Part 12: Other changes to the wastewater project

12.1
In Parts 7-11, we have described some of the major changes and challenges that the Council had to deal with between 2003 and 2007. There were many other changes during this period. In this Part, we provide our overall comments after briefly outlining the more significant of those other changes:

• the extensions to the project management contract with the Beca consortium;
• changes to the process for KDC to take ownership of the scheme;
• changes to the project documents;
• changes to the financing arrangements; and
• changes to what was to be built.

12.2
In summary, we conclude that:

• It was sensible for the Council to extend the Beca consortium's contract for project management, but it was done in a piecemeal way. The Council did not appear to have estimated or budgeted for the costs of the project management services.
• The financing and contractual arrangements were complex, and it appears that the Council and its advisers did not understand them well. The delays to getting started cost the Council an estimated $450,000 in financing costs.
• The Chief Executive and EPS decided to use swaps to hedge KDC's interest rate risks. However, they did so in breach of KDC's Treasury Management Policy, and it is not clear that the Council approved the decision to use swaps.
• The Council did not get independent legal advice about the new contractual documents or independent financial advice about the financing arrangement.
• It appears that, by this end of this period, the Council was no longer in control of the project or its costs.
• KDC's record-keeping was poor.

Extensions to the Beca consortium's project management contract

The Council agrees that the Beca consortium should continue as project managers through the construction phase

12.3
The original contract with Beca, in 2000, had been for the consortium to provide project management services until the signing of a contract for a BOOT type of PPP. The fee for those services set out in the contract was $617,000.

12.4
At a meeting on 23 July 2003, the Council considered a report from the Chief Executive recommending that Beca be retained until construction was complete (that is, until commercial acceptance). The report set out that, because of several changes that had occurred, the project management fees to date were then $799,525 and that the cost for the project management services until commercial acceptance would be a further $194,050. This made a total of $993,575, as well as a time and materials charge. The cost did not include legal advice Bell Gully was to provide through EPS or Beca. The report advised that this level of fees was appropriate in the context of a total project budget of $13 to $15 million.

12.5
The Council agreed to accept the proposal from the project managers to manage the project until commercial acceptance.

How to pay for the project management

12.6
It appears that, until that point, the Council had not considered how it would fund the consortium's project management costs. In a memorandum to the Chief Executive in December 2003, KDC's Finance Leader noted that Beca's fees of $641,000 had been funded from working capital and that a further $350,000 had also been committed. He noted that $1 million represented a "highly significant portion of our working capital".

12.7
By June 2005, KDC was having cash flow issues. In an email to the Chief Executive, KDC's Finance Manager noted that KDC's working capital was $768,000, which would not even meet monthly expenditure requirements. He advised that the same arrangement that had been reached between Simon Engineering, ABN Amro, and KDC needed to apply for EarthTech. This appears to be that ABN Amro would lend KDC money to pay for the project management costs and so restore KDC's level of working capital.

Project managers' contract is continued through the implementation phase

12.8
In January 2006, Beca submitted an offer to the Council for the consortium to provide services during the implementation phase of the wastewater project. These services included:

• administering the contract;
• providing periodic technical auditing services;
• seconding a person to act as a community liaison; and
• providing statutory planning advice for the subsidy application and for development contributions.

12.9
The community liaison representative was to be based full time in Mangawhai. The role would include:

• Liaison with residents and other affected parties, and the contractor's local representative;

• Being a referral point for all enquiries passed to Council;

• Provision of feedback and reporting to Council staff in Dargaville;

• Provision of current information to the Project Director administering the contract; and

• Meeting with residents as required to explain the construction of the scheme.

12.10
These services would cost $474,750. This did not include planning support services, which would be billed on a time and disbursement basis.

12.11
At its meeting in May 2006, the Council resolved to accept the proposal from Beca to manage the implementation phase of the wastewater project.

Our comments

12.12
The project still needed a substantial amount of management and monitoring. It was sensible to extend the contract with the Beca consortium and keep it in this role. In particular, the community liaison work that Beca carried out in the later stages of the project proved to be very important.

12.13
However, we consider that the way the contract extension was done is another indication of the lack of proper overall governance of the project. It was foreseeable from quite early on that project managers would be needed for the life of the project. However, the project managers' role was extended in a piecemeal way. As we set out earlier, in the initial stages of the project, the Council failed to identify what it needed to do to manage the project and the limitations of the project management services to be provided by the consortium. Without any other project management, it is clear that the Council was very dependent on the project managers to keep the project progressing.

12.14
We are also concerned that the Council did not appear to have clearly estimated and budgeted for the costs of the project management services.

Changes to how Kaipara District Council would take ownership of the scheme

12.15
The 2005 financing documents and Project Deed included a single date for commercial acceptance. Commercial acceptance was the point at which EPS was to sign-off for KDC that EarthTech had finished construction and demonstrated that the wastewater scheme functioned. After commercial acceptance, KDC was to draw down its loan and pay MDHL for the wastewater scheme. MDHL would then transfer ownership of the wastewater scheme to KDC.

12.16
In March 2007, Beca and EPS put a paper to the Council recommending that the Council change to a two-stage commercial acceptance process to lower the financing costs. KDC's term loan facility with ABN Amro had a lower interest rate than the financing ABN Amro was providing for the progress payments that MDHL was making to EarthTech while the scheme was being built. The purchase price KDC would pay MDHL after commercial acceptance included these construction financing costs. So KDC would save money if it could move some of that financing over to its lower-interest loan earlier.

12.17
Effectively, what Beca and EPS were proposing was that KDC would buy the wastewater scheme in two stages at two different dates and would draw down twice on its term loan facility to pay for the purchase. That is, by the date for Commercial Acceptance 1, part of the wastewater scheme would be completed. Provided that EPS signed off the work, KDC would draw down on its loan and pay MDHL for the part of the wastewater scheme that was completed and take ownership of it. When the remaining works were completed by the date set for Commercial Acceptance 2, KDC would draw down on the loan again, pay the remaining amount to MDHL, and take ownership of the rest of the scheme.

12.18
The consultants estimated that changing to a two-stage commercial acceptance process would save KDC about $322,000. In the paper to the Council prepared by Beca and EPS, there was nothing about the financial risks if the commercial acceptance dates were not achieved or how those risks could be mitigated. The Council agreed to adopt a two-stage commercial acceptance "provided that EarthTech or ABN Amro does not attempt to use this as a lever to re-negotiate the Project Deed or the financing documents".

Our comments

12.19
Changing the commercial acceptance dates could have saved KDC some money, but there were risks. If the project failed to meet the dates specified in the financing arrangements in the Project Deed and Tripartite Deed, the Council would incur additional costs. If the Council adopted this proposal, it also needed to manage the contract tightly to ensure that the timetable was met. These risks do not appear to have been fully explained or understood. As we explain in Section C, the project did not run to time and the decision to change the commercial acceptance dates ended up costing KDC more than it hoped to save.

12.20
KDC's former Chief Executive told us that the two-stage commercial acceptance was fully explained to the Council in a workshop. There were no records of this workshop or copies of any papers or presentations provided in KDC's files. Therefore, we were unable to confirm that the risks of the two-stage commercial acceptance process were fully explained to the Council.

The Council agrees to sign amended project documents

12.21
As explained in Part 11, in October 2006, the Council approved several amendments to the Project Deed and gave the Mayor and Chief Executive authority to execute the relevant modification to the Deed. However, the Project Deed was still not operative and so its modification process could not be used yet. The conditions in the Project Deed were met in August 2007, when the resource consents were granted, at which point the Deed became operative.

12.22
In September 2007, the Council was given a presentation about the modifications now being negotiated. These modifications:

• included changes to the treatment plant site that had been needed to resolve an appeal in the resource consent process;
• included the transfer pipeline to the farm;
• included the winter storage dam;
• removed the irrigation system at Mangawhai Park;
• provided for two months to refine the guaranteed maximum price; and
• provided for two commercial acceptance dates.

12.23
In November 2007, the Council received a further presentation at a workshop and formal meeting. The presentation set out the history of the project and the proposed changes. It noted that the risk allocation had changed because of the Local Government Act 2002, KDC's purchase of the farm, and the contract negotiations. Several risks had been taken back by KDC or were now shared by KDC and EarthTech.

12.24
The presentation set out that the total loan to be provided by ABN Amro was now $53 million. The guaranteed maximum price for construction had increased to $37.8 million. There was no detailed information in the material provided to the Council on the financing arrangements or details of the contracts that the Council was about to sign.

12.25
The Chief Executive's paper noted that the contract provided for only 1216 sections to be connected. However, further modifications would be negotiated while construction proceeded, and a further 500 to 1000 properties should be connected. He noted that the wastewater treatment plant was capable of servicing more than 2000 properties.

12.26
The Council minutes for the meeting on 28 November 2007 record that the Chief Executive's report stated that "The project remained within the parameters adopted by the Council and was recommended for signature." The Council authorised the Mayor and Chief Executive to execute the project documents.

12.27
Not all of the works that the Council had agreed to in October 2006 were included in the November 2007 Project Deed. We were unable to determine why the Council did not raise this issue when it agreed to execute the Project Deed. In addition, some changes to the scope of the works were anticipated before the Project Deed was signed, such as relocating the wastewater treatment plant because of one of the Environment Court appeals. These changes were not included in the Project Deed. The effect of these issues was that the Council still did not have clear understanding of what the full costs of the project would be when it agreed to sign the Project Deed.

12.28
On 7 December 2007, the amended project documents were signed. The amended documents reflected the change in the scope of the works, the increased costs, and the new two-stage commercial acceptance process. If construction went to plan, the total purchase price would be $42,891,500, made up of $37,840,182 in construction costs, the $800,000 advance to the Council for its project management costs, bank fees of $1,840,697, and interest costs of $2,165,000.

What professional advice was obtained?

12.29
Bell Gully assisted EPS with negotiating and completing the core part of the Project Deed, excluding the schedules, as well as the other project documents. Bell Gully provided a letter to KDC's Chief Executive setting out its involvement and confirming that the documents reflected EPS' instructions to it and its advice to EPS. Bell Gully confirmed that, on that basis, the documents were appropriate for KDC to execute and rely on. Bell Gully noted that this confirmation assumed that KDC was satisfied with "the structure of the Mangawhai EcoCare Project, the matters in respect of which KDC will need to satisfy itself, the commercial terms of each of the Project Documents, and the risks and obligations assumed by KDC under the Project Documents". The letter to KDC was two pages long and did not include any detailed information about the documents the Council was proposing to sign. The Council did not seek its own legal advice about the agreements before signing them.

12.30
The financing arrangements were complex. There were very few documents in KDC's files about the financing arrangements. We understand that EPS negotiated the financing arrangements on KDC's behalf. Beca told us that the financial arrangements EPS negotiated were provided to the Chief Executive for approval. The Chief Executive told us that EPS used PwC (Australia) to provide advice about the financing arrangements. We found no evidence in KDC's files that KDC staff or EPS used PwC (Australia) or sought independent financial advice about the financing arrangements that the Council would enter into. In particular, there was no evidence that an assessment was made of whether the financing arrangements offered by ABN Amro were competitive or provided value for money. In the presentation and report given to the Council at the meeting in November 2007, no information was provided about the details of the financing arrangements that were to be entered into.

Our comments

12.31
The delays in starting the project cost KDC a significant amount of money (about $450,000). The Project Deed was amended in October 2006 because it took more time to satisfy the conditions that had to be met before the Deed could become operative (resource consents and consultation processes under the Local Government Act 2002). The Deed was amended several more times during 2007 for the same reason. As we set out earlier in the report, we consider that KDC was unlikely to be able to meet the time frame given for satisfying the conditions and that the time frame was simply too short. This meant that it was likely that KDC would incur additional commitment fees and other bank fees from delaying the start of construction.

12.32
When the Deed was amended in October 2006, the commitment fees increased from $8,333 each month to $12,634 each month. The value of the works carried out by EarthTech in this period also bore interest at a rate of 9.75%, which was capitalised monthly. Further ABN Amro fees were also incurred. In total, close to $450,000 in financing costs were incurred before the amended project documents were finally signed in December 2007. These financing costs were made up of $218,643 in commitment fees and $228,175 in EarthTech's financing costs.

12.33
We are concerned that, when the Council signed the financing documents in October 2005, it did not understand that additional financing costs would be incurred if it failed to obtain the resource consents or complete its consultation within the time limit. As already noted, the original time allowed for these conditions was probably unworkable.

The changes that were made to the financing arrangements

A new Land Acquisition Facility Agreement

12.34
As discussed in Part 10, the Term Loan Facility Agreement had been amended twice previously to provide funds to purchase the farm. In December 2007, the arrangements for financing the farm purchase changed again. ABN Amro agreed to provide another term loan facility to KDC – this was called a Land Acquisition Facility Agreement.

12.35
The loan to be provided under the Land Acquisition Facility Agreement (the additional loan) was to be drawn down on 7 December 2007. KDC would use the additional loan to repay the entire principal and interest owing under the existing loan (called the term loan facility) as well as pay any associated costs, such as bank fees. The additional loan was to be repaid at Commercial Acceptance 1, or on 28 February 2009, when money was drawn down on the existing loan (the term loan facility) to pay for the first part of the wastewater scheme that had been completed. KDC was to use the money from the existing loan to repay the additional loan.

12.36
There were very few documents in KDC's files about the financing documents that were signed in December 2007. No information in the files explained why KDC entered into the Land Acquisition Facility Agreement or whether there were any financial advantages to this.

12.37
As with the other 2007 project documents, there is no evidence in KDC's records that the Council sought independent legal or financial advice before signing the new financing documents. There is also no evidence in KDC's records that the Council determined whether the terms offered by ABN Amro were competitive with what was available in the local government sector at that time. KDC's former Chief Executive told us that PwC (Australia) were used to provide advice about these issues. However, there is no record of any such advice in KDC's files. We did not confirm with PwC (Australia) what advice it gave.

Swaps

12.38
The documents to be signed by the Council in December 2007 included an International Swap Dealers Association agreement with ABN Amro. A swap is a contractual arrangement used to hedge risks. In this case, it was used to hedge interest rate risk.

12.39
In late 2007, EPS and KDC's Chief Executive agreed that it would be appropriate to use swaps to hedge KDC's interest rate risk under the loan agreements it was about to enter into. There was no information in KDC's files about why it wanted to use swaps or any advice about the associated legal and financial issues. Nor was there any evidence to suggest that KDC's Treasury Management Policy had been considered. That policy states:

2.1 Liability Management Policy

2.1.1 Interest Rate Exposure on Borrowings

…

(c) A passive approach will be taken to borrowing.

Attempts to identify advantageous interest rate trends and committing the borrowing programme to forecasted rates will be avoided. Trading and or speculative operations will be avoided, reliance being placed on risk management within available market strategies.

(d) When it is appropriate to do so, borrowing exposures may be hedged. Before resolving to hedge an exposure, or to delegate the authority to hedge a transaction or a specific series of linked transactions, Council must:

• obtain specific advice from expert advisers independent from those who are recommending the transaction

• be satisfied that the risk to the Council of not proceeding with the hedge is greater than the existing transaction without the hedge

• be satisfied that the reduction in risk is sufficient to justify the cost of the hedging instrument.

12.40
There was nothing in KDC's files to indicate that the Council was advised that staff were about to start using swaps. The Council was told that the interest rate was to be fixed, but it was not explained that this would be done by using swaps. From the information we have seen, it is likely that this action was inconsistent with KDC's policies and therefore unauthorised. We discuss KDC's use of swaps later in Part 17.

Increase in subsidy amount from Sanitary Works Subsidy Scheme sought

12.41
In December 2007, KDC's Chief Executive sent a letter to the Northland Medical Officer of Health seeking additional SWSS funding from the Ministry of Health. He advised that there had been several changes since the original application had been made. These changes had increased the estimated capital costs of the project to $53 million. The Chief Executive requested a further subsidy amount of $9.8 million in addition to the $6.63 million that had already been approved. He requested an initial payment of $880,000.

Our comments

12.42
In our view, these financing arrangements were overly complex for the nature of the project and KDC. To assess what was being proposed, the Council would have needed to be able to get independent advice from its own expert legal and financial advisers. In general, sophisticated financial arrangements such as swaps are more appropriate for organisations that are large enough to maintain their own internal treasury function or otherwise have arrangements for access to specialist treasury skills.

12.43
As with other aspects of the project, we consider that the amount of documentation supporting these financing decisions and the level of scrutiny of them was inadequate.

The changes that were made to what was to be built

12.44
Both the 2005 and 2007 Project Deeds set out the parameters of the wastewater treatment plant's capacity. However, it is difficult to compare them because the two deeds use different parameters. The key design parameter for a wastewater treatment plant is the maximum daily inflow peak in wet weather. This was set out in the 2007 Deed but not in the 2005 Deed.

12.45
The 2007 Deed changed the wastewater treatment plant that was to be built. The 2005 Deed provided that an IDEA (intermittently decanted extended aeration) plant would be built, and the 2007 Deed provided that a CASS (cyclic activated sludge system) plant would be built. Both are different forms of sequence batch reactors – that is, processing tanks that treat wastewater in batches. Components of the wastewater plant were also made significantly smaller.

12.46
In effect, in 2007, the treatment plant was made smaller while the population it would cater for increased. It appears that the design capacity for the wastewater treatment plant in 2005 had been too large.

12.47
Both Beca and EarthTech told us that in around 2005 Beca and EarthTech staff had several meetings to review the design. Beca told us that:

Our wastewater engineer noted the reviews were "high-level" in nature assessing the appropriateness of the works being proposed by [EarthTech], and bearing in mind that contractually [EarthTech] was responsible for the design and we had to avoid "instructing" [EarthTech] and thereby relieving them of that design responsibility (and transferring it to KDC).

12.48
We have not been able to establish whether the reduced size of the plant affected the construction price that had been negotiated in 2007. We could also find no evidence that any consideration was given to whether this reduced size would require the resource consents to be amended.

12.49
There was also no evidence that the Council was told in December 2007 about the proposed changes to the design of the wastewater treatment plant.

Our comments

12.50
We acknowledge that, in a BOOT type of PPP, the public entity does not need to have a full and detailed understanding of what is being built or how the infrastructure will work. However, it is usual for the public entity, as the ultimate owner of the asset, to specify in broad terms what was being built and have some oversight of it. The further away from the BOOT model, the weaker the long-term financial incentives on the contractor become. As a result, the purchaser is likely to need to become progressively more interested in the detail again.

12.51
The 2005 Project Deed included some specification of what was to be built. The extent of the changes to what was being built after that contract was signed suggest that there might not have been enough consideration of what was appropriate for KDC's needs when that contract was prepared. Again, the benefits of a PPP approach of "buying the whole package" are undermined if the preparatory work has not been thorough enough and changes are needed once the contract is under way. We consider that these changes show that the contract had not been adequately reviewed before it was signed.

12.52
As we set out in Section C, this attitude was also evident during construction, when it appears that, in some cases, what was built did not match what was in the contract.

12.53
We are unable to determine whether the reductions in what was to be built in the 2007 Project Deed translated into cost savings for KDC.

Our overall comments

12.54
In our view, the growing picture is that the Council was not really in control of the project or its costs. The various changes to the project described in this Part are characterised by poor data, not enough information being provided to the Council on what it was being asked to agree and sign, a lack of independent legal or financial advice about the transactions, little work to assess value for money, and inadequate scrutiny of the detail of the project documents. The financial risks of adopting a two-stage commercial acceptance process were not explained to the Council.

12.55
The Council signed the project documents when the scope of the works to be carried out was not resolved and when the contract documents did not include all known issues. This created uncertainty about the capital costs of the scheme and caused delays that meant KDC incurred additional costs.

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