Council agenda papers released today show that a revaluation of our pipes has increased the estimated replacement cost of those pipes by 80% based on the expert judgment of independent valuers. The headline here is that fully rates funding the depreciation for these water assets, as we normally do, would add another 9% on to rates - yikes! Instead, staff are recommending that we partially fund the depreciation for the next two years which will keep the rates increase at or below the 8.9% we consulted on.
Want to understand what this is all about and whether the recommendation is financially prudent? Read on!
As part of part of our planning for the Annual Report process, our auditors requested a detailed revaluation of our infrastructure assets (mostly water and transport assets). This is a reasonable request that we were expecting, as the COVID pandemic has caused rapid inflation and significant volatility of costs. While transport assets came back with a significant but manageable increase in replacement cost, the increase in replacement cost for water assets was frankly astonishing and comes on top of a 33% increase for water assets across the previous three year period. For those keeping score, across the past 5 years the cost to replace our city’s pipes has increased by roughly 10%, then another 10%, another 10%, another 40% and then another 40%.
While consumer inflation is running at around 6-7%, construction costs have been increasing much faster. For example, the price of steel has been extremely volatile and approximately doubled in the past 2 years. Supply chain issues (like shortage of materials such as GIB) affect materials needed to replace pipes as well. The housing crisis in Wellington is also making it harder to attract people to Wellington who can help us replace our pipes – which drives up wages, which drives up costs. We have also learned a lot more about our pipes after all the work we have put in replacing them in the past two years. For example, we have learned that our water pipes are generally buried much deeper in the ground than previously assumed. Digging deeper costs more.
Because of this increase in replacement cost, the depreciation on our pipes has increased by $34 million. If we follow our standard financial policies we would normally fund this through rates, which would mean increasing rates by a further 9% on top of all our other cost pressures. Clearly that kind of rates increase is not appropriate or affordable.
Instead, staff are recommending that for the next two years we only rates-fund the planned replacements for our water assets and not the full amount of depreciation based on the new valuation. This would mean collecting rates funding to pay for the $27 million worth of planned construction projects to replace our pipes next year, but not collecting rates funding for the additional depreciation costs of $61 million.
We are already investing as much as it is physically possible to deliver to improve our pipes in the next two years. With constraints on labour, material and professional services there is a limit to how many pipes we can replace in the next two years. We are already planning to spend close to (or possibly more than) what Wellington Water can deliver. Even if we throw more money at them, we don’t believe they could replace more pipes right now than they already are. Significant additional funding will be needed in future years once the capacity to deliver more pipe replacements has been increased, but for now any additional depreciation rates money we collect just goes to pay down debt.
All of that is confusing so I drew a picture below. The original LTP budget for 2022/23 (the first column on the left) was for $54 million in depreciation of which $27 million would be spent on replacing pipes and the rest used to pay down debt. After the revaluation the full depreciation amount has risen to $88 million, still with only $27 million of actual pipe replacement. The officer recommendation is that we only rates fund the $27 million of actual pipe replacement. This lowers the rates requirement compared to the LTP budget by $27 million. (It is just a confusing coincidence that the amount for pipe replacement and the reduction in depreciation funding are the same amount. Sorry, sometimes life is just like that.)
Partially funding depreciation as this proposal recommends is not normal practice at WCC, but normal practice is designed to cope with normal situations, and an 80% increase in the replacement cost of our pipes is really not normal. Fortunately, our financial policies include some exceptions to the normal process to be used if normal goes out the window. Staff are suggesting that it is appropriate and prudent in this case to use those exceptions.
In this case, the relevant reasons our financial policies allow for us to not fully fund depreciation are where the original borrowings have been repaid or where the replacement of the asset will be funded by a third party.
Through our participation in the government’s water reform process, DIA have identified how much of WCC’s total debt is related to our water assets. They have found that across $1.7 billion worth of assets (now $3.1 billion after revaluation) only about $50 million in debt remains unpaid. That’s actually not a lot. In other words, the vast majority of our original borrowings associated with water assets have been repaid. This is related to a key finding of the Mayoral Taskforce on Three Waters that WCC had been spending less on asset replacement and renewal than we were collecting as depreciation through rates – the excess was used to pay down debt.
Also because of the government’s three waters reform process, it is now likely that Wellington City Council will not be funding the replacement of these assets because the new Water Services Entity will fund those costs. (It is important to note that this option does not change the outcome of any funding that WCC might receive due to the water reforms. The only thing that would change is which bucket of government money the funding would come from. It is a complex money-go-round that I’m not going to get into here.)
Since both of these exceptions criteria have been met, our financial policy allows that it may be prudent to consider partially funding the depreciation on these water assets.
Given the complexity and uncertainty of the current environment, with COVID, substantial construction cost increases, and the water reform programme, I agree with the officer advice that partially rates funding the water depreciation for the next two years is worth considering.
This issue only further cements my view, formed as a member of the Mayoral Taskforce on Three Waters, that water reform such as that proposed by the government is absolutely essential. Wellington is at the forefront of this issue with some of the oldest pipes in the country and our extremely visible pipe failures, however I am in no doubt that other local authorities face similar ticking time bombs under their streets.
This may seem to be a last minute change but revaluations need to be completed as close to the end of the financial year as practical so they are as accurate as possible at financial year end. Generally speaking, any cost pressures that occur as a result of the revaluation can be managed through the final budget process. It is only the unprecedented 80% increase that has made this an unusual event and no one could have reasonably expected the valuation to increase by that much. The recommendations staff are proposing have been considered by the independent chair of our Audit and Risk Sub-committee and discussed with our auditor and staff managing the water reforms at DIA.
As to financial prudence, the staff recommended option will not make future generations worse off, while also balancing the affordability needs of current ratepayers. While some councillors would prefer to see council cut costs further, that should not be conflated with this issue. My own view continues to be that sudden and drastic cost cutting does more harm than good in the long run.
This council has delivered $17 million in savings over the past two years with an additional $15 million savings planned for next year. All while continuing to deliver mostly uninterrupted services to our community through a global pandemic. While there have certainly been some bumps in the road in the past two years, I personally tip my hat to the dedicated staff who have kept our city running while finding better ways of working that save ratepayers money.