Why revenue bonds could be a better option than Three Waters reform

Dr Eric Crampton
The Dominion Post
13 June, 2022

Bring on the bondholders.

New Zealand’s proposed Three Waters Reforms, which would force the amalgamation of council water services into four large providers under convoluted governance arrangements, is an attempted solution to a real problem. Just not a very good one.

I wonder about a better alternative.

A very short piece of legislation could allow councils here to follow local governments in America in issuing revenue bonds: debt backed by revenues from a project, rather than by ratepayers more generally.

It could deal to the real underlying problem that the Three Waters reform aims to solve, without forced amalgamations and without messy ownership structures. It could provide more diligent monitoring of infrastructure maintenance. And it would unlock opportunities for building other valuable infrastructure.

The real problem that central government officials are trying to solve with the reforms isn’t water quality and the consequences of Havelock North. A new water quality regulator is on that job regardless of what happens with water asset ownership.

The real problem? Too many councils, like Wellington, have done a terrible job in maintaining their pipes while loading up their balance sheets with debt for white elephants: convention centres and ridiculously costly earthquake strengthening of buildings that should be demolished.

And many councils cannot fund the infrastructure necessary for urban growth.

Council debt cannot exceed 280% of revenues without drawing penalties. A council at its debt limit cannot issue new debt to fund infrastructure unless that debt can pay itself off very quickly.

Infrastructure that should last for decades has to cover its cost within a few short years.

It is one of the root causes of our housing shortage. Councils use zoning and consenting to try to prevent people from building in places where funding infrastructure is too hard.

But there is no reason to believe that simply lifting Council debt limits would give us better water infrastructure. More boondoggles are more likely.

Central government sees the housing crisis, sees the infrastructure deficit, and worries that central government will forever be called upon to bail out irresponsible councils when the pipes explode.

So they have proposed a forced quasi-nationalisation of council water assets.

Those amalgamated entities need debt to finance infrastructure renewal and growth. If they were directly owned by councils, that would be hard. Their debt would be treated as council debt, subject to council debt limits. Ratings agencies would know that councils would back that debt through bailouts, if necessary.

The need for real balance sheet separation has driven a convoluted approach to water entity ownership – and no clear accountability of those entities to the households and businesses they serve.

Revenue bonds may be a far better alternative. They’re how American cities generally cover infrastructure costs.

This form of debt is backed only by the revenues generated by the project they’ve funded – whether a water pipe, or a subway system, or a highway. General obligation bonds (like standard New Zealand council debt), backed by a council’s main balance sheet, are only a third of investment-grade US municipal debt, according to Charles Schwab. Two-thirds of municipal bonds are revenue bonds. 

Instead of forcing the amalgamation of council water assets into messy structures, central government could pass a very short piece of legislation authorising councils, and council-controlled entities like water providers, to issue long-duration revenue bonds. Councils would be forbidden from using general revenues to pay off the bonds.

If Council needed to fund infrastructure for higher density, or for a new subdivision, it would assess the cost of the kit and the levy that could be placed on users or beneficiaries. It would put the proposition to investors in the bond market.

Riskier projects would draw higher interest rates than standard government debt, but that really is not a problem. Not having infrastructure is a real problem, and so is not having any reasonable commercial assessment of the viability of too many projects. The bonds would be far better than developer contributions, which wind up loading onto mortgages when people buy properties.

Bondholders bring in another benefit. If continued bond payments depend on a continued revenue stream from infrastructure users, bondholders will insist on monitoring that promised maintenance is undertaken.

The academic corporate finance literature argues that one of the big benefits of having a large bondholder is this kind of vigilant monitoring. The same would be even more true for council infrastructure, where some councils have a demonstrably problematic track record.

Right now, councils can underfund depreciation for years and earn only applause from local voters for keeping rates down and funding shiny new projects. If they also had to answer to bondholders, ignoring maintenance would be a more substantial problem.

And it could unlock the funding for a lot of projects beyond water infrastructure – so long as the projects could pay their own way. And it would avoid forced amalgamations.

Bring on the bondholders. We need them.

Stay in the loop: Subscribe to updates