Part 8: Funding the wastewater project

Inquiry into the Mangawhai community wastewater scheme.

KDC now had to find a new way of funding the project. Although the private sector partner would still fund the construction costs for the first five years, KDC had to fund it after that. KDC's Treasury Management Policy meant that it could not simply borrow the money. In the first half of 2003, KDC brought together several different mechanisms to fund the project. It summarised the expected costs and funding mechanisms in the Statement of Proposal that was released for community consultation in July 2003.

In this Part, we discuss the various funding mechanisms that were proposed and the issues that arose with them between 2003 and 2007, as follows:

  • KDC borrowing and the policy of debt segmentation;
  • obtaining a subsidy from the Ministry of Health;
  • the 2003 Statement of Proposal and charges to the ratepayers;
  • problems with the July 2004 development contributions policy;
  • changes to financing policies in 2006; and
  • our comments.

In summary, we conclude that:

  • There was no evidence that the Council did any systematic planning or budgeting for the funding of the project as a whole.
  • The Council's changes to its Treasury Management Policy in 2006 meant that it effectively no longer had any borrowing limits for the wastewater project.
  • The Council failed to get legal and treasury advice about the change to its Treasury Management Policy.
  • The tools that the Council wanted to use to fund the scheme were operating under new legislative requirements. The Council needed to understand what those requirements were and how they affected its ability to use those funding tools. As funding from those tools was critical to the ongoing affordability of the scheme, the Council needed to ensure that the details of the tools it proposed to use were lawful at an early stage. It did not do this.

Kaipara District Council's borrowing and the policy of debt segmentation

In 1998, KDC's Treasury Management Policy set its income-to-debt ratio at 2.5:1. This meant that KDC needed $2.50 of income for every $1 of debt. Earlier in 2002, the Council reviewed its Treasury Management Policy and concluded that the policy was working well. However, there were some concerns about the limits imposed on borrowing for infrastructure projects. KDC commissioned a consultant, Mr Larry Mitchell, to investigate the effect that introducing "debt segmentation" might have on borrowing ratios.

Segmentation of debt is basically breaking down total debt into parts. The parts are typically associated with different assets and the different communities that use them. It appears that what was being proposed was that KDC could have a lower income-to-debt borrowing ratio, depending on the extent to which KDC's debt could be classified (or segmented) as being "fully performing", "partly performing", or "non-performing". Mr Mitchell classified "fully performing" debt as:

…when "user pays" revenues derived from associated revenue earning asset categories or classes is sufficient to fully recover all costs including the debt servicing costs, principal repayments and interest of the debt attached/associated with the relevant asset classes.

Mr Mitchell determined that, at that time, 73% of KDC's total debt was fully performing and that this exceeded other "peer" councils' proportions for this category of debt. He advised that, provided that the level of fully performing debt did not fall below 65% of KDC's debt and because the wastewater scheme debt was not included, KDC could change its borrowing limit to an income-to-debt ratio of 2.0:1. This would allow KDC to assume more debt while remaining within the terms of the Treasury Management Policy. The advice to KDC explained why that was appropriate for KDC's circumstances.

In October 2002, the Council agreed to consult on the proposal to change the Treasury Management Policy by including debt segmentation and changing the income-to-debt ratio as part of the 2003/04 Draft Annual Plan process.

The Council discussed that decision, and that it should soon be able to borrow more, in its January 2003 meeting about how it was going to fund the scheme. This increased ability to borrow was a critical part of the funding plans.

The Council formally adopted the lower income-to-debt ratio of 2.0:1 in the 2003/04 Annual Plan.

Application for a subsidy from the Ministry of Health

The Sanitary Works Subsidy Scheme

The Ministry of Health introduced the SWSS in May 2002. The aim of the SWSS was to improve sewage treatment and disposal for small communities that would otherwise not be able to afford sewerage schemes and to meet public health and resource management requirements. The award of a subsidy depended on the local authority agreeing to match the amount awarded with an equivalent district contribution.

The SWSS guidelines provided that the size of the works eligible for subsidy was based on the estimated population of the "participating community" in five years' time. KDC was required to agree to ensure that the subsidy's benefits were passed on to the "participating community".

There was a three-stage process for an application to the Sanitary Works Technical Advisory Committee (SAWTAC):

  • a preliminary application, to establish whether the project would be likely to qualify or whether it needed more work, and the percentage of the capital cost that was likely to be available through the subsidy;
  • an application for provisional acceptance, which required a proposal that would enable the amount of subsidy to be identified and funding to be reserved for a set period while consents were obtained and financing confirmed; and
  • the final application for subsidy had to be submitted for final endorsement once the detailed engineering design was completed, resource consents issued, all funding arranged, and the applicant was ready to commit to construction contracts.

Kaipara District Council's preliminary application

In late 2002 and early 2003, KDC had a policy of users paying for the costs of infrastructure they benefited from. This conflicted with the requirement in the SWSS guidelines that the local authority provide a contribution from across the district. The PSC acknowledged that KDC's user-pays policy did not enable a district-wide contribution. In a briefing paper prepared for a meeting with the Ministers of Local Government and Health, KDC noted that "For a large predominantly rural Council with isolated communities this approach would be politically unacceptable."

At its January 2003 meeting, the Council decided to submit an application to test its eligibility. It also resolved to consider its position about the issue of district-wide subsidies while developing a negotiation strategy with which to lobby the Government to modify the guidelines.

Beca managed the SWSS application on behalf of KDC. It submitted a preliminary application to the Ministry of Health in March 2003. It was approved in May 2003.

The provisional application

KDC submitted a stage 2 provisional application on 1 July 2003. The estimated capital costs of the scheme were listed at $15 million, broken down as follows:

  • treatment plant, $2.6 million;
  • reticulation, $11.3 million; and
  • disposal system, $1.1 million.

Initially, this provisional application was not approved. This was because it did not contain a design report or a programme/cash flow and because the estimated cost of the scheme was not designed for a projected population in five years' time. SAWTAC was also concerned about the apparent uncertainty with the method and long-term security of effluent disposal (at that stage, the site for disposing of the treated effluent had not been determined). It was also concerned about the proposed methods of managing the risk that the asset would not be in the condition required under the contract at the 15-year handover point. It invited KDC to submit a revised application.

KDC provided further information in November 2003. Estimated capital costs had now increased to $16 million (excluding the estimated $2.5 million of costs to connect individual properties). KDC provided details of the interim guaranteed maximum price of $16.8 million agreed with Simon Engineering ($800,000 of which was KDC costs) and the annual initial operating costs of $600,000. In the application, KDC also stated that the DBFO process it had adopted meant that there could be no cost increases outside its direct control.

The application provided the statistics in Figure 3 about the then-current population and KDC's growth projections until 2009. The statistics assumed a 6.7% annual increase in population and dwellings.

Figure 3
Beca's population projections, November 2003

  2003 2004 2005 2006 2007 2008 2009
No. of dwellings 1272 1357 1448 1545 1649 1759 1877
Week day population 2786 2972 3171 3384 3611 3853 4111
Weekend population 3116 3325 3548 3786 4039 4310 4599
Summer peak population 5622 5999 6401 6830 7287 7776 8297

Source: Additional information provided to SAWTAC for SWSS Application, November 2003, Section 9.

On 25 November 2003, SAWTAC recommended provisional approval of a subsidy of $6.63 million, including GST. The subsidy was based on an estimated capital cost of $20.8 million ($18.5 million excluding GST) and amounted to 31.89% of the capital cost. The approval noted that the scheme was based on a population of 5622, the summer peak population in 2003. The Ministry of Health advised KDC on 16 December 2003 that the Minister of Health had approved the provisional application and agreed to provide a subsidy of $6.63 million. The Ministry also advised that the SWSS criteria had been amended to allow local authorities to determine how their districts would meet their contribution (equivalent to the SWSS subsidy).

The SWSS subsidy reduced KDC's funding requirement. This meant that KDC now needed to borrow $6.63 million less or could reduce its other funding sources.

First Statement of Proposal and charges to the ratepayers

KDC needed to prepare a Statement of Proposal on the scheme to consult the community with. The draft Statement of Proposal was provided to the Council at its meeting on 23 July 2003, where it was adopted for public consultation.

The Statement of Proposal set out that the wastewater scheme proposed by Simon Engineering was a "fully reticulated scheme with a single centralised treatment plant and disposal to land with the opportunity for beneficial reuse". It noted that Mangawhai's ability to fund the required works was limited and that this "…has undoubtedly been a contributing factor for some in the community to object to any proposed scheme".

The Statement of Proposal provided information about how the proposed wastewater scheme was to be implemented, how much it would cost, and how it would be funded, including the rates and charges that ratepayers would pay. It set out that the project to implement the scheme would be a DBFO type of PPP.

The Statement of Proposal included a section headed "Cost". This section stated that Simon Engineering had "provided the lowest Net Present Value cost for the project and also demonstrated the greatest flexibility in being able to adjust its payment schedule to meet Council requirements". It stated that the pre-tender estimates were for capital costs of less than $17 million and annual operating costs of $800,000 (with adjustments to be made for inflation and population growth) and that Simon Engineering's tendered costs were within that. It is unclear what these figures were based on, because they were not the same as the benchmark figures. In particular, the annual operating cost in the benchmark had been estimated to be $290,000 in 2002, rising to $375,000 in 2027.

The Statement of Proposal noted that KDC had required Simon Engineering to finance the cost of construction for the first five years of operation only, with KDC then needing to refinance the capital cost after that time. It stated that Simon Engineering had provided the estimated costs of operating the scheme over the 15-year life of the contract. KDC had then developed a model to calculate the "start-up fees" (which would fund the capital cost of the scheme) and annual rates (which would fund the annual operating costs) that ratepayers would pay over 25 years.

Section 11 of the Statement of Proposal set out how this mix of "start-up fees" and annual rates would fund the scheme, as shown in Figure 4.

Figure 4
Fees and annual rates included in the 2003 Statement of Proposal

Fee and annual rates Current ratepayer Future ratepayer
Start-up fee $1,450 inc GST $16,312.50 inc GST
Annual rates 1-2 pans $483.75 inc GST
Annual rates 3+ pans $483.75 inc GST + $50 per extra pan in excess of 2

The model assumed that $5.5 million of the debt associated with funding the capital costs would remain owing after those 25 years and that the $5.5 million would be paid off over the next 15 years. That is, the model assumed that the debt associated with funding the capital costs would be paid off over 40 years. The Statement of Proposal noted:

The assumption of a 40 year period to completely fund the initial scheme addresses the issue of intergenerational equity. This means that a future generation which benefits from capital investment in infrastructure now, will also contribute to the cost of that infrastructure.

The model also incorporated the annual operating costs.

The Statement of Proposal noted that the Council had decided the assumptions on which the funding model was based after receiving feedback from the community. It stated that:

The primary consideration in this respect has been that current ratepayers should not carry the full burden of funding the proposed scheme to the benefit of future ratepayers.

The proposed annual rates for operating costs

As Figure 4 shows, the proposed annual rates would be differentiated on the basis of the number of pans on a property, regardless of the type of property. This was not consistent with the Local Government (Rating) Act 2002, which provided that, if rates were to be differentiated on that basis, then a residential property was to be treated as having one pan, regardless of the number of actual pans on the property.

After consultation, the Council changed the proposal so that only commercial properties would pay a differentiated rate depending on the number of pans. It also changed from talking in terms of current and future "ratepayers" to current and future "sections". A section was defined as a section with a "separate title" as at 22 October 2003.

The proposed "start-up fees"

Although the Statement of Proposal did not specifically refer to development contributions, it seems that the "start-up fee" for future ratepayers was intended to be a development contribution. It was described as "a charge of contribution levied under the Local Government Act 2002 to fund the infrastructure at the time of connection to the service".

The Statement of Proposal noted that "all existing undeveloped sections (properties without a habitable dwelling and or existing system) within the area will be considered as future sections for charging Start Up Fees".

The Statement of Proposal also explained that the proposed rates and fees did not include the costs of connecting existing premises or households to the scheme. It set out that owners of properties would be responsible for getting the plumbing work done to connect their properties, although it noted that KDC might look at this issue again.

The Statement of Proposal set out three options for existing residents to pay the start-up fee:

  • pay in full at March 2004 (and receive a $100 discount);
  • pay in full by March 2005; or
  • make four payments during 2004/05.

The Statement of Proposal set out what areas were included in the drainage district – that is, the areas that would be serviced by the scheme. It outlined the risk allocation and noted that "The Project Deed or contract between the Kaipara District Council and Simon Engineering will clearly spell out the responsibilities allocated to each party and the associated risks." It also noted that, although Simon Engineering had considered a range of disposal sites for the treated effluent, the disposal site was still to be decided.

The process KDC used for the 2003 Statement of Proposal is set out in more detail later in this Part. The Council set up a Hearings Committee to hear and consider submissions. The Council considered the Hearings Committee's recommendations on 22 October 2003 and confirmed that it would continue with the scheme.

The Council made several changes to the Statement of Proposal because of the Hearings Committee's recommendations. These included changing the terms "current and future ratepayer", the boundaries of the drainage district, and how the annual rate for residential and commercial properties would be levied. The Council changed the annual rate so that residential properties paid a uniform rate regardless of the number of pans on the property. Commercial properties paid a differentiated rate depending on the number of pans on the property.

In late 2003, EPS sought advice from Bell Gully about several issues with the proposed rates and development contributions. Beca told us that this was done as a variation to the original scope of the services that the project managers would provide under the contract. Bell Gully provided its final advice in February 2004. That advice confirmed that, generally, KDC could use development contributions if they were provided for in a development contribution policy and if the amount of the contributions met the requirements of the Local Government Act 2002. The Chief Executive provided this advice to the Council at its 25 February 2004 meeting.

A report to the same Council meeting included a table (as shown in Figure 5) setting out an updated proposed charging regime. This regime no longer mentioned start-up fees. Instead, it referred to uniform standard charges and development charges, with the development charges increasing for sections with titles issued after 1 July 2004.

Figure 5
Funding regime proposal

Uniform Standard Charge Development Charges Residential Non residential
1 Current section $1,450.00 $0.00 $1,450.00 $483.75 per section $483.75 per pan
2 Future section
Resource consent & Title issued prior to 1/7/04
$1,450.00 $14,862.50 $16,312.50 $483.75 per section $483.75 per pan
3 Future section
Resource consent granted prior to 1/7/04 but title not issued
  $16,312.50 $16,312.50 $483.75 per section $483.75 per pan
4 All other future sections   $16,312.50 $16,312.50 $483.75 per section $483.75 per pan

Source: Paper to the Council on Mangawhai EcoCare Project, Confirmation of Preferred Proponent and Agreement to Proceed, dated 17 February 2004, page 3.

The reasons for decision in the Council minutes stated:

The proposed regime has been legally checked and complies with all statutory requirements while being the proposal considered most appropriate by Council following its deliberations during the special consultative process.

Problems with the July 2004 development contributions policy

Beca prepared a draft policy for KDC providing for the collection of development contributions for the wastewater scheme. We could not establish from KDC's records whether KDC officers were involved in preparing this policy. However, Beca told us that the draft policy was prepared in full consultation with the Chief Executive and KDC officers. The policy does not seem to have been legally reviewed. The Council consulted on the policy using the special consultative procedure under the Local Government Act 2002. The Council adopted the policy, which came into effect from 1 July 2004.

The 2004 Development Contributions Policy provided that development contributions would fund 60% of the capital cost of the scheme. The policy did not take account of the requirement in the Local Government Act 2002 that development contributions must be linked to growth and can only be used to recover capital expenditure that was necessary for growth.

Although KDC's 2004 Long-Term Council Community Plan (LTCCP) included the Development Contributions Policy, neither the funding impact statement nor the Revenue and Financing Policy included development contributions as a funding mechanism or the amount to be collected as development contributions, as required by the Local Government Act 2002.

KDC's files show that it soon became apparent that several developers were interpreting the Development Contributions Policy in a way that had not been intended. One problem was confusion about whether the developer or the subsequent purchaser of a section was liable to pay the development contribution. KDC sought legal advice in March 2005. The law firm Brookfields advised KDC to amend the policy. KDC issued a Statement of Proposal amending the policy in March 2005.

Several submitters raised other issues than those KDC had sought submissions on and challenged other aspects of the policy, including its compliance with the requirements of the Local Government Act 2002 and its retrospective effect.

KDC again sought legal advice from Brookfields, who advised that it could "not be confident that the Policy, with or without amendments to the development contributions categories, would survive legal challenge".

In June 2005, after communications from a solicitor acting for several developers, KDC sought further legal advice about the policy. Brookfields recommended that KDC consider suspending the policy and reviewing it. At that point, KDC had not collected any development contributions, even though the policy had come into effect in July 2004. At its meeting on 24 August 2005, the Council resolved to suspend the application of the policy until it adopted a revised policy.

Changes to financing policies in 2006

It appears that the Council reviewed both the Revenue and Financing Policy and the parts of its Treasury Policies relating to borrowing in 2005. KDC's files and the draft 2006-16 LTCCP are not particularly clear, but it appears that KDC intended to consult on these two policies as part of the 2006-16 LTCCP process.

KDC's Treasury Policies included a "Borrowing Limits Policy". This policy classified KDC's debt into two groups: core debt and segmented debt. The policy then set out the criteria for classifying debt into the two groups. The main borrowing limit in the policy was the income-to-debt ratio of 2:1. However, the policy provided that segmented debt was to be excluded when determining the amount of debt for the purposes of the ratio. This was a significant change from the previous policy.

The rationale for the policy change appears to be that:

This separation of debt into two broad tiers or categories, (those of "Core" debt and "Segmented" debt) has become necessary due to the significant increases of Council borrowing proposed to finance local (sub-District) infrastructural water and wastewater asset development schemes such as "Mangawhai EcoCare".

The policy defined core debt as "the normal and customary level of Council borrowing (loans)".

The policy defined segmented debt as "debt identified using strict definitions and criteria that meet the tests as set under ‘the Provisions of Segmented Debt'". The policy further noted that it was finance that "had been raised to fund the development of local sub-District level infrastructural utility assets".

The Council also amended its Revenue and Financing Policy – in particular, the debt provisions. The amended policy provided detail on when KDC could classify debt as segmented debt. The Revenue and Financing Policy stated:

The Council has, since its last Revenue & Financing Review (conducted in 2003), entered a new debt-raising environment. This has led to the development of new methods of managing higher debt levels and has been made necessary for the following reasons:

• New infrastructure asset developments (for example the Mangawhai "EcoCare" scheme) that involve very large capital requirements and result in major increases in the Council debt.

• Existing Kaipara District Council debt level maxima are exceeded with the inclusion of these added debt-funded developments.

The Borrowing Limits Policy and Revenue and Financing Policy also provided that those who benefited from the infrastructure asset would repay segmented debt associated with that asset through mechanisms such as targeted rates or development contributions. The criteria for debt segmentation included that the amount recovered through such mechanisms would need to be:

… sufficient to meet all scheme funding and servicing costs and is available directly to the Council, as a full recovery of all of the costs of development capital funding as well as costs related to the asset, including depreciation and the costs of debt servicing associated with the asset.

Mr Mitchell told us that he provided some advice on debt segmentation to KDC but that he was not involved in finalising the changes to the policies. He told us that "the clear purpose of the segmented debt policies was to ensure that debt to finance EcoCare was always matched by Mangawhai revenues derived from the usage charges from the scheme sufficient to support the project's debt servicing costs". He also told us that at all times he "cautioned prudent debt levels".

Our comments

Our main concern about the work done on funding is that we found no evidence of any kind of systematic planning and budgeting for funding the project as a whole. Work was done on individual issues when they arose, and documents were prepared for individual purposes, such as the SWSS application and the formal community consultation. However, that work did not draw on any internal KDC system for managing the project. We saw no documentation to suggest that a system for planning, management, reporting, or budget purposes existed.

The result has been that it is difficult to get a clear and consistent overall picture of the project's costs and KDC's funding proposals. Different documents use different figures and terminology. The estimated costs changed quickly, and the likely funding sources were not precisely defined. The Council does not seem to have tracked what the estimated costs were going to be or how it was going to fund them within the parameters of the funding sources available and in keeping with KDC policy. We have tried to reconstruct that picture for ourselves during this inquiry, but it has not been possible to do so with any precision. The summary in Appendix 5 shows the quality of the information.

In our view, this level of informality is totally inappropriate for a project of this size and complexity, with the financial constraints that the Council was working under. Although the project managers might have done formal project management for the work they were carrying out, the scope of their services were limited. The Council needed to understand what issues the project managers were not managing and keep general oversight of the project. We could find no evidence that the Council did either.

Borrowing policy and debt segmentation

The work that KDC did to review its borrowing limits in 1998, and between 2002 and 2004, was careful. It included an analysis of how KDC was positioned compared to similar local authorities. The borrowing limits that required annual income to be two and a half times the amount of debt, and then two times the amount of debt, were conservative but reasonable based on the advice the Council received.

However, the change in the debt policy in 2006 that excluded segmented debt from being subject to any borrowing limits does not seem to have been as well thought through by KDC. We formed this view for a number of reasons.

First, comments in the debt policy noted that KDC had entered a new debt-raising environment and that the debt policy was changed out of necessity. Commenting that the change was made out of necessity, rather than setting out a rationale for the change, suggests a view that the change had to be made regardless of its merits.

Second, although the provisions in the policy for debt to qualify as segmented looked sensible, there was a level of subjectivity in them, and the provisions did not include borrowing limits for segmented debt. Setting borrowing limits is helpful because it provides an objective measure. At the time, section 104 of the Local Government Act 2002 required the Council to include specific borrowing limits in its policies. In our view, excluding segmented debt from borrowing limits did not comply with the intent of the legislation and reduced the focus on affordability of total KDC debt.

Third, the concept of segmented debt as something quite separate from KDC debt is not accepted practice in any other local authorities. Other local authorities that managed their debt internally by breaking it down into parts did so under an overall council debt strategy with overall borrowing limits applying to total council debt.

Fourth, KDC did not seek independent legal and treasury advice about the change to its debt policy. Given that financing policies are required by legislation, that KDC's policy was different than other local authorities, and that changes to the policy appeared to be driven by necessity, it would have been prudent for KDC to get independent legal and treasury advice.

Fifth, when assessing whether debt is within borrowing limits, it is important to ensure that the right revenue and debt amounts are used. Under KDC's policy, the segmented debt and the associated revenue that would be used to service and repay that debt needed to be excluded from the amounts used. We noted that, when it assessed the borrowing limit on core debt, KDC did not explicitly exclude the revenue associated with the segmented debt. This resulted in the revenue associated with segmented debt being accounted for twice. It meant that the Council was making financial decisions on the basis of artificially inflated revenue to service and repay the core debt. KDC's former Chief Executive and Mr Mitchell both told us that the debt segmentation policy was not intended to be applied in this way.

Charges to ratepayers

In our view, the Council needed to closely manage the expected cost and funding for the scheme, given that affordability was such an issue. In particular, it needed to understand:

  • the funding model that PwC (Australia) had developed;
  • the growth projections that the funding model relied on;
  • the mechanisms proposed for funding the cost of the scheme; and
  • the risks – for example, if growth did not occur as projected.

KDC's former Chief Executive told us that the funding model was initially fully explained to the Council and that councillors indicated that they had a good understanding of it. He noted that, when additional connections were proposed to be added, the funding model would be reworked and reported to the Council incorporating the new costs. He told us that this was done at workshops "so the Council could be fully informed and ask as many questions as it needed to understand the matter". He also told us that the mechanisms to fund the cost of the scheme, including when refinancing was needed (when the loan expired), the length of time over which the financial model was run, and how each of the elements of the cash flow contributed to this were all explained to the Council initially at workshops and then each time the PwC (Australia) model was reworked.

We discuss the growth projections the funding model relied on, and risks if that growth did not occur, in Part 11.

As we have set out above, there are risks to providing information such as this in workshops when the papers then do not form part of KDC's records behind its decisions. Because there were no records of workshop meetings, we were unable to confirm what KDC's former Chief Executive told us.

The main funding for the scheme was going to come from charges to ratepayers over the life of the scheme. These included development contributions and rates. These revenue tools are tightly constrained by the Local Government Act 2002 and the Local Government (Rating) Act 2002. In our view, the Council should have considered the legal detail of the charging mechanisms available to it from the outset. Instead, the early papers and funding proposals are written in high-level terms using language that does not match the terms used in the Local Government Act 2002 and the Local Government (Rating) Act 2002.

In our view, the Council did not pay enough attention to the need to ensure that its charges complied with the law. The problems with the clarity and enforceability of the initial Development Contributions Policy meant that development contributions were not able to be charged for much of the time during which growth occurred.

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