The Government's water reform policy may weaken LGFA’s financial stability and increase council borrowing costs, warns S&P

The Coalition Government's revised water reform policy could weaken the finances of the agency responsible for raising debt for local councils, credit rating agency S&P Global Ratings says.

Last week, the coalition revealed its alternative water reform policy. It will allow the Local Government Funding Agency (LGFA) to lend to council-controlled water organisations without worrying about balance sheet separation.

The LGFA raises debt on behalf of local authorities at more favourable rates than they could have accessed directly. The agency is 80% owned by 30 councils, with the remaining 20% owned by the Crown.

The Crown’s ownership stake reassures credit rating agencies and debt investors, who view the agency as a safe investment, believing the Government would step in during a crisis.

Despite the Crown ownership, the LGFA’s creditworthiness is largely based on the quality of its traditionally conservative loan book. Councils currently face borrowing caps ranging from 175% to 285% of their revenues. However, the LGFA now plans to offer loans up to 500% of revenues for council-controlled water organisations, potentially leading to a significant rise in overall council debt.

Labour argued that this policy ignored advice from credit rating agencies and would detrimentally affect council ratings, increase borrowing costs, and lead to further rate hikes.

On Monday, S&P published a bulletin warning the new policy could impact its assessment of the LGFA’s creditworthiness.

“The New Zealand Local Government Funding Agency loan asset quality could weaken if it materially pivots toward providing debt finance for new council-controlled water entities,” it said. 

“The stand-alone credit profiles of water CCOs [council controlled organisations] are likely to be weaker than the average council rating of roughly 'AA'. Councils could transfer their water-related infrastructure assets and liabilities into these newly formed CCOs in the coming years, which would drive the CCOs' borrowing needs”.

The LGFA’s average loan asset quality could decline if it begins extending credit to highly indebted water CCOs. Its AA+ foreign currency credit rating and AAA local currency credit rating were based partly on its high-quality loan book. 

The LGFA could mitigate potential risks by bolstering its internal liquidity, securing additional backstop capital, or adding new risk management policies.

There have been suggestions that the Crown might assist the LGFA in raising debt limits to 350% of revenue for certain high-growth councils, which could require additional capital support.

S&P warned that raising debt limits could weaken the credit quality of councils. Debt limits were already lifted in 2020, to help councils cope with the Covid-19 pandemic, and the rating agency had been expecting that decision to be rolled back in 2026. 

“Increasing the debt ceiling will generally be negative for credit quality across the sector, which is already highly indebted by international standards. New Zealand councils' increasing indebtedness is one driver behind a weakening trend in the system's institutional framework”. 

However, these negative trends could be offset by a recent rise in borrower loan margins and subscription rates, which should help bolster LGFA's capital base.

Could negatively impact credit ratings

S&P’s bulletin did not constitute a rating decision. However, in a separate email to Interest.co.nz, analyst Martin Foo emphasised that lending to CCOs and raising council debt caps could negatively affect ratings.

“It may precipitate some council downgrades and further weigh on our 'institutional framework assessment' for the council sector, which we already consider to be weakening”.

Foo also noted that economic regulation and professional management of CCOs could lead to higher water revenues compared to when they were managed by elected councillors.

This would mean higher water prices for households but lower debt servicing costs for councils, potentially improving their debt-to-revenue ratios.

The new regulations will empower the Commerce Commission to establish both minimum and maximum revenue thresholds for water entities and, if necessary, mandate the construction of specific infrastructure.

This approach mirrors the regulation of gas and electricity line companies, though the proposed legislation for water entities is tailored and, in some instances, more stringent.