8. Recommendations – Role of Council

8.1 Introduction

There are many options available to Councils considering a support role with water enhancement schemes.

There is clearly a role for Council initially championing and facilitating the project to get it moving. This role includes community liaison and education along with provision of some feasibility and resource consent funding (provided by way of loan or convertible equity to recover the investment in the event that the scheme is successfully implemented).

Subsequent to initial facilitation it is difficult to recommend a specific role for Council given that each scheme has different characteristics and requirements, as does each Council.

The role that Council will ultimately take should be based on the answers to the following issues:

The level of private sector participation
What level of debt and equity can be provided by the private sector? Have users signed long term-supply agreements? What type of funding mechanism does the private sector require from Council?
Social and community benefits available
Do the social and community benefits expected by the scheme justify Council investing significant funds or taking a significant risk to support the scheme?
Council capacity to provide funding
Does Council have the capability to provide the required funding considering other competing demands for money? Is the return on the investment sufficient to cover the risks being undertaken?

8.2 Recommendation for Council

Appropriate Funding Options

Study 2 – "Review of equity funding options" concluded that the most appropriate funding option for a water enhancement development was "project finance".

The key requirements of project financing are:

high revenue security – through secure long-term supply contracts with customers;
high revenue quality – credit worthy customers with affordable contracts;
lower levels of equity required (20% to 50%);
security requirements secondary.

Therefore in order for Council to assist a scheme to meet project financing requirements the following roles may be appropriate.

under writing revenue capacity (8.2.1);
providing funding for equity requirement (8.2.2);
providing financial guarantees for secondary security (if required) (8.2.3).

As stated above the actual role(s) undertaken by Council is likely to be different for each scheme depending on:

the level of private sector support within the region;
the level of social and community benefit provided by the scheme and therefore the level of justification for Council support;
the cost to Council for providing the support relative to the benefits provided;
the financial capability of Council to provide the support required.

Each role assumes that the project can satisfy RMA provisions and therefore is environmentally sustainable.

8.2.1 Revenue Underwriting

Where a scheme has not been able to encourage the required level of water user take-up Council may need to underwrite scheme revenue in order to secure project financing.

Revenue underwriting involves Council committing to purchase all unsold shares in a scheme, with the intention of on-selling the shares to water users when demand increases. This undertaking would commit Council to an up front equity contribution and then an on-going take-or-pay commitment for each share that it eventually purchased.

The intention would be for Council to lease the water rights to users over the period of ownership to recover the take-or-pay contract costs, and generate a return by building a premium into the water charge. This needs to be approached with caution. If water users know that they will be able to access Councils water rights in perpetuity without making the upfront capital commitment, this may reduce the incentive for them to commit equity funds or sign long-term take or pay contracts. This is also a risk to the users, given that the rights could be on-sold to another party for personal use removing these rights from the lease market.

Risk and Exit Strategy

Undertaking this role can expose Council to a high level of risk if there are no risk strategies in place to address or manage this exposure. The key risk management strategies relate to scheme selection criteria prior to acceptance, limiting the potential share purchase exposure and ensuring there is an efficient exit strategy in place.

The following table outlines key risk management and exit strategies:

Risk	Risk management	Details
Underwriting agreement signed with a high-risk scheme increasing Councils loss exposure.	Scheme must meet strict selection/evaluation criteria prior to agreement being signed.	Criteria includes: Scheme equity payment and water charge is financially viable but the conservative nature of current landowners is hindering development. Scheme has a large command area serviced by a limited number of rights. Development cannot be effectively staged to meet shareholder demand. Scheme has exhausted all options in relation to private sector investment (water users and non-users)
Water user is take-up is very low and Council is required to make a significant financial commitment to the scheme.	Conditions to be applied to the agreement to limit Council exposure.	Conditions include: Scheme complying with minimum private sector commitment levels (i.e. 70%) before underwriting will be provided. Ensuring water rights are tradable on a short term water market to allow recovery of take-or-pay commitment
Council is unable to exit the scheme and continues to be exposed to financial risk through take-or-pay commitments for an extended period.	Agree exit strategy prior to signing agreement. Include provisions in the agreement to accelerate Council exit.	Exit provisions include: Ensuring water rights are permanently tradable through an active water trading market. Restrict private permanent water trading until Council has been able to sell down ownership (with an adequate return). Include a formal exit strategy in the agreement. i.e. repayment of outstanding shares required at year X (including a financial return), or take-or-pay commitment ceasing at year X and equity balance transferred to a loan for repayment.

8.2.2 Partial Funding Provider

Where customer commitment is high, but water users are having difficulty raising the upfront equity balance, Council assistance may be in the form of providing funding support to the scheme. Type of support provided would largely be determined by the private sector requirements but will include one or a combination of the following:

debt;
equity;
hybrid equity.

If Council is to provide funding assistance, the most appropriate type of support is likely to be the provision of hybrid equity³.

The key advantages of Council providing hybrid equity are:

It acts as equity for the scheme - It strengthens the financial position of the scheme by lowering the gearing ratio allowing the scheme to access additional debt funding or more favourable funding terms.

It acts as debt for the Council - It allows the provider (i.e. Council) more flexibility to set the terms and conditions of the funding in relation to return on investment and exit/repayment provisions as if the funding related to debt.

Risks with providing this funding can be largely mitigated by securing the equity balance over a future targeted rate and therefore ensuring the financial commitment can be recovered, including a return commensurate with the risks undertaken.

Exit Strategy

Although provision of debt and hybrid equity provides a defined exit strategy (i.e. through repayment terms), this is likely to be spread over a long period (up to 20 years). Council focus should be on exit as soon as practically possible. Once the scheme is operational with strong user commitment the majority of investment risk has been ameliorated and Council should attempt to transfer the investment to the private sector.

This exit arrangement can be formalised prior to development. For example, subject to a number of key performance indicators, a private sector party agrees to take the investment over from Council. These indicators are likely to include minimum customer take-up rates, financial performance indicators and service delivery indicators.

8.2.3 Provision of Financial Guarantees

Provision of a financial guarantee is an efficient form of funding assistance for Council to provide to a scheme. There are minimal costs for Council associated with this arrangement provided the guarantee is not called. As discussed earlier Council is able to structure a guarantee in such a way that it is secured over a future targeted rate and therefore ensures any financial commitment can be recovered, including a return commensurate with the risks undertaken.

Exit Strategy

Limiting the time period of the guarantee provides Council with a route for exiting the risk of exposure from a financial guarantee. These guarantees can expect to be limited to a five-year period.

8.3 Indirect financial support from Council

8.3.1 Supporting infrastructure/general requirements from Council

Provision of Council support in the form of additional development and maintenance of public infrastructure (e.g. roading, drainage, water and sewerage) required to support a more intensified land use and population increases as a result of water enhancement is a critical issue to be factored into Councils decision on the level of support that they are able undertake for a water enhancement scheme.

As discussed early, the key justification for Council support is the level of net economic, social and environmental benefits provided by the scheme as compared to other competing projects. When Council is determining net community benefits, the additional costs relating to infrastructure development and maintenance will be a critical component.

Providing this infrastructure therefore has a direct impact on the level of funding support that Council is justified in committing to these developments.

3 Examples of hybrid equity include: subordinated loans, redeemable preference shares and convertible notes

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