Part 4: Getting the design of a council-controlled organisation right

Governance and accountability of council-controlled organisations.

4.1
In this Part, we consider:

4.2
In setting up a CCO, a local authority may need also to consider other questions such as:

  • how it will manage possible conflicts between its role as shareholder of a CCO and a role as purchaser of the CCO's services or regulator of the CCO's activities; and
  • whether it needs to ensure a "level playing field" between the CCO and the CCO's local competitors.

The need for clarity of purpose

4.3
It is important that a local authority is clear about why it has a CCO or CCOs. The purpose of each CCO needs to be clear to the local authority's elected members and to the CCO. The purpose for the CCO is likely to affect:

  • the choice of the CCO's legal form;
  • the detail of its constitution;
  • who the local authority appoints to govern the CCO; and
  • the arrangements that the Council puts in place to monitor the performance of the CCO (see Part 7).

4.4
A local authority must consult the community before setting up a CCO.21 It must be able to state the CCO's purpose clearly to enable effective consultation with the community and to set clear objectives for the CCO. This is an opportunity for the local authority to explain its reasons for setting up a CCO, say why it is choosing a CCO over other options considered, ensure that its objectives for the CCO are known, and take account of community views in its decision-making process.

Local authorities should consider whether the CCO's purpose is consistent with the purpose of local government

4.5
The purpose of local government was changed in 2012. It now focuses on the needs of the local authority's own district or region for local infrastructure, local public services, and regulatory functions. The purpose for local government formerly referred to promoting the social, cultural, economic, and environmental well-being of communities, in the present and in the future.

4.6
A local authority must, in its district or region, "meet the current and future needs … for good-quality local infrastructure, local public services, and performance of regulatory functions in a way that is most cost-effective for households and businesses".22 It would seem that the purpose of a CCO should fall within that statutory definition of the purpose of local government.

4.7
Section 11A of the Act provides that a local authority, in performing its role, must have particular regard to the contribution five core services make to its communities:

  • network infrastructure;
  • public transport service;
  • solid waste collection and disposal;
  • the avoidance or mitigation of natural hazards; and
  • libraries, museums, reserves, and other recreational facilities and community amenities.

4.8
Most of the activities of the CCOs known to us fit within the five core areas listed in paragraph 4.7. Other activities include:

  • contracting in areas outside core activities, such as property development, including outside the district or region;
  • economic development;
  • forestry and farming; and
  • technology and innovation (where it is not obviously related to core activities such as waste).

4.9
Our observation from this study and our other work with local authorities is that most local authorities have not yet considered in any detail how the 2012 revised purpose of local government might affect or constrain CCO activities.

Should the entity be commercial or non-commercial?

4.10
When setting up a CCO, a local authority needs to decide whether the CCO's main purpose is to operate a business for profit or to perform a public benefit activity, such as provide a service to the community on behalf of the local authority.

4.11
If the local authority intends the entity to be a profit-making enterprise, the entity will be a CCTO and the most appropriate structure for the entity is likely to be a company. For non-profit activities, such as operating community facilities, the entity will be a CCO and a structure such as an incorporated society or charitable trust may be more appropriate.

4.12
When considering the Auckland Council CCO structure, the Auckland Transition Agency noted the benefits of carrying out commercial activities through CCOs:

  • CCOs can use board appointments to introduce commercial disciplines and specialist expertise to add value to CCOs and help them to better achieve their objectives and the Council's long-term strategies.
  • CCOs focus on achieving a constrained set of business objectives (as opposed to the much broader focus of councils). This, along with a corresponding drive to align resources with the required outcomes, brings a unifying focus to the entity.
  • CCOs can make efficiency gains by aligning systems and processes to the specific needs of the business (again, as opposed to the multi-faceted nature of councils).
  • CCOs are often able to collaborate more effectively, especially by forming partnerships and alliances with the private sector. CCOs are commonly perceived as being more commercial and flexible than local authorities.23

4.13
From the local authority's perspective, giving responsibility to a capable board to run a commercial activity efficiently on the local authority's behalf can free up the local authority to focus on matters such as strategy, policy, or regulatory functions.

Why set up non-profit CCOs?

4.14
Most of the reasons for setting up separate entities relate to commercial entities. The Royal Commission noted that the main reason for setting up a non-profit CCO was to empower a local community. As Figure 3 shows, a local authority may also set up a CCO with the intention of distancing it from the local authority to better attract funding from the community, particularly in the arts sector.

Figure 3
External funding sources for non-profit council-controlled organisations – Tauranga Art Gallery

Tauranga Art Gallery was initially set up by an independent trust. Much of the capital funding came from private sources. The Gallery later became a CCO when the Council was required to provide ongoing operational funding and determined that increased oversight was required.

One of the Gallery's objectives, as set out in its Trust Deed, is to lead and promote activities to raise funds for the Gallery. A review of the Gallery's governance structure in January 2013 (Morrison Low, Tauranga City Council Review of CCOs and Tauranga Art Gallery Trust) identified the lack of funding as an ongoing concern. The report commented that no public art gallery is self-sustaining financially, and all rely on public funding to be sustainable. The report also recorded a view that potential donors can be reluctant to donate funds to a Council-owned entity because benefactors think that they are subsidising the Council. This concern has led to the establishment of independent fund-raising foundations, in Tauranga and elsewhere.

4.15
A local authority may also seek to "ring-fence" risk. We commented in Part 3 that local authorities need to recognise that they are likely to retain reputational responsibility for CCOs even when they try to transfer risk.

Tax

4.16
Tax considerations are also relevant in deciding whether to set up a commercial or non-commercial entity, and in CCO group structures where some of the entities are profitable and some are not.

4.17
A non-profit CCO with charitable purposes that is not a company may be recognised as exempt from income tax. A CCO can operate on a commercial basis but be a non-profit entity. However, if it has a purpose of making a profit and is able to return profit to its shareholders, it will be a CCTO.

4.18
Tax is a complex area on which a local authority should seek specialist advice.

The council-controlled organisation's constitution

4.19
In setting up a CCO, the local authority will prepare the CCO's constitution. This is a set of rules for governing the actions of a CCO. The Act requires all decisions about operating the CCO to be made in keeping with its statement of intent (discussed in Part 7) and constitution, so it is important to get the constitution right.

4.20
Most CCTOs will be companies, but a non-profit CCO could be a trust, partnership, incorporated society, joint venture, or other arrangement. The form of the "constitution" referred to in the Act will vary accordingly.

4.21
The constitution is a means by which the local authority can:

  • define what matters must be referred back to local authority and what can be decided by the CCO's directors;
  • permit directors of the CCO to act in the interests of the local authority or holding company, rather than the CCO, as provided by section 131(2) of the Companies Act 1993; and
  • recognise and set out procedures for managing potential conflicts between its roles as owner and purchaser or funder or regulator (see paragraphs 4.37-4.42 ).

4.22
Formal documents such as the constitution and the statement of intent, and non-statutory measures such as a letter of expectations, play an important role in ensuring that the purpose and role of the CCO is clearly understood. These documents should be reviewed regularly – see Example 4 in Appendix 1.

Section 131(2) of the Companies Act 1993

4.23
There is a question as to whether a CCO company's constitution should include a provision enabling a director of the subsidiary to act in what the director believes to be the best interests of the parent rather than the subsidiary, as permitted by section 131(2) of the Companies Act 1993.

4.24
In our view, section 131(2) of the Companies Act adds little to the requirements of the Local Government Act. Section 59(1)(a) of the Local Government Act provides that the principal objective of a CCO is to "achieve the objectives of its shareholders, both commercial and non-commercial, as specified in the statement of intent". This means that the interests of a CCO ought to be aligned with those of its parent authority. However, it is possible that issues may arise that are not specifically covered by the statement of intent.

4.25
There are arguments in favour of including a provision to give effect to section 131(2) in a company CCO's constitution. CCOs are part of a local authority group, and the community frequently expects the same accountability from a CCO as it does from the local authority. A section 131(2) provision enables directors to take account of the wider social obligations of the parent authority.

4.26
It is possible that directors less used to governance in the public sector might take comfort from such a provision. Further, it might help councillors who are directors of CCOs to manage any potential conflict between their roles as councillor and as director.

4.27
Of the local authorities we reviewed during our work, most include a section 131(2) provision in the constitutions of subsidiary companies.

Holding company

4.28
A holding company will have responsibility for managing a local authority's interests in its subsidiary entities and will usually carry out the monitoring role on behalf of the local authority (see Parts 6 and 7). The holding company's primary responsibilities will be for the strategic direction of the local authority's CCOs as a group and monitoring their operational performance.

4.29
A holding company can develop and promote best practice in corporate governance processes. It can contribute specialist commercial skills, experience, and business disciplines to the monitoring of the local authority's trading activities and be a valuable adviser to CCO directors and officers.

4.30
Of the local authorities we considered in this review, Christchurch City Council, Dunedin City Council, and Greater Wellington Regional Council have holding companies. Tauranga City Council had a holding company but has now disestablished it.

4.31
We discussed the advantages and disadvantages of a holding company with people we interviewed. They identified the following advantages of a holding company:

  • It enables a clear focus on subsidiary entities' performance and governance.
  • Borrowing can be managed at a group level.
  • It helps to separate politics from the commercial realities of running a business.
  • It can remove or reduce undue political influence on the appointment of directors for the subsidiaries.
  • It enables an appropriate delineation between operations and governance responsibilities.

4.32
On the other hand, interviewees identified the following disadvantages:

  • A holding company structure does not help with community relations and often makes discussions between the local authority and an operational CCO difficult.
  • A holding company can act as a barrier between the subsidiary and the elected members – delegating the monitoring role to a holding company can create an additional layer of reporting that elected members do not support because they want to "look the board in the eye".

4.33
We discuss monitoring by holding companies further in Part 7, and Examples 1 and 3 in Appendix 1 are about holding companies.

Other matters to consider

4.34
A local authority will never be just the shareholder of a CCO. It will always be accountable to the community for the activities of the CCO. It is also likely to have other roles for the CCO – such as purchaser, regulator, or promoter of economic development in the district.

4.35
A protocol to clarify the various relationships between the local authority and the CCO can help define the governance relationship. Such an agreement will also help define the commercial relationship between a CCO and its parent entity where goods or services are being purchased.

4.36
Where possible, local authorities should consider and make their position on these matters clear when setting up a CCO. This is because they can affect community views on the proposal.

Managing the owner/purchaser roles

4.37
When a local authority is purchasing services from its subsidiary, there is an inherent tension between the two roles. As shareholder, the local authority is interested in the efficient and successful operation of the CCO. It sets objectives and expects the CCO to achieve them. Those objectives might include making a profit. However, as purchaser, the local authority will want to minimise the cost of the service, whether that cost is met by the authority directly24 or by fees paid by ratepayers.

4.38
As shareholder, the local authority will monitor the CCO's performance (unless that function is carried out by a holding company). It may also want to monitor aspects of the CCO's performance in providing services. The two concerns should be separate, and the monitoring processes should ideally be kept separate. For instance, different council officials could be responsible for the two functions.

4.39
For example, in Christchurch, City Care has separate relationships with Christchurch City Holdings Limited (CCHL) as its parent and with the Council officers for the works contracts it has with the Christchurch City Council.25 City Care representatives we spoke with said that they had no contact with councillors (other than in their capacity as CCHL directors). They described the relationship with the Council as "purely contractual" and related only to service delivery. City Care's accountability relationship is with its immediate parent, CCHL.

4.40
The "ownership" relationship will be recorded in the statement of intent and any letter of expectations. It is important that the purchaser relationship is also recorded.26 A purchase contract will define matters such as service level, price, and the rights that the local authority will have as purchaser to monitor the CCO's performance of its obligations.

4.41
Determining fees and charges is an operational decision that the directors of the subsidiary are responsible for. However, the local authority could reserve the right to set fees or require the CCO to consult it. In practice, ratepayers will want affordable fees and charges for services. Ratepayers may look to their elected representatives to intervene when fees are increased or when ratepayers consider them to be too high. Although actual accountability will lie with the CCO, elected members will retain some political accountability. We discuss this matter further in Part 8 and in Figure 7.

4.42
A local authority should consider whether, if the service and its price is so significant or sensitive that elected members want to have a continuing involvement in it, it may not be a suitable function for the local authority to devolve to a CCO.

Competitive neutrality

4.43
Local authorities generally try to promote economic development in their districts by encouraging businesses to set up there. However, there is an argument that CCOs operating in direct competition with private businesses may inhibit competition and deter business growth.

4.44
The Act has some restrictions to ensure "competitive neutrality" for CCTOs. These provisions restrict the local authority's ability to lend money on favourable terms to CCTOs or to give any guarantee, indemnity, or security for a CCTO's performance of its obligations.27

4.45
There is no restriction in the Act on a local authority awarding contracts to its CCOs. This is a matter of policy for local authorities. The local authority's procurement policy should cover contracting with CCOs and how it fits with the local authority's overall policy and strategy. In some instances, local authorities might have strategic reasons for giving their CCOs work, such as ensuring their financial viability. However, controversy can arise if it appears that the local authority favours its CCOs by awarding contracts to them or subsidising their operations.

4.46
In other instances, local authorities require their CCOs to compete for work on the same footing as other businesses. This can be a concern for CCOs, especially if they are facing financial difficulties and if they see themselves as part of the broader council group that the local authority has responsibility for. Equally, the community may consider that the local authority should favour its CCO as a local employer over competitors from outside the district. We consider this further in Example 2 of Appendix 1.

4.47
The question of subsidy, whether real or perceived, can arise when a CCO competes with a privately owned business. Figure 4 describes the example of Tauranga City Council's aquatic centre, which includes a gym.

Figure 4
Competing with private businesses – Tauranga City Council's aquatic centre and gym

Bay Venues Limited is a subsidiary of Tauranga City Council. It manages the Council's aquatic centre and gym. It charges one fee for membership of both the swimming pool and the gym. Other gym providers argued that they cannot match this deal and that the CCO is subsidising the cost of gym membership.

Tauranga City Council has a policy* about Council involvement in commercial activity and whether the Council or a CCO should deliver that activity. The policy covers factors such as financial benefit to the community, contribution to the Council's strategic objectives, synergy with a public service delivered by the Council, and competitive issues.

Councillors were satisfied that the gym was making a profit that subsidised the ratepayer-funded aquatic facility. It appeared that the fees charged were at the upper end of typical membership fees in Tauranga, and that there was no subsidisation of the gym.

The Council has agreed, in its Enduring Statement of Expectations for Bay Venues Limited,† that the CCO may increase fees for "non-commercial pricing decisions" – where an entry price has a Council subsidy – without consulting the Council, provided the increase does not exceed the annual increase in the Consumer Price Index. Any pricing change above that must be agreed with the Council as part of annual funding negotiations. The CCO can set prices for commercial activities as it wants, as long as the Council has warning of any significant change.

* See Example 5 of Appendix 1 and http://econtent.tauranga.govt.nz/data/documents/committee_meetings/2014/december/agen_council_15decem2014_dc358.pdf.

† Commercial Activities in Council Facilities Policy, adopted 15 June 2011.

Council as regulator

4.48
We comment on the regulatory responsibilities of local authorities for the sake of completeness.

4.49
Local authorities have many regulatory responsibilities under several statutes. Local authorities can be both service provider and regulator of that service. They can also be in competition with other private providers at the same time.28

4.50
If a CCO carries out regulatory functions, the local authority should ensure that it puts in place the same separation between the regulator function and the CCO as it does when the local authority carries out the regulated activity.

21: Section 56 of the Act.

22: Section 10(1)(b) of the Act.

23: Auckland Transition Agency (March 2010), Auckland in Transition Report of the Auckland Transition Agency, "Volume 2 Attachments: Council Controlled Organisations". page 8.

24: Section 14(1)(f) of the Act requires a local authority to carry out any commercial transactions in accordance with sound business practices.

25: We discuss City Care and its contracting arrangements in Example 2 of Appendix 1.

26: If the CCO is responsible for delivery of infrastructure, services, or regulatory functions for the local authority, there must be a contract or other binding agreement, unless one of the exceptions in section 17A applies – see sections 17A and 61 of the Act.

27: Sections 62 and 63 of the Act.

28: New Zealand Productivity Commission (2012), Local government regulatory performance.