Mini-Hoon: S&P's Anthony Walker critiques 'Local Water Done Well'

Just briefly, I spoke last night with Standard & Poor’s Global Ratings Director of Government Ratings Anthony Walker last night about a research note S&P Global published yesterday titled: ‘New Zealand Water Reforms Don’t Guarantee Rating Relief For Local Councils.’

He told me there was no guarantee the current Government’s ‘Local Water Done Well’ reforms would alleviate the negative outlooks S&P Global had on many councils’ credit ratings, even though the creation of separate water authorities in accounting terms appeared to lessen their apparent exposure to big new debt-funded water infrastructure investments.

“In capital markets, off the books doesn’t always mean off the hook. As New Zealand local councils pursue new water service models, we think shifting assets and liabilities “off-balance sheet” may ease the optics, but not the underlying credit risk.” Standard & Poor’s Global Ratings Director of Government Ratings Anthony Walker

In my view, that’s a problem for councils and the Government, who may have hoped the creation of the new water authorities would reduce the exposure of ratepayers and taxpayers to new borrowings for water and free them up to expand without the need to use the Crown’s or council balance sheets. The hope that ‘off balance sheet vehicles’ can do the heavy lifting underpins the Government’s entire housing growth strategy. It has enabled the Government to remain committed to not borrowing directly through the Crown’s balance sheet.

The first cab off the rank, Watercare, has been able to separate completely from the Auckland City Council and has been promoted as the model, but it is the exception because it has its own specific Act of Parliament, which actually puts the Crown on the hook, Anthony said.

In my view, this S&P analysis that the other water authorities are still tied to Council balance sheets, has put a major spanner in the works of the entire infrastructure funding strategy the Government is relying on.

I have published this article and video for all to read and watch as part of my public interest mandate covering our political economy. Paying subscribers support this work. You can too by subscribing.

A lightly edited transcript of our conversation

Firstly, I asked Anthony to expand on the details of the note.

“It’s designed to highlight the analytical issues that we see when it comes to the local water reforms when it comes to councils. The councils have been provided up to six options by the Crown via a DIA (Department of Internal Affairs) guidance document. And what we’ve done here is gone through how we would view each of those six. Now, only three of them are being pursued by councils,” he said.

“What we’ve found is that there’s 22 councils doing business as usual, another eight doing a single owned entity and another 38 potentially merging into 12 big entities. And their ratings outcomes do depend on which option is chosen. As you highlight, some will be better off, some will be worse off, and some will be somewhere in the middle. And what we’ve done here is we’ve found that, or we’re showing the market and the councils right now that if you are going to go out there with financial guarantees, it’s not going to be off the books for credit ratings.”

‘You can’t really have your cake and eat it too’

I then asked him why in capital markets “off the books doesn’t always mean off the hook,” and what were the gradations used by S&P to decide how much ‘on the hook’ councils were.

“One of the things to say here is that we don’t rate to accounting standards. Accounting standards, they vary from very good to very bad across the world. And we work in all systems globally. And even in New Zealand, we don’t think the accounting standards are as holistic as others. Operating leases and capital leases are a prime example. That’s debt in every other market in the world, advanced market we work in. So we put those on balance sheet, even though the accounting standards in New Zealand say no,” he said.

“You can’t really have your cake and eat it too. You’re going to get cheaper interest rates because you’re guaranteeing it. Well, then the government is going to have to bail it out when something goes bad.” Anthony Walker

“And that’s what we talk about when we say in capital markets, off the book doesn’t always mean off the hook ,because accounting standards might say it’s not there, but when councils are guaranteeing it, it is there.

“We’ve had people say to us, well, we’re only going to guarantee it because we don’t think it needs to be guaranteed. Well, capital markets and investors don’t believe that. That’s why they want the guarantee. So you can’t really have your cake and eat it too. You’re going to get cheaper interest rates because you’re guaranteeing it. Well, then the government is going to have to bail it out when something goes bad.”

‘Labour’s involvement of Iwi helped create greater separation’

Anthony said S&P also looked at the activity of the new entity, and whether it was an essential service.

“Is it a port? Is it a commercial business, or retail business? Or is it doing an essential service like water where people can’t live without? Are there other providers of water in the system in your area? And if the answer is no, and this is the only water provider that gives you water to live on. Obviously, when the council are owning it, obviously it’s going to be very essential,” he said.

“And then the other thing we look at is the role and the linkages between the council. And this is where the Three Waters from the former Labour government tried to separate this Iwi ownership. I know that wasn’t very popular throughout the country, but that was why they went down this path, to try to dilute the linkages with council control.

“Because if the council is controlling it, they’re appointing managers, they’re appointing boards, they’re signing off statements of intent, signing off decisions and now they’re guaranteeing them, then this is a council entity. They can’t just wipe their hands and say, it’s not my fault, not my responsibility, and by the way I have a watertight guarantee (to back that up).” he said.

“These things will come back to bite you. They’ve (bond investors) seen them around the world. In fact we have seen many governments around the world step in to bail out businesses which are not guaranteed, and they’re not water providers so this is why we kind of look at a holistic approach about what may or may not happen.

Why Watercare is different

Anthony then talked about Watercare, which has been cited as a model, and why it was different.

“So Watercare, we have separated from Auckland’s balance sheet and that’s specifically because legislation bans Auckland from providing any financial support at all. So we believe that if something goes wrong with Watercare. It’s going to be the Crown who’s asked to step in to support it,” he said.

“And these are different things because maybe a smaller council, we could pull water off the balance sheet of a small council under that rule, but how would that entity go and borrow? It can’t borrow in the same terms as Watercare. It just can’t do it from the sheer size.”

I then asked about the impressions voters and politicians might have had about how Local Water Done Well had created a way for them to avoid having the debt on Crown and Council balance sheets, and therefore to have cheaper rates with lower interest rates, all other things being equal.

Anthony said the biggest determinant of council interest costs was whether they borrowed through the Local Government Funding Agency (LGFA), which is a Government-backed joint borrowing vehicle, which sets the rules for councils about how much debt they can have relative to their income.

“The biggest determination of council debt caps or the limits of borrowing is not a credit rating. They can keep borrowing. we’ll keep rating them. We might rate them in the triple B category in a decade’s time if they borrow massively. They can still borrow. The biggest pull-back on the leverage of the sector is actually the LGFA debt caps,” he said.

“So if the LGFA was to loosen those, they could still borrow through the LGFA, which is still rated AAA on the local currency scale. So that is one area where credit ratings can have an influence, but the credit rating is an outcome. It’s not an input.”

What is the point of all this asset shuffling to create new vehicles then?

I then asked if Local Water Done Well and the creation of the new accounting vehicles would actually reduce borrowing costs, or was it just a lot of shuffling?

“There is a lot of shuffling. Some of these reforms do have an impact. They do matter. They mean that some councils can borrow more under certain structures than they would otherwise at the same rating. But if you look at the cost of debt, the cost of debt for the Crown is the cheapest. Councils are the second cheapest. Non-councils are the third cheapest, whether that’s a water utility or a bank or something else.

“Given that a water utility, particularly a small one, which most of these councils would be, would likely be standalone credit profile maybe in the Triple B, maybe Double B. It means that the council guarantee which would lift that back up towards the council level, would actually be very vital for it to get cheaper financing,” he said.

“But then again, if it was all in the balance sheet for the council and the council was one notch lower on the rating, it may still be cheaper that wa,y because the LGFA is the ultimate determination here of the credit quality and the credit rating.”

Anthony said the role of the LGFA was crucial.

“So while we did lower 18 Council ratings this year, the LGFA rating wasn’t impacted because they were actually kind of countering that with higher capital requirements and higher assets to kind of shore up their credit quality.

“So they are managing that risk. What happens when the councils borrow through the LGFA and the councils own the LGFA? So they are ultimately the decision makers here. The LGFA will increase the cost that they borrow from the market. They borrow at 3%. They’ll lend it onto councils potentially at 3.25%. If you’re a better rated council, maybe you get at 3.1%. So they actually determine the difference in outcomes here when it comes to council interest rates rather than what the rating may do if councils were borrowing directly in the capital markets.

‘It all depends on the LGFA, which sets the rules with Crown backing’

“The credit rating would have a much bigger impact on cost of debt in New Zealand if these councils were borrowing outside the LGFA.”

“Earlier this year, sorry, we downgraded 18 councils. Going from a AA to AA, AA plus and AA rating had no impact on their interest costs. Going one notch below that from a AA to AA minus increased their interest costs on new borrowings, not the existing debt, but new borrowings by 0.05%. So five basis points.

“If we lowered by one notch again because they doubled their debt levels from 180 % on average to 360%, we potentially may have another 0.05% or a five basis point increase in costs.”

I then asked Anthony about whether all the shuffling to change the ‘optics’ for Councils and the Government would actually improve costs much.

‘Shifting ‘off balance sheet’ doesn’t change our view’

“This is what this note is partly there to tell councils and investors. It’s explaining how we look at the six options provided, whether they would be outside our credit rating or not. But if you’re shifting something to an in-house business unit, where you’ve got staff sitting on the floor next to you and you’re shifting to a single-owned entity, with ratings and revenues quarantined, They think they may have a separate business structure, but ultimately, they’re probably the same people doing the same job for the same people and probably having the same cost base.

“They may actually have a bigger cost base if they’re going to ramp up their spending. So while it might shift it from the parent accounts under New Zealand accounting standards, they’re likely to be captured under the group accounts. So they’re still on the broader balance sheet that most governments don’t focus on.”

Ka kite ano

Bernard

This is a public episode. If you'd like to discuss this with other subscribers or get access to bonus episodes, visit thekaka.substack.com/subscribe