Auditor-General's overview

This report describes how Kaipara District Council (KDC) managed the Mangawhai community wastewater scheme between 1996 and 2012, as well as the role played by other agencies, including my Office.

The matters this report covers are long and often complex, but the overall picture is simple. I summarise it as a woeful saga. Overall, the inquiry found that:

• KDC failed to attend to its fundamental legal and accountability obligations.
• KDC effectively lost control of a major infrastructure project.
• Some of the work done on behalf of the Auditor-General has fallen short of the standards I expect.

Why I agreed to carry out this inquiry

The Commissioners and staff at KDC, together with the community they serve, have to find a way forward on the challenges facing them. No inquiry by this or any other office can do that for them. What this report can do is:

• tell the story of what happened; and
• draw out lessons for the sector, so other communities can avoid facing similar challenges.

When KDC asked me to carry out this inquiry, it told me that it did not think it and the community could move forward effectively without an objective account of what happened. It was also clear to me that my Office could identify important lessons for the sector. These were the two public-facing purposes of our work.

However, there was a third purpose. Questions had been raised about the quality of the work done by KDC's auditors. That work is done in my name by people I appoint. The role of Auditor-General is an important and long-established constitutional safeguard. As the current holder of that office, I have an obligation to maintain the health, capability, and reputation of the organisation. If there were problems, I wanted to understand and fix them. I therefore wanted to put the spotlight on my own organisation and scrutinise the work being done in the name of the Auditor-General. I considered that I needed to do that formally and publicly.

What happened with the wastewater scheme?

After 20 months of carefully collecting and analysing evidence, this inquiry has made some clear findings about what happened. The positive findings are that:

• the decision that Mangawhai needed a reticulated wastewater scheme was well founded; and
• the wastewater scheme that has been built works effectively and has appropriate capacity for population growth.

The other findings are more sobering.

Overall, KDC has ended up with a wastewater scheme that works, but it has come at a significant cost. The fact that we cannot put a precise figure on that cost is indicative of KDC's poor management.

KDC's records did not contain good or systematic information on the total amount spent. However, our best estimate is that the total cost was about $63.3 million.

The overall costs are not just financial. They include a failed council, councillors who have been replaced with commissioners, the departure of a chief executive, a severely damaged relationship between the council and community, an organisation that has needed to be rebuilt, and much more.

KDC had poor governance, management, and records

This report sets out the facts that we have been able to establish and provides our comments on them. However, our work has been made much more challenging by the poor state of KDC's records. My staff went to considerable lengths to obtain information from other sources, but there are many points where we have simply been unable to establish exactly what happened. These points are highlighted in the report.

KDC's decision-making processes were also poor throughout the entire 16 years of the wastewater project. KDC relied too heavily on its professional advisers and had a practice of receiving briefings and effectively making decisions in informal workshops. The governance and management arrangements put in place specifically for the project were also inadequate. In our view, these underlying problems made it harder for KDC to deal with the problems that emerged as the project progressed.

Out of depth with public private partnership decision

KDC decided that it wanted to explore a public private partnership (PPP) approach, to keep the debt "off the balance sheet" and to put as much risk as possible on to the private sector provider.

In my view, this decision took KDC out of its depth. It followed all the right basic steps when it initially went to the market for advisers and put the project to tender, but it did not fully understand the complexity of what it was doing. The early decision to use a PPP approach put too much emphasis on achieving a certain accounting outcome and the transfer of risk, and not enough on value for money and affordability. KDC's decision-making about the PPP was not consistent with the good practice guidance that was available at the time.

In late 2002, the enactment of the Local Government Act meant that KDC could not proceed with the type of PPP contract that it had gone to tender with. It decided that it could proceed with the preferred provider that had been selected for negotiation and modify the basis for the negotiations. The new legislative constraints should have prompted a more fundamental reconsideration of how the project was being approached.

Poor contracting

Contract negotiations were well advanced with one company when its parent company went into voluntary administration in 2005. KDC decided to negotiate directly with EarthTech, one of the other tenderers from 2003. That decision left KDC unable to assess whether the contract it negotiated was cost-effective or competitive.

KDC's approach to funding the project was inadequate. It did not do enough to check the appropriateness of the policies it was adopting. The changes KDC made to its Treasury Management Policy meant that it effectively had no borrowing limit for the wastewater project. It also implemented its debt segmentation policies badly.

The contract was signed in 2005 without an identified disposal site for the effluent. This was unwise. It created a significant risk for the project and left KDC in a weak bargaining position when purchasing a site. The 2005 contract allowed $361,000 for disposal costs, but the total costs ending up being about $14 million. KDC had entered into legal commitments to proceed without having a good understanding of the total cost of the project.

The contract was revised substantially in 2007. Changes included provision for a pipeline and associated works that were needed because KDC had bought a farm as a disposal site that was some 11 kilometres away from the treatment plant. We identified many flaws in the way KDC went about approving the contract and in the detail of the contract itself. We question whether the final contract achieved KDC's original financial and risk management objectives.

I am also concerned that KDC does not appear to have regarded the disciplines and checks in the contract about the construction and handover process as particularly important. In my view, the relatively relaxed approach that was taken to some of these protections, such as the approval processes involved in commercial acceptance and handover of the asset, exposed KDC to unnecessary risk.

Attempts to spread the cost among more ratepayers

For these and other reasons, the costs of the project increased steadily. KDC assessed affordability by considering the annual cost to ratepayers. It decided to increase the number of estimated ratepayers that would be covered by the scheme and contribute to funding it. KDC increased the scope of the project to cover more properties and adopted new growth projections that assumed more properties would be developed.

We have criticised these decisions on the grounds that they were not based on good information and did not take adequate account of the risk of slower growth. KDC's focus on the annual cost to the ratepayer as a measure of affordability was unfortunate: it meant that it did not fully appreciate the significant increase in capital costs and the effect on the project's overall affordability.

Making significant changes after consultation

This report also criticises KDC for putting out a Statement of Proposal for consultation in February 2006 based on one set of proposals and then deciding to change the growth projections, the area covered by the scheme, and the cost of the project in October of the same year.

Consultation and communication with the community was good in the early stages of the project. However, it reduced considerably from about 2006, once significant problems started to arise.

Complicated financing arrangements

As the project proceeded, it became clear that KDC did not understand the detail of what was involved in the complex contractual and financial arrangements or how the various parts related to one another.

This report is particularly critical of how little grip on the financing and borrowing arrangements KDC appears to have had. My staff identified several instances where unwise financial arrangements created additional costs. For example:

• The delays to the start of the project cost KDC an estimated $450,000 in additional financing costs.
• A swap transaction had to be broken because it did not match with the commercial acceptance dates and expected cash flows under the contract. The swap termination costs were $840,000.

The review of the work carried out in my name

The independent review of Audit New Zealand's audit work

While this inquiry has been under way, many people have suggested that it is inappropriate for me to review the work of my own business unit. I disagree. There are times when the head of any organisation needs to take a hard look at what is being done inside a part of their organisation.

The standard approach is to commission an independent person to carry out the review and provide a report. That is what I have done. I commissioned an independent expert, with a well-qualified peer reviewer, to provide me with his views on the quality of the work that has been done on my behalf.

That process is totally transparent: the terms of reference and the full and independent review report are published as part of this report.

There were problems with the way some of the audit work of KDC was carried out. The review noted that audit quality varied significantly over the period covered by the review, although there was a notable improvement in later years. The review criticises the quality of documentation in some audit files, particularly the documentation that should explain why particular audit judgements were reached. It also finds that, in the years 2006 to 2009, the auditor did not reassess the status of the wastewater project, despite it undergoing significant changes during these years, and did not identify it as an audit risk. Nor did the auditor identify problems with KDC's rates. The auditor relied too much on the information KDC's management provided. As a result, the independent review concluded that the audit work carried out in those years was inadequate.

I am disappointed by these findings.

However, I take comfort from the fact that the independent review did not raise concerns about Audit New Zealand's general systems and methodology. Successive independent reviews of Audit New Zealand in the last decade identified no matters of concern. At a personal level, I also know that Audit New Zealand's leadership and staff have a deep commitment to professionalism, hard work, and the important role that they play in our system of public sector accountability.

In recent years, Audit New Zealand has had a programme of work to improve the quality and consistency of its audit work. The benefits of this work are apparent. However, I consider that more is needed to reassure Parliament, the public, and public entities that they can rely on Audit New Zealand's work. The steps I am taking to ensure that the lessons are learned and that there is consistent quality across all audits include:

• requiring that Audit New Zealand demonstrate to me that it consistently maintains an appropriate standard of work, by developing an improvement programme that will be overseen by two independent advisers;
• deciding that, until that reassurance is provided, I will not allocate new audits to Audit New Zealand; and
• accelerating the Office of the Auditor-General's normal quality assurance programme so that all auditors of local authorities will have had a review of a local government audit file by the end of June 2014.

Audit New Zealand has agreed that these steps are appropriate. It will continue its quality improvement work with additional focus on the matters raised about KDC.

The review of how the Office of the Auditor-General and other accountability agencies responded to concerns

This report contains a review of the way that the Office of the Auditor-General (OAG) and other accountability agencies dealt with the concerns members of the public raised with us. That part of the inquiry was carried out by Phillippa Smith, the Deputy Auditor-General, because she had not had any significant involvement with matters relating to KDC in the past.

This review acknowledges that many of the concerns that correspondents raised have proved to be well founded. However, it has concluded that the various agencies' responses were generally reasonable, given the role and approach of the agencies and the information available at the time. Nonetheless, it is clear that the OAG can improve how it communicates with correspondents and that there would be value in the accountability agencies working more closely together and pooling information where possible.

I have acknowledged that, with the benefit of hindsight, it would have been appropriate to reconsider the situation more fully in late 2011, in light of the renewed correspondence from ratepayers and the additional information emerging from KDC. If we had done so, this inquiry might have begun a few months earlier.

However, that would not have changed what happened, because the wastewater scheme was already built and operating. An inquiry cannot undo the cumulative results of years of poor decision-making.

What lessons can we take from this saga?

It is often said that we learn most from our mistakes. This saga has provided many valuable lessons for all those involved and for the sector as a whole. This report highlights lessons about:

• governance – such as the need for members of a governing body to have the courage to keep asking questions until they understand what they are deciding, and the benefits of formal processes and records to support decision-making;
• management – such as the importance of understanding the limits of contracting out so that organisations do not become too lean, the need to maintain enough financial expertise to manage their financial affairs, and the importance of project governance and management arrangements that ensure that a steady eye is kept on the big picture;
• PPP arrangements – such as the need to ensure that entities have the expertise to manage complex contracts, the fact that accounting issues should not drive the decision to enter into a PPP, and that transferring risk has costs and should not be seen as an end in itself;
• public sector auditors – such as the importance of understanding the critical risks of an entity (looking beyond the financial statements to the entity as a whole and looking across successive years to consider trends), the need to document evidence and judgements, and the need for good and open communication between the entity and the auditor if the relationship is to be effective and provide value; and
• accountability agencies – such as the need to talk to one another and share appropriate information, the need to keep an eye on the developing big picture alongside the detail, and the dangers of inadequate communication and assuming that people are familiar with the details of the agencies' roles and how they work.

There are two other general points that emerge from this inquiry that I highlight here, for everyone in the public sector:

• Legality and accountability must be fundamental to all parts of a public entity's work.
• A public entity cannot contract out all responsibility for what is done in its name.

Legality and accountability are fundamental in the public sector

The underlying issues that are of most concern are the lack of attention that KDC gave to its legal obligations and to its obligation to be able to account to the community for its decisions and actions.

I acknowledge that these issues were at the heart of the concerns raised by ratepayers.

Legislation enacted by Parliament is more than general guidance. Every public entity is exercising the power of the state. The essence of the rule of law is that the power of the state must be exercised in accordance with the law. Compliance with the law is not optional, and near enough is not good enough. There have been too many examples in recent years of public sector entities being too cavalier about matters of legal compliance. All public entities need to pay careful attention to both the spirit and the letter of their legal obligations if they are to retain the trust of the people they serve.

It is also fundamental that public entities should be able to demonstrate what they are doing and why, when that is questioned. Public entities should expect to be tested, whether by members of the public, the media, or the courts. This is accountability in action, and public entities need to be ready to explain themselves. That has implications for how public entities operate on a daily basis: they need full and proper records of their work that show what decisions were made, who made them, and the basis on which they were made. I was shocked by the state of KDC's records and its loose approach to decision-making.

Responsibility cannot be contracted out

Many public entities contract out parts of their work to other providers. That has always been the case, and it will continue. It is often efficient. However, the responsibility for the work still rests with the public entity. Any public entity that is contracting out work must ensure that it retains enough oversight and control to enable it to give effect to that responsibility. Whether that has been done is usually tested when something has gone wrong and the responsible entity is not ready or able to respond quickly and appropriately. It can be a painful and expensive lesson.

Sophisticated contracting techniques, such as PPPs, enable a careful allocation of risk between the contracting parties. This allocation process creates incentives for efficiency and effectiveness. Public entities need to understand that it does not mean that they are no longer responsible.

Conclusion

It is important not to lose sight of the practical achievement that sits behind this inquiry: Mangawhai needed a reticulated wastewater scheme, and it now has one that operates well. But that achievement has come at a significant cost. It has exposed significant weaknesses in the way that KDC has been operating. It has also highlighted some challenges for the local government sector more broadly.

It is also important to remember that an audit provides a level of confidence about publicly reported information, but is not a total health check on the finances and performance of an entity. I can't put it any better than this comment to me from a public entity:

By its nature, there's potential to miss things as you can't audit everything. External auditors are indicators. It's still valuable information but [entity] processes should provide you with greater assurance.

Nonetheless, it is clear that some of the audit work has fallen disappointingly short of the standards we and others expect. For this, I apologise unreservedly.

This inquiry has been long and hard for all involved and has taken considerable resource. From my perspective, it will be worth the considerable resource we have invested in it if local and central government use this report as a basis for genuine reflection and debate on how we can do things better. I would like to assure the community that the OAG and Audit New Zealand will be doing this. We have taken to heart the message that we need to do more, throughout all our work, to join the dots.

Finally, I offer my thanks to all those who have been involved in this inquiry – my staff, the consultants who helped us, and the people from KDC, as well as the parties who provided us with information and comment during our work.

My particular thanks go to the Mangawhai community for their patience and willingness to share their information and concerns with my staff.

Lyn Provost
Controller and Auditor-General

26 November 2013

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