Part 2: New requirement for a financial strategy
2.1
In this Part, we:
- discuss the legislative context for a financial strategy and our views on what makes a good financial strategy;
- highlight common themes we saw in the 2012-22 LTP financial strategies;
- focus on the use of debt in the sector; and
- discuss the legislative framework for the requirement to produce a financially prudent LTP and consider the broader drivers of financial sustainability.
Legislative context
2.2
Local authorities are required to comply with the financial management provisions set out in sections 100 to 111 of the Act. The TAFM changes implemented in November 2010 made some minor changes to the content, review, and publication requirements of local authorities' financial policies. The most substantial change was the addition of section 101A, which introduced the requirement for local authorities to prepare a financial strategy as part of their LTPs.
2.3
The TAFM changes recognised the merits of transparently presenting a local authority's financial strategy in the LTP. This was to make it easier for the reader of an LTP to understand the local authority's financial intentions and, more importantly, to provide a better link to the local authority's service delivery intentions than had previously been required.
2.4
The purpose of the financial strategy is described in section 101A(2) of the Act. The financial strategy is to facilitate:
(a) prudent financial management by the local authority by providing a guide for the local authority to consider proposals for funding and expenditure against; and
(b) consultation on the local authority's proposals for funding and expenditure by making transparent the overall effects of those proposals on the local authority's services, rates, debt, and investments.
2.5
Section 101A sets out some specific content requirements for the financial strategy, including:
- the factors expected to be significant during the period of the LTP;
- expected changes in population and the use of land, and the capital and operating costs that any changes would require;
- the expected capital expenditure on infrastructure required to maintain current levels of service; and
- other significant factors affecting the local authority's ability to maintain existing levels of service and to meet additional demands for service.
2.6
Local authorities must also include some specific statements in the financial strategy on:
- their quantified limits on rates, rate increases, and borrowing; and
- their ability to maintain existing levels of service and to meet additional demands within the rates and borrowing limits.
2.7
The local authority also has to state its policy on providing security for its borrowing, its objectives for holding and managing investments and equity securities, and quantified targets for returns on investments and equity securities.
2.8
As we have supported more transparent disclosure of financial strategies since the 2006-16 LTPs,2 it was important for us to focus on this new requirement in the 2012-22 LTPs.
2.9
The financial strategy sets out the overall financial goals of the local authority and where the local authority wants to be positioned during, and at the end of, the LTP period.
2.10
This links closely to the requirement in section 101(3)(b) of the Act for the local authority to make adequate provision for the needs identified in the LTP, taking into consideration the overall impact on the current and future well-being of the community. It also ties clearly to the purpose of local government, as set out in section 10.3
2.11
We were pleased to see the financial strategy included as a compulsory disclosure. We had some concerns that the sector might simply adhere to the specific requirements of section 101A and not focus on the broader intention of increased transparency. If this happened, the change would not reach its potential nor meet the underlying intentions of section 101A – helping the community to better understand the implications of a local authority's strategy and its position.
2.12
Every entity has a financial strategy, whether it has been documented or not. The financial strategy can be inferred from decisions and actions. The new requirements of the Act did not ask local authorities to produce something that had not already been present – the requirement was to document and transparently present that strategy for consultation with the community.
2.13
Most local authorities made their financial strategy a key consultation issue in their 2012-22 LTPs. Some provided particularly clear messages about future implications for ratepayers.
2.14
In general, we consider that the financial strategy disclosure requirement improved the information contained in the LTPs and helped communities to assess the implications of decisions they were consulted on.
2.15
A review of the financial strategy disclosures has reinforced our view that the greatest value is obtained when the local authority provides a broad discussion of the implications of the chosen strategy rather than limiting itself to the specific disclosure requirements of section 101A(3).
2.16
We continue to encourage local authorities to base their approach to disclosing their financial strategy on the intention of the Act – rather than as an exercise in complying with the letter of the law. We also caution against any further prescription of disclosure requirements in this part of the Act, which could lead the sector to address the financial strategy requirements in a mechanistic way.
2.17
Before the financial strategy requirements were added to the Act, few local authorities attempted to document their financial strategy. The former Manukau City Council was one of the exceptions – it included a financial strategy in its 2009-19 LTP. Although the strategy was not fully aligned to the requirements of the subsequently enacted section 101A, it still provides a useful example.
Assessing what makes a good financial strategy
2.18
In preparing for auditing the 2012-22 LTPs, we worked with Thames-Coromandel District Council, which was the first local authority to fully develop its draft financial strategy. Based on that work, we prepared brief guidance (see Figure 1) to help other local authorities to prepare their financial strategy. We circulated the guidance in late 2011, so local authorities could assess the adequacy of their financial strategy before completing their draft LTP for consultation.
Figure 1
Financial strategy guidance
| Principal criteria | ||
|---|---|---|
| 1 | Does the strategy adequately explain/summarise the intended level of service (including consideration of the renewal profiles evident within asset management plans) and associated cost implications for both operating and capital expenditure? | |
| 2 | Does the strategy adequately explain/summarise the intended revenue flows (all key funding flows including rates, development contributions, and other key revenue items), the use of debt (including internal borrowings), and associated funding implications? | |
| 3 | Does the financial strategy clearly set out a strategic "destination"/end point? If the strategy is designed to achieve a particular financial position with implications for the community, are these made clear? | |
| 4 | In drawing the first three criteria together, does the financial strategy demonstrate an overall cohesion of these three elements and demonstrate the prudence and sustainability of its approach? | |
| 5 | Does the financial strategy include the information requirements of section 101A of the Act? | |
| Presentation preferences | ||
| 6 | Does the financial strategy form part of the "right debate" – in other words, is it presented as a key issue "upfront" in the LTP? The upfront disclosures may be a summary of the financial strategy found elsewhere within the LTP. |
|
| 7 | Is the financial strategy presented in one place? Our preference is for one coherent strategy that, if it contains cross-references to other areas of the LTP (for example, growth assumptions), will need cross-references to discrete sections that can be clearly linked and are able to support the clarity of the financial strategy disclosures. |
|
2.19
With criterion 4 in Figure 1, it is important for a local authority to consider whether the underlying strategy is truly long term and sustainably aligned to the future needs of the community. These needs are largely, although not completely, assessed with reference to the AMP. The renewal, replacement, and development needs of infrastructure systems are essential to the uninterrupted delivery of services to the community.
2.20
It is important that every local authority consider the long-term picture provided in its AMPs (as well as assessing the robustness of the AMPs) and appropriately factor the information about the profiles (peaks and troughs of spending needs) into the presentation of the LTP. This is because infrastructure systems primarily have useful lives of more than 50 years, while an LTP addresses only a 10-year period – a small part of the assets' service delivery to the community.
2.21
SOLGM noted in its guidance Dollars and Sense that:
A robust financial strategy must be grounded in sustainability of service and therefore draws on (among other matters) ... asset information and activity management plans. A strategy that does not adequately reflect activity plans will struggle to demonstrate prudence and will probably be frequently breached.4
Financial strategy themes in the 2012-22 long-term plans
Themes arising
2.22
A financial strategy is much more than a plan to address current issues. However, we found that the effects of the current economic environment, particularly the prolonged global financial crisis, clearly featured in the financial strategies set out in the 2012-22 LTPs.
2.23
The main issues affecting the chosen financial strategies that we observed repeatedly in local authority LTPs were:
- reducing or deferring spending;
- an increased use of district-wide funding to spread the costs of infrastructure upgrades for small communities;
- the need for a number of large infrastructure projects to meet legislative requirements;
- a focus on stabilising or reducing overall debt; and
- delaying capital projects because of lower or uncertain growth.
Reducing spending
2.24
The theme of reducing spending was reflected in a variety of ways. We saw projects that had previously been included in long-term forecasts reclassified as "nice to have" rather than essential to core service delivery. Some community facility projects were removed from the LTP or delayed, and the local authorities' contributions to some community-led projects were reduced.
2.25
This theme also manifested in forecast reductions in the level of renewals compared with the level signalled in AMPs. This approach is sometimes described as "sweating the assets" and has a greater risk in terms of possible asset failure than a renewal programme based on AMPs. This strategic approach is not without risk to the community.
2.26
The risks include a weakening in the social fabric of the community because there are fewer community facilities or a major infrastructure breakdown due to delayed renewal work. A breakdown could lead to environmental damage, loss of service delivery to the community for a period of time, or the need to carry out more expensive, urgent, and unplanned replacement or renewal projects.
2.27
On the other hand, reductions in previously forecast expenditure could signal that AMPs might have been "gold plated" by forecasting asset replacements either earlier or to a higher standard than necessary. We note that local authorities are unlikely to specifically state that AMPs have previously been "gold plated". However, changes to forecast expenditure that are accompanied by explanations that there will be little effect on levels of service may be an indicator of this.
2.28
We acknowledge that most local authorities applying this approach will usually carry out visual inspections and testing of assets close to the end of their useful lives rather than relying solely on AMP data. In our view, this type of physical inspection should accompany decisions to deviate from programmes signalled in AMPs.
2.29
We saw some instances where local authorities disclosed the potential implications of reduced expenditure on levels of service, so the community could evaluate those implications. However, most LTPs focused narrowly on the ability to restrain rate increases in the short term. This is an aspect where we consider that the sector needs to improve the clarity of its discussion with the community.
2.30
Some local authorities plan to cut costs through operational efficiencies. Wellington City Council will try to find efficiencies of $219 million during the period of its LTP.5 The savings are to come from various operational areas but also from substantial reductions in the level of renewals. The LTP discloses the risks associated with this approach. In the Council's view, the feedback from community consultation acknowledged a willingness to accept this risk to obtain the resulting reduction in rate increases.
2.31
Auckland Council is forecasting cumulative efficiency savings of $1.7 billion during the period of its LTP. The savings are expected to start at $131 million annually and rise to $188.2 million.6 Auckland Council's savings are expected to come from improved procurement practices as contracts are progressively rationalised after amalgamation, process automation, system rationalisation, resource optimisation, and enhanced commercial management.
Increased use of district-wide funding
2.32
Another theme of the 2012-22 LTPs was that local authorities – primarily the small and rural local authorities – looked for ways to spread the costs affecting small communities. We saw a move away from the use of targeted rates (to attribute the costs of core infrastructure to particular communities) to district-wide funding of projects.
2.33
We saw this most often with infrastructure systems needed to meet higher performance levels required by legislation, such as drinking water supply and wastewater disposal schemes. Local authorities often assessed that the costs for the communities receiving the service were not affordable for that community. Several local authorities were grappling with issues of fairness in the context of the realities of affordability.
2.34
In many small communities where core systems need to be upgraded or replaced, there is no scope to achieve the economies of scale of a more densely populated or less isolated area.
2.35
The increase in district-wide funding of infrastructure reflects a significant change in philosophy. In the past several decades, local authorities have focused on funding infrastructure projects from those who generated the cost and received the benefit of the asset's service.
2.36
Many of these legislatively driven upgrade schemes come with a penalty regime for non-compliance. Evaluating whether to incur the cost of the upgrades or the penalties is a challenge for some local authorities:
- When preparing its draft LTP, Central Hawke's Bay District Council considered moving to a district-wide funding approach. The Council discussed the approach extensively in workshops. However, despite the significant targeted rates expected to be imposed on some small communities, the Council decided it was not yet prepared to move to a district-wide funding model.
- Mackenzie District Council presented a district-wide funding model in its draft LTP, to help spread the costs of necessary upgrades to essential infrastructure in several of its small townships. After a substantial and unfavourable response from the communities that would shoulder a share of the cost of upgrades for other communities' schemes, the proposal was removed from the final LTP.
- Rangitikei District Council proposed a move to a district-wide approach to rates, with the goal that all urban ratepayers in the district would pay the same amount for the provision of equivalent services, aligned to their property values, and that capital upgrades would be smoothed across the district. The change of approach was accepted during consultation, and it is now being applied.
Large infrastructure projects required to meet legislative requirements
2.37
Local authorities are concerned about the high costs associated with upgrading core infrastructure to meet legislative requirements, particularly compliance with drinking water standards. We noted that this pressure appearing as a theme in the 2009-19 LTPs, particularly for the smaller rural local authorities, and it continued to feature strongly in the 2012-22 LTPs. The significance of the costs of these compulsory upgrades has led many local authorities to conclude that they cannot comply with the legislative requirements other than by adopting the district-wide funding approach discussed above.
2.38
Many of the affected local authorities' LTPs have stated that the significant costs of meeting legislative standards might outweigh the expected benefits from the improved service delivery. We are aware that this issue continues to be of major concern to much of the sector.
Focus on debt reduction
2.39
Throughout the sector, financial strategies prominently featured the stabilisation or reduction of debt through the 2012-22 period. Despite this focus, debt is forecast to increase for the sector as a whole. The increase is attributable to a few local authorities with high debt. When Auckland Council is excluded, sector debt begins to decrease from 2019/20 onwards.
2.40
Overall, 25 local authorities plan to reduce their debt during the period of the LTP. There was a lot of narrative in LTPs explaining the focus on reducing indebtedness. In paragraphs 2.91 to 2.97, we discuss a widely used measure of indebtedness – the ratio of debt to revenue, which shows a largely downward trend during the period. However, we also note that, in our view, this measure is not considered high quality or usefully indicative of organisational health.
2.41
Local authorities that do not like to use debt are not necessarily following a risk-free financial strategy. Not using debt can delay important infrastructure projects, which can have significant flow-on effects. For example, traffic congestion can stifle economic growth.
2.42
Used in an appropriately prudent manner, debt is an effective way of spreading the costs of long-life assets. This approach applies the cost of the asset to the generations receiving the benefits more effectively. There is a risk that focusing on debt reduction without accurately evaluating whether debt is being managed within prudent levels could compromise investment and future needs.
A cautious approach to growth
2.43
Although the 2009-19 LTPs forecast some effects from the global financial crisis, local authorities still expected to grow during the 10-year period – but with less growth in the initial two or three years.
2.44
The 2012-22 LTPs are more cautious about growth predictions. Financial strategies are generally based on low or no expectation of growth, or a desire to respond to growth or prepare for growth close to the time it might occur. This reduces the risk of spending to expand infrastructure for growth that does not eventuate.
2.45
Strategies that include descriptions of "just-in-time" responses to growth are common in the 2012-22 LTPs. Part 5 discusses the example of Queenstown-Lakes District Council, which has taken this approach.
2.46
Delaying work to address growth needs can also have a significant effect on the community. For example, new properties might not be able to connect to core systems when they need to because the systems do not yet have the necessary capacity.
Overall assessment on the quality of financial strategies
2.47
In our view, local authorities provided better information to their communities in the 2012-22 LTPs because of the requirement to present a financial strategy. The sector used the presentation of financial strategies to address some important issues through the LTP consultation process.
2.48
Most local authorities did a more thorough analysis of their current approach and what they would do in the future than they had in previous LTPs. In the current financial environment, that analysis is helpful and provided local authorities with a framework to present the community with options for how to proceed.
2.49
However, some local authorities have not fully grasped the concept of a financial strategy. The financial strategy in their LTPs is largely a description of the financial picture that results from fitting together many individual planning decisions. This can be described as a "bottom-up" presentation of the financial strategy and often lacks overall coherence.
2.50
In contrast, our recommendation – and what we consider the legislators intended – is for local authorities to determine and clearly present their long-term goals, or strategic destinations, and to prepare the individual building blocks to achieve those goals – from the top down.
2.51
We acknowledge that preparing a financial strategy is always going to be iterative. The complexity of the factors that need to be taken into account, such as making decisions in a political environment, will result in a mixture of a top-down and a bottom-up process.
2.52
In our view, Hamilton City Council's LTP presents a good financial strategy. It provides a clear description of the current situation and sets clear goals that will enable the Council to work towards being in the position it wants to be in by 2022. The whole LTP uses plain language, which makes it easy for the reader to understand the issues. The financial strategy, in particular, presents the issues and the options to address the issues. It is not lengthy; nor does it describe the issues in an unnecessarily complex way. It uses graphs effectively to reinforce and support the messages.
2.53
In our view, Hamilton City Council showed that, even when the financial situation is complex, a financial strategy can be presented in an effective way (see Figure 2).
Figure 2
Our summary assessment of Hamilton City Council's financial strategy
| Hamilton City Council's issue was that a prolonged period of rapid growth had required the Council to invest in new infrastructure, facilities, and services. Much of this investment had been funded through the use of debt, which was reaching unsustainable levels in 2012. Growth had slowed, which reduced the income anticipated from developers and delayed expansion of the ratepayer base. The Council's financial strategy clearly sets out the approach it has chosen to address these issues. The approach includes a fixed level of rating increases for existing ratepayers during the LTP period, increasing "user pays" through increases in fees and charges for various services, reductions in some grants and service levels, and some asset sales. The focus for debt is on containment. Debt had been forecast in the 2009-19 LTP to move as high as $700 million, but during the period of the 2012-22 LTP it is forecast to remain instead near $440 million (after a small rise in the first two years, to meet contracts already committed to). Although the level of debt during the 2012-22 period increases by 2%, the Council's financial strategy is predominantly about debt containment and how to manage the ongoing need for infrastructure development without increasing the rates burden or creating an unsustainable future rates burden (by borrowing). Despite this, the Council is still well outside the normal range in terms of our debt-related resilience indicator. Hamilton City Council's ratio of interest to rates revenue ranges from 16% to 23% during the LTP period, with an average of 18%. The sector average is 9% (see paragraph 4.52). For our other resilience indicator associated with debt (interest to debt), the Council is at or slightly below* the average for the sector (reflecting its membership of LGFA). There is also a reduction in the Council's own measure of debt to revenue, which moves from 250% to 180%. In terms of our sustainability measure of debt to assets, Hamilton City Council sits within the normal range throughout the period of the 2012-22 LTP. |
* Hamilton City Council's interest rates range from 5.4% to 6.0%, with an overall average of 5.8%.
Debt trends in detail
Introduction – funding sources available to the sector
2.54
Section 103(2) of the Act sets out the funding sources that are available to local authorities. They include general rates, targeted rates, lump sum contributions, fees and charges, interest and dividends from investments, borrowing, proceeds from asset sales, development contributions, financial contributions, grants and subsidies, and any other source.
2.55
Although section 103(2)(j) refers to "any other source" being used, in reality a local authority could not normally use other means of raising revenue without legislative changes (see our discussion at paragraph 5.22 about Auckland Council's LTP).
2.56
An important part of the financial strategy and funding approach of every local authority is the choice of rating system. This includes the choice of valuation system, and whether and how to apply differential rating and uniform annual general charges. These choices are policy matters for the local authority, which can result in significant variations in the total amount of rates revenue raised and, in particular, the distribution of the rating burden throughout the community.
2.57
The increased use of district-wide project funding in the 2012-22 LTPs reflects the choice of some local authorities to spread the cost of infrastructure upgrades across the rating base instead of using targeted rates. This is a philosophical choice that has implications for ratepayers. It is also a choice that can affect the amount of revenue that needs to be generated from other sources available to the local authority.
2.58
The approach to rating, and how it is integrated and balanced with the other sources of funds, is set out in the local authority's revenue and financing policy.
2.59
We note that the proportion of revenue from rates is forecast to be stable at 52% of total operating income for the sector as a whole. However, there is a wide variability between individual local authorities.
2.60
Some of the sources of funding set out in section 103(2) of the Act are not available to all local authorities. For example, not all local authorities have returns from investments or assets to sell, or development and financial contributions (which are a significant source of revenue only if the local authority is undergoing substantial growth).
2.61
Practices vary widely. We have already discussed Hamilton City Council's approach. We have also seen increases to fees and charges in the 2012-22 LTPs from local authorities focusing on identifying and attributing the costs they incur more directly to the driver or beneficiary of those costs, to limit the general effect on rates.
2.62
Local authorities have limited scope to significantly alter the amount of revenue available through these sources. This limitation is usually on the grounds of affordability of the full costs of services to which fees and charges might apply (such as fees for library books or dog registration).
2.63
After rates, the next most significant source of funds available to a local authority is debt. Rates and debt provide the most significant and, arguably, the most flexible sources of funds to a local authority. The extent to which local authorities use rate increases and debt directly affects the levels of service delivered to the community – they are inextricably linked.
2.64
The next section discusses the main points about the use of debt by local authorities. Appendix 2 sets out the 2011/12 and 2021/22 forecast debt balances for all local authorities. We have focused on the "extreme" local authorities – those with LTPs that plan either no debt or a high use of debt. We chose to examine these outliers to see whether there is an issue with how the sector is using debt.
The no debt/low debt group
2.65
Five local authorities plan to have no debt during the 10 years of the 2012-22 LTP:
- Bay of Plenty Regional Council;
- Northland Regional Council;
- Southland Regional Council;
- Taranaki Regional Council; and
- Waikato Regional Council.
2.66
These are all regional local authorities. Regional local authorities usually have less debt because they have fewer large infrastructure systems. In general, the sector uses debt to finance the development and renewal of large long-life infrastructure systems (such as water supply schemes) that require substantial upfront investment. The systems are usually funded by debt to spread costs and achieve equity between ratepayers over time.
2.67
We note that most of the regional councils continue to benefit from dividends from large funds vested through restructure processes of the past.
2.68
The exceptions within the regional local authority grouping are Greater Wellington Regional Council and Hawke's Bay Regional Council. These two local authorities have a high level of debt because they are involved in high-cost infrastructure projects that are not typical of regional local authorities. Figures 3 and 5 describe the situations of Greater Wellington and Hawke's Bay Regional Councils.
2.69
Other regional councils with debt, but at much lower levels, are Environment Canterbury, Otago Regional Council, and West Coast Regional Council.
2.70
Environment Canterbury's debt arises from the Waimakariri flood protection project and the Clean Heat programme. West Coast Regional Council has a very low level of debt that is expected to remain reasonably stable during the LTP period, and this is also for flood protection and Clean Heat projects. Otago Regional Council expects to repay the outstanding debt for its share of the construction costs of the Forsyth Barr Stadium in 2013/14, and the diminishing amount of remaining debt is primarily for flood protection work.
2.71
Most regional councils use debt for flood protection schemes, which is consistent with using debt primarily to fund infrastructure systems.
2.72
We note that, compared to previous LTPs, fewer smaller district councils are operating without using any debt.
The high or rapid growth of debt group
High debt
2.73
Of all the local authorities, Auckland Council is planning to have the most debt during the LTP period. The forecast closing debt balance in 2021/22 is $12.5 billion. This accounts for 68% of the sector's total debt in 2021/22. Five other local authorities, each with forecast closing debt greater than $300 million, account for another 12% of the total.
2.74
It is notable, although unsurprising, that the six local authorities expecting to hold 80% of the sector's debt are mainly those servicing our largest urban communities. Using debt is highly correlated to servicing the needs of our largest urban populations and the growth in these areas, such as meeting transport needs in Auckland and Wellington. Figure 3 provides our summary assessment of Greater Wellington Regional Council's financial strategy.
Figure 3
Our summary assessment of Greater Wellington Regional Council's financial strategy
| The 2012-22 LTP for Greater Wellington Regional Council (Greater Wellington) forecast the highest regional council debt and fifth-highest local authority debt. Greater Wellington has also forecast the second-highest change in amount of debt (after Auckland) during the LTP period. Its proportion of debt to total assets is outside the normal range for all 10 years of the LTP period and is the highest for the sector (at an average of 30%, compared to the sector average of 6%). Why is Greater Wellington so different from other regional councils? Greater Wellington began investing in substantial transport infrastructure upgrades in 2007 after the Crown approved a $500 million package for upgrading the Wellington rail network. This was followed in July 2011 with a funding package to address deferred renewals. Greater Wellington has commitments to further upgrade regional transport infrastructure during the period of its LTP. This investment is to address and reverse a previous lack of investment over several decades. The forecast includes investing in integrated ticketing and improving the reliability and frequency of the public transport network. The LTP also forecasts significant investment in upgrades to flood protection schemes and the need for a new water storage facility near the end of the LTP period. The financial strategy is based on borrowing for initial capital investment. Operating revenue is to be used to fund interest on debt and to repay the principal amount borrowed. Greater Wellington intends to promote intergenerational equity by using debt. Greater Wellington forecasts receiving significant government subsidies from the New Zealand Transport Agency during the LTP period. In contrast to Auckland Council, most of this support is confirmed.* Central government grants are forecast to contribute between 50% and 60% of annual operating costs. Greater Wellington is a founding member of LGFA, so it can reduce debt costs. Its LTP states that it has an AA credit rating. |
||
| The debt limits set out in Greater Wellington's financial strategy are calculated based on net debt, and that is how the debt is presented. At the end of the LTP period, Greater Wellington's forecast gross debt is $100 million more than net debt. The limits Greater Wellington has set out in its LTP are: |
||
| Limits set out in financial strategy | Highest ratio in LTP period | Highest ratio in period calculated on a gross debt basis |
|---|---|---|
| Net interest/total revenue < 20% | 6.4% | 7.0% |
| Net debt/total revenue < 250% | 106.2% | 138.0% |
| Net interest/annual rates < 30% | 11.1% | 17.0% |
| This shows that Greater Wellington is well within its limits and is not obscuring matters by presenting the figures based on net debt. Greater Wellington plans to use the greatest proportion of rates revenue to fund the transport activity. We note that Greater Wellington does not rate for depreciation – rates fund only debt repayment and the cost of financing Greater Wellington's share of capital expenditure. We consider this reasonable, given that the upgrades are current, the assets are long-lived, the projects are jointly funded, and any future replacement will most likely be possible only with central government support. It can be argued that funding for depreciation on these assets would penalise current ratepayers and adversely affect intergenerational equity. The rate limits set out in the financial strategy include a split limit. Rate increases for new services are limited to 5.5% on average, while average rate increases for existing services are limited to the LGCI. This means an average increase of 3% each year. Greater Wellington does not expect to breach either of these limits during the LTP period. |
||
* Because most of the support is confirmed, we did not modify our audit opinion for Greater Wellington (in contrast to our opinion for Auckland Council, where we emphasised the matter of this uncertainty).
2.75
Christchurch City Council, a large metropolitan local authority, is missing from our data set because it was not required to prepare and adopt an LTP for 2012-22. When we examined the 2009-19 LTP for Christchurch City Council, we noted that the closing debt forecast for 2018/19 was $868 million. Before the earthquakes, the forecast debt position of the Council was consistent with the pattern of other metropolitan local authorities.
2.76
Had circumstances not changed, Christchurch City Council would also have been in the group that plans to hold most of the sector's forecast debt. This again illustrates that the highest level of debt is linked to the largest populations and highest levels of economic development and growth.
2.77
An area of greater concern lies with local authorities that have high debt but are not metropolitan, such as Tasman District Council. Tasman District Council forecasts a closing debt of $311 million. This is higher than the debt expected by local authorities in more metropolitan or densely populated urban areas, such as Dunedin and Palmerston North.
2.78
Figure 4 provides our summary assessment of the risks of Tasman District Council's financial strategy, which is linked to its funding philosophy and its growth challenge.7
Figure 4
Our summary assessment of Tasman District Council's financial strategy
| Tasman District Council's LTP states that its financial strategy is to fund capital and renewal expenditure through borrowing. The Council has adopted this approach instead of setting aside funds to replace assets as they wear out – that is, cash funding depreciation. As a result, by the time the asset needs to be replaced, the Council will normally have repaid the loan for the original asset and can borrow for the replacement of the asset. Under its current approach, Tasman District Council will always have a substantial amount of debt. The Council has a financial strategy of rating enough to repay only existing debt. It will incur asset renewal expenditure every year, which it will continue to fund through debt. The renewal-related debt will continue to increase because of cost increases, such as bitumen prices, and the timing of asset renewals. Also, many of the Council's assets are comparatively new, meaning that there is likely to be more renewal work required in years to come. Debt levels are exacerbated where growth continues and levels of service increase, which requires more debt funding. This is evident in the Council's LTP, where levels of service improvement in water treatment are forecast to significantly affect the Council's debt levels. Typically, other local authorities fund renewal work out of rates and New Zealand Transport Agency subsidies. Local authorities take this approach because they consider that:
We note that, when considered from a whole-of-network perspective, the cost of renewals is relatively consistent each year. Tasman District Council's approach means that it is incurring interest on renewals, which other local authorities do not incur, and the cost incurred does not improve the performance of its infrastructure network. Tasman District Council's approach has increased its risk in the following areas:
Tasman District Council recognises the risks of its proposed debt. In its LTP, it notes the intention to review major capital projects and its policy to fund renewals through debt. This review is due for completion in mid-2013. We also note that, at present, Tasman is experiencing high growth. For the year to June 2011, its growth rate was as high as Auckland's. Tasman District Council has a comprehensive and regularly reviewed growth strategy, which is detailed across its 17 settlements. The LTP assumptions note that projects will be moved to meet any changes in growth rates. |
Highest debt movements – most significant increases in debt
2.79
Auckland Council's LTP includes the biggest change in debt. The Council is proposing to incur $7.5 billion of additional debt between 2011/12 and 2021/22. This is 87% of the total debt movement for the sector.
2.80
The other local authorities with high debt movements forecast during the LTP period are also mainly those with the highest closing debt balances. The exception to this pattern, moving from a relatively low base, is Hawke's Bay Regional Council (see Figure 5).
2.81
We also note that other local authorities with high gross debt increases are metropolitan local authorities, such as Wellington City Council and Tauranga City Council, or local authorities facing growth, such as Kapiti Coast District Council, Queenstown-Lakes District Council, and Tasman District Council.
2.82
The highest percentage movement in debt reveals a slightly different picture. Hawke's Bay Regional Council is forecasting the greatest percentage increase in debt from 2011/12 to 2021/22 – 530%.
Figure 5
Our summary assessment of Hawke's Bay Regional Council's financial strategy
| Hawke's Bay Regional Council's debt is forecast to grow from $15.7 million to $99.3 million during the LTP period. This puts it seventh in terms of greatest debt movement and first in debt percentage movement (at 530%). Based on an analysis of the forecast financial statements alone, Hawke's Bay Regional Council has an implied interest rate throughout the LTP period that is outside the normal range of 3.1% to 8.8% – its interest rate moves between 11.3% and 16.9%, and averages 13.1%. Hawke's Bay Regional Council has the highest proportion of average interest expense to rates, at 38%. During the period of the LTP, the percentage of rates used to pay interest costs ranges from 13% to 56%. Why does Hawke's Bay Regional Council appear so different? There are two components that explain Hawke's Bay Regional Council's situation. The finance costs included in the main financial statements include interest on borrowings and fees associated with the transfer of Napier leasehold properties to an investor. This is an important part of Hawke's Bay Regional Council's financial strategy. When these fees are extracted from finance costs, the interest rate range reduces to between 5.8% and 7.7%, with an average of 7%. Interest as a proportion of rates ranges from 6.5% to 38.5%, with an average of 23%. Hawke's Bay Regional Council's financial strategy has several substantial investment projects. Its economic development goals are mainly linked to improving land use and increasing exports in the region. The investments will be managed through the Council's holding company, Hawke's Bay Regional Investment Company Limited. The projects are all subject to a strict business case regime where the viability of each project must be proved. The main projects are:
There has been no increase to the general rate in the last three years. During the LTP period, rates as a proportion of revenue are in the 29% to 35% range, which is below the sector average of 52%. This shows that the planned investment activity of the Council will not directly affect ratepayers. |
2.83
Other local authorities near the top of the list for percentage debt movement do not have high dollar value debt. Three of these are small local authorities – Grey, Opotiki, and Rangitikei District Councils.
2.84
Although these three small local authorities have large percentage increases (139%, 229%, and 445% respectively), their closing debt balances are still small in comparison to their asset bases and to the rest of the sector.
2.85
Grey District Council is incurring more debt for its wastewater scheme upgrade. Opotiki District Council has proposed higher debt for its wastewater renewal and expansion projects and its harbour development project. Rangitikei District Council's debt is for wastewater and water supply upgrades.
2.86
In Opotiki, the Council clearly states in its LTP that this expenditure has been allowed for by "reducing debt over time in order to have capacity to invest in growth opportunities when they present themselves".8 The harbour development project, which is intended to bring economic and social benefits to the district, will go ahead only if the forecast level of external funding support is obtained. We highlighted the high level of uncertainty associated with this assumption in our audit report, using an emphasis-of-matter paragraph (see Appendix 3).
2.87
Again, the sector is using debt to facilitate substantial projects.
Highest dollar value decreases in debt
2.88
Two local authorities have forecast large decreases in debt. Dunedin City Council's debt is forecast to decrease by $34 million, largely because of the completion of a number of large capital projects early in the LTP period. From 2013/14 onwards, Dunedin City Council repays more debt than it borrows. Western Bay of Plenty District Council's debt is forecast to decrease by $41.5 million as the local authority focuses on debt repayment.
2.89
Again, large movements are strongly correlated to high 2021/22 debt balances. Both of these local authorities forecast 2021/22 debt balances in the top 20 of the sector – their debt is forecast to be greater than $100 million, despite these substantial debt reductions.
Highest percentage decreases in debt
2.90
There are also some local authorities forecasting substantial percentage reductions in the amount of debt held from 2011/12 to 2021/22. The highest declines are primarily, but not exclusively, in smaller local authorities. Other than the five local authorities that had debt at the start of the 2012-22 LTP period and expect to have fully repaid this debt before 2022 (a 100% decrease in debt – see Appendix 2), the greatest decreases are forecast by Otorohanga District Council (85%), Otago Regional Council (84%), Waimate District Council (78%), Hauraki District Council (66%), and Whakatane District Council (63%). We consider that this reflects the tradition of small local authorities preferring not to use debt. It may also be because of a low level of new capital projects.
Using debt to total revenue to assess the prudence of local authority debt
2.91
Local authorities often use debt as a proportion of total revenue (sometimes based on net debt) as a key limit against which they limit debt increases. Auckland Council has the highest stated limit at 275% (which is calculated on a net debt basis). The financial strategies of the local authorities with the highest dollar value debt generally focus on reducing their proportion of debt to revenue during the LTP period.
2.92
We calculated a proportion for the sector using gross debt to total revenue by year, because using gross rather than net debt is a more conservative measure. The local authority with the highest proportion was Taupo District Council. In 2012/13, Taupo District Council's proportion of debt to total revenue is 258%. It is forecast to steadily decline during the LTP period to 154% by 2022. Hamilton City Council also begins with a high proportion of 237% in 2012/13, declining to 166% by 2022.9
2.93
In contrast, Auckland Council has forecast the highest proportion of debt to total revenue in 2021/22 at 246% – an increase from 193% in 2012/13.
2.94
We understand that the general intent of the measure of debt to total revenue is to assess the amount of annual revenue required to repay debt at a point in time. However, we question the value of this as a measure. In many instances, there are items within total revenue that do not reflect actual cash that could be made available to repay debt (such as vested assets). Also, most of the revenue received from rates and government subsidies is required to meet the costs of either agreed projects or annual operational costs for delivering essential services (such as the costs of electricity to operate wastewater pump stations). These costs could not be diverted to fully repay debt in any one year without cutting off essential services.
2.95
We acknowledge that many local authorities nevertheless use this measure because it is employed or required by credit rating agencies, including LGFA (see paragraphs 4.49-4.50).
2.96
In our view, it is important for the sector to consider other ways of measuring the effect of debt on the local authority. We consider that possible measures include those that assess the level of control debt has over the organisation, so that undue control can be monitored. This may be by measuring the interest effect on revenue, or debt as a proportion of assets. The other main concern is that the local authority remains capable of meeting interest and principal payments as they fall due. Measures to assess this area would usually focus on cash flow capability and whether it is enough to cover expected outflows. A possible set of indicators is presented in Part 4.
2.97
Local authorities usually borrow funds for an extended period, to achieve intergenerational equity, and to facilitate longer-term investments that would not be possible with existing resources. For these reasons, assessing how debt relates to total revenue is not helpful. Any reduction in the proportion of debt to total revenue during the period of the LTP does not necessarily indicate an improving or declining debt situation, but needs to be considered with other measures and the individual circumstances of the local authority.
Financial prudence and sustainability
2.98
In our view, two aspects of prudence are important for the sector:
- prudence as it is defined in section 101 of the Act with a financial focus; and
- prudence in the broader context of sustainable and long-term delivery of services.
Prudence
2.99
Section 101 of the Act sets out a general requirement for local authorities to manage financial matters prudently and in a manner that promotes the current and future interests of the community.
2.100
Assessing whether a local authority has a balanced budget provides a starting point for assessing financial prudence, but further analysis is required.
2.101
The Act requires each local authority to answer for itself, within its own context, whether the budget presented in the LTP is financially prudent. Auditors are required to form an independent opinion on whether the forecast is financially prudent. Both the local authority and the auditor make an informed judgement on this point. Assessing financial prudence is not a science but a matter of judgement. The primary sources of assurance for the auditor are considering the process the local authority used to complete its prudence assessment, and the quality of the information provided to the local authority so it could consider the relevant factors.
2.102
Importantly, the Act requires financial prudence to be considered on the basis of current and future interests of the community. Therefore, the useful life of assets and, in particular, future capital requirements must be considered during the LTP period – not just the forecasts. Consequently, any analysis of the financial strategy and consideration of its implications for prudence must consider the entire life cycle of a local authority's assets. The local authority ought to demonstrate that it should be able to deliver services sustainably for years to come.
2.103
It is not only the long life cycle of assets and the need to maintain essential services in perpetuity that have an effect on prudence. There are also significant implications for financial prudence in land-use planning decisions – particularly those that commit a local authority to extend the boundaries of land available for development and require the extension of infrastructure systems. These decisions can, by implication, commit the local authority to take on the risk of predicting the timing of this development, which can have significant effects on debt levels and rates.
Our conclusion about local authorities' financial prudence
2.104
Our 2012-22 audit reports concluded that the LTPs of all local authorities indicated that they were financially prudent. In eight reports, we highlighted certain assumptions or risks that those local authorities faced in achieving their plans, but did not call the local authorities' financial prudence into question (see Appendix 3).
2.105
However, the assessment of financial prudence remains a substantial challenge for local authorities. To make and act on the best assessment of financial prudence for the sake of the community, local authorities must consider financial prudence in a wide, robust, and long-term manner.
Broader drivers of sustainability
2.106
We recently commissioned a research report on indicators of public sector financial sustainability.10 The report suggested that, to assess prudence and sustainability, indicators should cover not only financial areas but also social, environmental, and public sector factors. These factors are the long-term drivers of demand for, and effective delivery of, services to the public or the ratepayer.
2.107
Although the report had a largely national focus, the findings are relevant for local government. We have incorporated some of the report's findings in the discussion in Part 5. Here, we set out our view of the broader drivers of sustainability in local government.
Considering the longer term
2.108
LTPs cover a 10-year period, which is a long time for detailed planning but a short time in the life of the major assets that local authorities have stewardship of. New Zealand's central government and many overseas jurisdictions are now looking 40 to 50 years ahead when planning.
2.109
When preparing their LTPs, local authorities also have to consider irregular peaks and troughs in their capital expenditure (because different projects will have cost peaks at different times) beyond the 10-year planning period, and how those peaks and troughs might affect decisions and financial prudence now and in the long term.
Tailoring indicators
2.110
The research report we commissioned lists 21 headline indicators that might be used to assess financial sustainability in central government. It also points out that indicators used internationally show as much local variation as they do commonality. We have not attempted to separately devise a set of indicators tailored to local government, but have considered the relevance of the 21 indicators and where variations or different indicators might be appropriate.
Contextual indicators
2.111
A number of the indicators are for areas that are primarily either private or central government responsibilities, such as income disparity, labour productivity, and business innovation. Tracking such indicators might be useful contextual information for local authorities, but is not likely to directly affect planning.
Important non-financial drivers
2.112
There are several important social and environmental drivers of long-term financial sustainability, and their trends should be taken into account in planning. Section 101A of the Act recognises this, stating that financial strategies in the LTP should include a statement on "factors ... expected to have a significant impact … during the … years covered by the strategy". These factors include expected changes in population and land use, expected capital expenditure, and "other significant factors" affecting the local authority's ability to maintain existing levels of service and to meet additional demands for services.
2.113
The research report we commissioned suggests that life satisfaction, civic engagement, biocapacity,11 net greenhouse gas emissions, and solid waste production are important indicators of social and environmental drivers. The report proposes that current trends in these be projected for 40 to 50 years. Some or all of these are already taken into account, either explicitly or implicitly, in the LTPs, but it might be useful to use these or similar indicators more explicitly as part of local authorities' future long-term planning.
Important financial drivers
2.114
Business and household income and wealth are important determinants of the ability to pay rates and other charges. It would be useful (and feasible) to track trends in income, particularly in low-growth or depopulating areas. Many local authorities already do this. Housing availability and affordability also affect the ability to pay rates and need to be considered.
Nature of local authority spending
2.115
The research report tentatively suggests that spending could be re-categorised as "redistribution", "investment", "defensive", and "other", to help get beyond the categories of "consumption" and "capital" expenditure used in traditional accounting. The underlying idea is that governments invest in capability (not just through capital expenditure), but also spend money that does little more than prevent or ameliorate bad situations. Our long-term preference is an upward trend in the first type of expenditure and a downward trend in the second, or at least an upward trend in the first relative to the second.
2.116
The suggestion seems broadly applicable to local authorities, which do very limited amounts of redistribution, have high levels of capital investment, perform a range of regulatory activities that have both investment and defensive aspects, and do some defensive spending, mainly through regulatory activities.
Local authority capability
2.117
We discuss the financial capability of local authorities in Part 4. In summary and in relation to the research report's indicators:
- Net income almost always stays positive, and local authorities, in the main, stay well within the golden rule of fiscal policy, that governments should borrow only to invest.
- Financial condition, as measured by both gross and net debt levels, is usually sound, with credit rating and default risk low to negligible in most local authorities.
- We found that buffer capacity is built into local authorities' operations, partly through low debt levels and partly through their ability to meet unplanned costs through insurance and other mechanisms. We note that local authorities are learning to leave some buffer capacity in their plans to cope with unexpected day-to-day expenditure. For example, the Local Authority Protection Program Disaster Fund (LAPP Fund) is an explicit insurance agreement with central government to provide partial funding for spending shocks.12
2.118
The research report suggests two indicators of non-financial capability:
- A general measure of capability to deliver into the future. This is a very important issue for local government, particularly for small, usually rural, local authorities. They have serious limits on their capacity to employ or access relevant expertise (for example, at chief financial officer or engineer levels), and to deliver services to desired quality levels and on time.
- A more specific measure of fiscal governance. In Parts 3 and 4, we describe how local authorities vary enormously in their situation and underlying capacity but are broadly fiscally conservative. Local authorities should, generally, be considered more at risk from their circumstances (such as depopulation) than from poor fiscal management.
Conclusion on the broader drivers of local authority sustainability
2.119
Many local authorities are already tracking some or all of these or similar indicators. However, we consider that local authorities could do more to build a much longer-term view into their planning, and to explicitly track and project trends in key drivers of their financial sustainability.
2: Matters arising from the 2006-16 Long-Term Council Community Plans (2007), page 85, and Matters arising from the 2009-19 Long-Term Council Community Plans (2010), pages 15 and 17.
3: The Better Local Government reforms are proposing changes to the purpose of local government as currently defined in the Act.
4: SOLGM (August 2011), Dollars and Sense guidance, page 36.
5: Wellington City Council, Long-term plan 2012-22, page 200. Forecast savings equate to just under 5% of operating expenditure.
6: Auckland Council, Long-term plan 2012-22, Volume one, Chapter 2, Section 2.4, page 38.
7: We seriously considered whether to include an emphasis-of-matter paragraph in the audit report of Tasman District Council. However, we did not do so because we considered that the issues the Council faces as a result of its current strategy do not have an immediate effect on the Council. The longer-term risks of the current strategy were addressed through management reporting.
8: Opotiki District Council, Long-term plan 2012-22, page 21.
9: Taupo District Council's net debt to total revenue will decline from 134% to 43% during the LTP period. Hamilton City Council's net debt to total revenue will also decline from 250% to 180%. See Figure 2.
10: Anderson, B (2012), Research report on public sector financial sustainability, stability and resilience, unpublished report commissioned by the Office of the Auditor-General.
11: Biocapacity is short for biological capacity – the calculated ability of ecosystems to produce useful biological materials and absorb carbon dioxide emissions.
12: We acknowledge that, after the Canterbury earthquakes, the LAPP Fund will require several years to be built back up.
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