in part 1. This is especially the case if it results in water-related debt being transferred over a longer period than water-related revenues.

It may also expose the LGFA to the creditworthiness of the new WSEs if the LGFA lends to the WSEs. We understand no decision has been made around this yet, and that several steps would still be needed to effect such a change, including a vote by the LGFA's shareholders to amend its policies.

Equally however, immediate repayment from councils of their water-related debts to the LGFA could present challenges in managing significant liquid assets, interest rate risk, and maturity mismatches. While councils can repay the LGFA early, if the LGFA agrees, the LGFA is unable to repay its investors.

The LGFA may be able to conduct some early buybacks of bonds, but we believe it would be more likely to gross up its liquid assets under this scenario. If WSEs become members, the LGFA may opt to lend these funds to the WSEs instead.

Pressure For Amalgamations Could Rise

The draft Review Into The Future For Local Government notes capability, capacity, and funding constraints, particularly for smaller councils. It argues there are areas for potential collaboration that can harness both local agility and scale efficiencies. If the Crown adopts this, it could make smaller councils nervous, especially once key water responsibilities shift to WSEs.

Investment in transport and water assets are the largest items in a territorial authority's capex program. Water assets alone represent about 40% of the average council's planned capex between 2025 and 2029. For some councils this is more than 50%. Therefore, councils are likely to become smaller once the reforms commence. Councils that are already small face the risk of further contraction or indeed questions over their long-term viability.

Other delivery areas, particularly regulatory functions, are resource-intensive with little obvious need for variation across neighboring councils. If the local government sector is to leverage scale efficiency, it could cast doubt on the need for 78 local councils, especially at the smaller end.

Chart 1

New Zealanders Will Pay No Matter Who Delivers The Infrastructure

We believe there has been too little scrutiny of the affordability of the perceived NZ$120 billion-$180 billion investment in the three waters reforms. Attention has instead focused on ownership and co-governance. One key benefit from the Crown's perspective is that the reforms should relieve councils of water responsibilities and reduce pressure to increase annual general property rates--a hot topic long before the reforms were envisaged.

No matter who delivers the required infrastructure, the cost of such investment is astronomical. If councils fund the investment, general property and targeted rates will likely soar to record levels. If WSEs fund the investment, water charges will likely soar instead.

The Crown argues that WSEs will benefit from efficiencies of scale and will better prioritize the required investment than councilors with short-term horizons governed by elections. Opponents argue the benefits of efficiencies of scale are overstated and could occur in other ways (e.g., through smaller regional council-controlled organizations).

In either scenario, there is no free lunch, and New Zealanders face much higher costs to fund this investment no matter who delivers it.

Related Research

• Pipedream Or Panacea: New Zealand's "Three Waters" Reforms Pt. 1, Feb. 28, 2023
• Credit FAQ: Lifting The Lid On New Zealand's "Three Waters", Oct. 13, 2022

Editor: Lex Hall

Designer: Halie Mustow