Part 3: Watercare Services Limited

Local Authority Governance of Subsidiary Entities.

301
Watercare Services Limited (WSL) was established by the then Auckland Regional Services Trust (the ARST) in 1991 as a LATE. An amendment6 to the Local Government Act 1974 (“the Act”) dissolved the ARST, and transferred all the shares in WSL to six Auckland local authorities with effect from 1 October 1998.

302
WSL is a limited liability company responsible for providing bulk drinking water and wastewater treatment services to the Auckland region. It is the largest bulk water and wastewater company in New Zealand, owning and operating assets with a combined replacement value of over $2,000 million dollars. These assets include dams, treatment plants, water mains, reservoirs, pump stations, and sewers. The company’s principal customers for the supply of bulk water are the six shareholding local authorities (or their agents).7 It treats wastewater for four local authorities and over six hundred commercial customers.

303
We outline the governance framework for WSL and then focus on two elements –

  • the discharge of ownership obligations by the shareholding authorities; and
  • WSL’s key business processes –

before making some overall comments and recommendations.

The Governance Framework

304
The governance framework for WSL is largely determined by legislation. The Act sets out general statutory accountability requirements for LATEs. As amended in 1998, the Act also:

  • includes specific governance and accountability provisions for WSL; and
  • places additional obligations and constraints on WSL’s operations and on the roles and functions of the six shareholding local authorities.

305
The most significant accountability requirements for WSL are:

  • WSL must “manage its business efficiently with a view to maintaining prices for water and wastewater services at the minimum levels consistent with the effective conduct of that business and the long-term integrity of its assets” (section 707ZZZS of the Act);
  • WSL is not permitted to pay a dividend to its local authority shareholders; any surplus must be either re-invested in the business or distributed to its customers; and
  • WSL must, each year, prepare and submit to each shareholder indicative asset management and funding plans. In preparing its draft SCI the company must consider any written submissions on those plans.

306
The most significant obligations and constraints for the six shareholding local authorities are:

  • they are not permitted to sell or otherwise dispose of their shares in WSL;
  • they must, in their capacity as owners, act in the best interests of those who live in the Auckland region; and
  • they must enter into an agreement outlining the process to be followed in appointing directors to the board of WSL, setting their terms of office and remuneration, and specifying how they will approve:
    • the SCI for WSL;
    • any major acquisitions by WSL; and
    • the distribution of surpluses by WSL to its customers.

307
WSL’s shareholders are shown in Figure 1 (on page 39), and its governance framework in Figure 2 (also on page 39).

Figure 1
Shareholders of Watercare Services Limited

Local Authority Shares
No. %
Auckland City Council 108,551,635 41.7<
Manukau City Council 65,481,895 25.1
North Shore City Council 29,988,909 11.5
Papakura District Council 9,667,225 3.7
Rodney District Council 3,602,651 1.4
Waitakere District Council 43,400,849 16.6
Totals 260,693,164 100.0

Figure 2
Governance Framework of Watercare Services Limited

Figure 2.

308
The then Government intended WSL’s governing legislation to be a temporary arrangement pending a proposed governmental review of water and wastewater services in New Zealand. The present Government has not, as far as we are aware, taken up that proposed review. However, the six Auckland local authorities decided late in 1999 to undertake their own review of water, wastewater and stormwater services in the Auckland region. The review group expects to report in 2001.

Ownership Obligations of the Shareholding Local Authorities

309
We expected that ownership arrangements in relation to WSL would have the following features:

  • a framework which fosters effective decision-making;
  • an effective process for the appointment and remuneration of the governing body;
  • a process for consultation on the SCI; and
  • an effective means of monitoring WSL’s performance, and of holding the board to account.

A Framework which Fosters Effective Decision-making

310
The shareholding local authorities’ relationships with each other are governed primarily by:

  • the Act;
  • a Shareholders’ Agreement, approved by the Minister of Local Government in December 1998; and
  • WSL’s constitution, to a very limited extent.

311
The interests of the shareholding local authorities are represented by a Shareholders’ Representative Group (SRG) to which each local authority sends two representatives, usually councillors. While the allocation of votes among the six shareholders gives the larger local authorities greater voting power, equal representation of each shareholder on the SRG, in theory at least, gives each an equal voice.

312
Our review of SRG documentation indicates that the group has been well aware of the various objectives it must try to reconcile in performing its functions. In May 1999 the SRG considered and endorsed the recommendations of a paper from its advisers which outlined the following range of objectives facing it:

  • as investors, to increase the value of the company by maximising profits;
  • as representatives of and advocates for the residents of Auckland (the ultimate consumers of WSL’s services), to ensure that WSL provides high quality, healthy and reliable services, and minimises its prices;
  • as advocates for the interests of the community, to allow WSL to make reasonable (but not excessive) profits while minimising its costs and carrying out its activities with minimal impact on the environment;
  • as owners of the direct retail customers of WSL8, to encourage the company to provide high quality services and minimise its prices;
  • as potential future competitors, to ensure that the company does not act anti-competitively; and
  • as environmental guardian for the region, to ensure that WSL’s activities have minimal impact on the environment and promote conservation.

313
An Officers’ Working Group (OWG), on which each shareholder is represented, serves a similar co-ordinating function at officer level. The Auckland City Council services the OWG.

An Effective Process for Appointment and Remuneration of the Governing Body

314
The Act establishes principles for the selection and appointment of directors. The Shareholders’ Agreement outlines the agreed recruitment and appointment processes, including:

  • a process for reviewing the knowledge, experience, and skills of existing directors;
  • preparation of a job description for directors;
  • recruitment advertising; and
  • systematic short-listing procedures.

315
In 1999 the SRG developed a list of competencies for WSL directors and engaged consultants to carry out an evaluation process to:

  • review those competencies;
  • develop a process for reviewing directors; and
  • carry out the review.

316
We expect that the evaluation will:

  • serve as a sound basis for appointment processes in the future; and
  • provide a means of assurance that the board comprises the appropriate mix of competencies and is working together well.

A Process for Consultation on the SCI

317
The legislation outlines how the SCI is to be prepared, consulted on, and finalised, giving the shareholders and the board the opportunity to:

  • reach a mutual understanding of each other’s interests and objectives; and
  • reach agreement on the strategic direction of WSL.

318
In considering the board’s draft SCI, the shareholding local authorities need information and analysis from which to determine their own interests and priorities. The OWG provided the information and analysis to the SRG, and this information gave the SRG a framework to evaluate WSL’s draft SCI for 1999-2000. In an April 1999 report to the SRG, to assist it in assessing the board’s proposed SCI and funding plans against its own interests and perspectives, the OWG outlined:

  • possible high-level objectives for WSL;
  • processes by which the shareholders’ objectives might be incorporated into WSL’s SCI; and
  • how performance targets might be developed to support those objectives.

319
In the process of consultation on the content and format of the SCI, fundamental differences in perspective between the parties were exposed. A series of communications took place between the board and the SRG, and between WSL management and the OWG. The SRG examined the document in detail and:

  • analysed the company’s proposed capital expenditure programme, asset management plans, and funding plans;
  • reviewed WSL’s forecasts and assumptions;
  • modelled the impact of funding options; and
  • on the basis of that analysis, encouraged WSL to make a number of amendments to the content and emphasis of the document.

320
The consultation process thereby served a valuable purpose in identifying areas where there was a lack of clarity about the governance framework, and in providing an incentive to seek solutions.

An Effective Means of Monitoring WSL’s Performance and Holding the Board to Account

321
WSL supplies a range of information to the SRG in a variety of ways. First, as required by the SCI, WSL provides the SRG with:

  • asset management plans for its water and wastewater businesses;
  • funding plans for its water and wastewater businesses;
  • half-yearly and annual reports; and
  • an environmental report.

322
Correspondence from WSL to the SRG included a significant volume of additional information sought by the shareholders (including financial models, funding options, and capital expenditure projections).

323
The SRG also receives quarterly management reports from WSL, which are analysed by the OWG. These contain:

  • an assessment of financial performance for the quarter;
  • operational information;
  • schedules of capital expenditure;
  • summarised progress reports on individual capital projects; and
  • explicit reporting against SCI reporting targets.

324
The OWG raises questions to be addressed by WSL when the company presents these reports to the SRG at quarterly briefings.

325
Formal reporting by WSL to its shareholders is complemented by informal communication between the chairpersons of the SRG and WSL, and between local authority officers and WSL’s senior managers.

326
The SRG has taken steps to hold WSL to account for its cost structures; for example, by seeking evidence of the reduction of operating costs over time. We endorse this approach. The SRG has also sought independent audits of the major capital projects managed by WSL.

327
WSL has responded to demands for a cost control regime in various ways. For example, in its SCI the company makes commitments to:

  • a range of cost minimisation targets; and
  • quarterly reporting on participation in an appropriate performance benchmarking and information disclosure regime.

Key Business Processes

328
We identified the following business processes as particularly relevant to governance arrangements:

  • asset management planning;
  • funding and pricing mechanisms;
  • the relationship between WSL and its customers; and
  • cost-efficiency considerations.

Asset Management Planning

329
The Act makes asset management a central function for WSL. Demand for water will increase as population growth and economic development continue in the Auckland region. New infrastructure will be needed for wastewater collection and treatment to:

  • cater for continued growth and urban intensification;
  • meet the requirements of the Resource Management Act 1991; and
  • meet public expectations for a cleaner environment.

330
In response to demand projections for the region, WSL had approximately $500 million of capital expenditure planned for the following five years. WSL has adopted a 20-year period for asset management planning, identifying projects required to:

  • cater for growth;
  • meet changing customer service and environmental standards; and
  • provide for asset renewal and replacement.

331
Core functions of the WSL board include:

  • approval of the asset management plan;
  • monitoring capital expenditure; and
  • oversight of major capital projects.

332
The asset management plan provides the basis for a credible financial plan and the framework within which WSL will design and build the necessary infrastructure to meet desired levels of service. Accordingly, the Act requires WSL to submit an asset management plan to each shareholder and to consider any submissions made on that plan in preparing the draft SCI. In this way asset planning is integrated into the accountability relationship between the company and the shareholders and, through them, with the public.

333
While under no obligation to do so, WSL makes a copy of its asset management plans available to its local authority bulk water and wastewater customers, recognising the potential efficiencies from joint planning.

Funding and Pricing Mechanisms

334
The funding plan draws directly on the capital and operating expenditure outlined in WSL’s asset management plans, showing:

  • how those assumptions translate into revenue requirements;
  • how prices and charges have been calculated at an aggregate level; and
  • a range of possible pricing profiles into the future.

335
The SCI, the asset management plan, and the funding plan are designed to determine the approach WSL must take in setting its prices.

336
The funding plan is based on a range of assumptions – all of legitimate interest to any owner – about the timing of capital expenditure, levels of gearing (the debt/equity ratio), and target rates of return. Both the Act and the nature of WSL’s business as an infrastructure manager make scrutiny of the funding plan a central role for the shareholding local authorities.

337
However, the parties did not share a common view on the manner in which consultation should be undertaken. Confusion over the roles and responsibilities for funding and pricing decisions have led to disputes between WSL and its shareholders and customers. We discuss the implications of unclear roles and responsibilities below.

The Relationship Between WSL and Its Customers

338
We found that there were very different understandings of the roles of WSL and its customers in the price-setting process. In our view, these differences gave rise to a dispute over WSL’s right to include in its prices a margin for a return on equity.

339
In our view, WSL’s customers can reasonably expect WSL to consult them on:

  • tariff structures, explaining its proposed pricing policies and considering comments on them;
  • delivery standards;
  • incentives to manage end-user demand;
  • security of supply; and
  • other contractual matters.

340
The local authority customers have the overriding goal of securing – for their end-user consumers, the residents of the Auckland region – an optimum mix of quality, security and value.

341
The Act provides for WSL to set its charges after consulting the shareholding local authorities on its asset management and funding plans. These matters were discussed with the shareholders and reflected in the company’s SCI.

342
Having consulted its shareholders, however, WSL was drawn into further negotiations with its customers in the second half of 1999. At issue were a similar set of pricing matters concerned with the funding plan, capital expenditure projections, and the target return on equity.

343
We examined records of the negotiations between WSL and the local authority customers or their agents. We also examined exchanges between the shareholding local authorities and the company over a number of months in 1999.

344
The documentation indicates that the SRG was aware of the need to keep the local authorities’ interests as shareholders separate from their objectives as customers. However, there is a fundamental tension between the dual roles of local authorities as customer and owner. The lack of a comprehensive and clear formal contract between the local authorities as customers and WSL as supplier has heightened this tension.

345
The local authorities are faced with the following conflicting influences:

  • their dual roles as owners and customers, which give rise to tensions between short-term and long-term objectives; and
  • statutory prohibitions on WSL paying a dividend and on the local authority shareholders disposing of their shares. Together, these provisions are likely to weaken the normal incentives for a shareholder to enhance the value of the company, or to seek an adequate return on their investment.

346
Inevitably, choosing pricing paths to achieve given revenue requirements involves trade-offs among profitability, service levels, and the timing of capital expenditure. Particular conflicts arise between, on the one hand, a short-term focus on prices and, on the other, the urgent need for long-term infrastructure investment.

347
At the time of our study, WSL and its local authority customers had begun discussions on a protocol to clarify the relationship between the company and the local authorities in their conflicting roles as customers and shareholders. In defining agreed principles underlying the governance relationships between the parties, the protocol represents a valuable opportunity to clarify the roles and governance responsibilities of each party.

348
Records of contract negotiations show that WSL had sought a long-term contract with its local authority customers to secure a degree of certainty about future income streams in order to meet the costs of its substantial capital expenditure programme. However, uncertainties about WSL’s future and the planned review of the water industry have weakened the incentives for the parties to reach agreement, despite extensive discussions.

349
The commercial service relationship is defined simply by an historical operating agreement. The relationship between WSL and its local authority customers would be placed on a more solid footing by a comprehensive long-term contract incorporating initiatives such as options for demand management and risk-sharing.

Cost-efficiency Considerations

350
A monopoly supplier can be regulated by a comprehensive disclosure regime using accepted industry benchmarks and consistent targets against which to compare relative efficiency. In the absence of such requirements, a monopoly supplier has the potential to exploit its position in various ways. Possible monopolistic behaviour includes:

  • overstating demand and inflating the capital expenditure needed to meet that demand;
  • inflating asset values as a basis for driving up prices;
  • hiding costs;
  • failing to pass operating and capital efficiencies on to customers; and
  • making inefficient choices about the mix of funding sources (principally retained earnings, borrowings and equity) to finance operational and capital expenditure.

351
In its capacity as a single supplier of essential services, WSL should be able to demonstrate that it runs its business in an efficient manner. As noted in paragraph 305, the legislation requires WSL to manage its business efficiently. Business processes that promote efficiency encompass:

  • transparent information disclosure;
  • cost benchmarking;
  • a sound and effective contractual relationship with customers; and
  • an agreed and well-understood process for setting prices.

352
The Act promotes transparency through, for example:

  • the requirement for asset planning and funding documents; and
  • the requirement that WSL cost its water and drainage services separately.

353
Our analysis of documentation and correspondence between the SRG, customers and WSL indicates that WSL has responded positively to demands for information.

354
Assurance of cost control, and operating and capital efficiency, requires:

  • regular flows of comparative information prepared on a consistent basis; and
  • industry-specific measures for evaluating trends in service levels and unit costs.

355
Customer agreements provide for some disclosure of operating costs, and opportunities for cost and price minimisation have been discussed between WSL and its shareholders.

356
The records reveal a reluctance on the part of the local authority customers to enter into the long-term contract sought by WSL. Their reluctance arises from a desire that a contract should be sufficiently flexible to enable the parties to take advantage of changes to legislation and industry structure. In our view, the weak incentives for the parties to enter into arrangements which are in the best long-term interests of end-users are likely to be perpetuated by:

  • continuing uncertainty about the contractual relationship between WSL and its customers; together with
  • a lack of clarity about their respective roles and responsibilities.

357
Documentation also revealed apparent confusion over the roles of shareholders and customers in the negotiation of WSL’s prices. Revenue requirements, and thereby pricing paths, are set through a process prescribed in the legislation. This process entails consultation between the company and its shareholders on the content of the asset management plan, the funding plan, and the SCI. These three documents provide an agreed strategy and direction for WSL over the following year.

358
WSL’s pricing negotiations with its customers, however, reflected a confusion of local authority roles between those of shareholder and customer. The local authority customers raised issues, including:

  • the level of WSL’s budget surplus;
  • the rate of return component underlying WSL’s pricing profiles; and
  • the level of WSL’s retained earnings.

359
The negotiations reflect ongoing tensions between the roles of the parties and the need for a shared understanding of price-setting processes within the broad legislative framework.

Conclusions and Recommendations

360
Our analysis points to inherent tensions in governance arrangements. Tensions in the relationships between WSL and the local authorities in their dual roles of shareholder and customer arise from:

  • Confused roles and responsibilities, leading to competing incentives for the local authorities as shareholders and as customers.
  • Expectations about the manner in which WSL will conduct its operations. WSL is expected to follow a corporate commercial model, applying business disciplines to management of infrastructure, but also to adopt a pricing regime which has regard to a range of public interest considerations.
  • A governance framework which precludes the shareholding local authorities from pursuing the normal interests (value maximisation for potential sale and a dividend stream) of commercial owners.
  • Weak incentives for cost efficiency and limited measures for benchmarking performance given the single supplier status of the company.

361
The Act recognises these tensions. It requires the local authorities to exercise their ownership rights in the public interest. At the same time, it preserves a commercial structure (other than the restrictions on dividends and selling out) to the extent that the governing body of WSL has the usual powers and rights of a company board along with significant powers to set prices.

362
Structures and ownership throughout the water industry create the potential for similar tensions over pricing and investment issues. We identified a need to manage the competing interests inherent in the current governance arrangements for WSL. To date these arrangements have generated incentives and behaviour that present obstacles to the long-term resolution of these underlying tensions.

363
WSL operates under legislation that was intended to be temporary. The previous Government’s proposed review of the water industry in New Zealand has not made significant progress. Uncertainty about the future of water and wastewater services in the Auckland region has not promoted effective business planning and strategic decision-making.

364
However, the Auckland region’s local authorities are currently carrying out a review of regional water, wastewater, and stormwater services. We suggest that the Government gives careful consideration to its findings, and we recommend that, as soon as practicable, the Government declare its intentions for the structure of the water industry in Auckland. A sound and effective governance structure and long-term certainty need to be provided to both WSL and its shareholding local authorities.

365
In the interim, WSL and its shareholders should take every step to improve their relationships. Immediate steps that could be taken are:

  • negotiating long-term contracts between WSL and its customers; and
  • developing a comprehensive protocol between WSL and its local authority shareholders to define the roles and relationships between the company and its owners and customers.

366
We understand that, since the time of our study, discussions have continued on negotiation of contracts and development of a protocol. We encourage the parties in their efforts to put their relationships on a firm business footing.

6: The Local Government Amendment Act 1998.

7: Metrowater, a LATE, is responsible for the distribution of water in Auckland City, while United Water distributes water under a franchise agreement with Papakura District Council.

8: With the exception of Papakura District Council, which has franchised its local water/wastewater activities, WSL’s shareholders also own the local water/wastewater providers which are WSL’s direct customers.

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