Report to FINANCE & MONITORING Committee for decision

11/360 Subject: Prepared by: NZ Local Government Funding Agency Mike Drummond (Group Manager Corporate Services) Meeting Date: 16 June 2011 Report to FINANCE & MONITORING Committee for decision SUMMARY This report is to update the committee on the status of the local government debt vehicle initiative. The proposal has now been considered by nine Councils as part of their 2011/12 Annual Plan deliberations. These nine Councils have been closely involved with the initiative from its early days in 2008/9 and represent nearly two thirds of the outstanding local government sector debt. The initiative involves setting up a CCTO to be known as the NZ Local Government Funding Agency (LGFA). The purpose of the LGFA is to provide the sector with access to funding on much better terms then we currently have. The LGFA model works because of the significantly lower interest rate margins that the LGFA can achieve, when compared to individual Councils borrowing in their own name. This is especially true for smaller Councils like Gisborne who are unrated. The LGFA model is based on a number of successful overseas precedents where centralised funding has resulted in reduced funding costs. There is a significant commitment from Central Government to the initiative this includes the Crown taking a shareholding in the LGFA. In December 2010 a Cabinet Committee agreed to the recommendations put forward in a cabinet paper jointly prepared by Treasury and the DIA. The recommendations give the proposed LGFA exemptions from a number of Acts including the Reserve Bank Act, Income Tax Act, and the Securities Act. This will allow the LGFA to access the retail bond markets in the same manner as Councils do. One of the key risk factors to be considered is the requirement for principal Shareholders to enter into a guarantee arrangement for the purposes of enhancing the financial strength of the LGFA. This is not an uncommon feature of these funding agency models. An evaluation of the risks presented to Council by the guarantee arrangements has concluded that there is an extremely low likelihood of a call being made on Council, under the terms of the guarantee. A more significant risk is that the LGFA does not achieve sufficient scale and size of operation with 1-2 years of commencing operations. In this regard all Councils are being asked to clearly signal their intentions. We will not finally sign off on our involvement until after the 2012-22 LTP consultation has been concluded. This will provide further opportunity to review the progress of the LGFA. DOCS_n201432_v1 Page 1 of 10

RECOMMENDATIONS That the Committee 1. receives the report 2. Recommends that Council a) approves the proposal to join the Local Government Funding Agency Scheme as a Principal Shareholding Local Authority and related amendments to the Councils Treasury Policy and that the proposal be subject to a special consultative process to run in conjunction with the 2012-22 Ten Year Plan consultation OR b) approves the proposal to join the Local Government Funding Agency Scheme as a limited participant and related amendments to the Councils Treasury Policy and that the proposal be subject to a special consultative process to run in conjunction with the 2012-22 Ten Year Plan Consultation OR c) approves the proposal to join the Local Government Funding Agency Scheme as a non-shareholding borrower and related amendments to the Councils Treasury Policy and that the proposal be subject to a special consultative process to run in conjunction with the 2012-22 Ten Year Plan consultation. Mike Drummond Group Manager Corporate Services Keywords: Funding agency, Ten Year Plan, Principal Stakeholder DOCS_n201432_v1 Page 2 of 10

1. BACKGROUND During 2009 Local Government New Zealand and Central Government jointly funded a scoping study to investigate the feasibility of a Local Government debt vehicle. This followed discussion of the issue of local government funding costs and the potential constraint this was placing on local infrastructure projects and economic growth at the Government s job growth summit in early 2009. Cameron Partners and Asia Pacific Risk Management were engaged to undertake the study. In summary, the study concluded that there was the potential for significant benefits to accrue to the Local Government sector through enhanced access to funding and lower funding costs. During May 2010 it was agreed to undertake the next stage of work, including detailed financial modelling, to confirm overall financial benefits of the proposed Local Government debt vehicle. This work was funded by nine Councils (Auckland city, Manukau City, Hamilton City, Tauranga City, Whangarei District, Wellington City Council, Wellington Regional, Tasman District and Christchurch City) at a cost of $50,000 each. A steering group for the initiative was also established at this stage. The steering group included representatives from Christchurch, Wellington, Auckland and Hamilton City Councils along with Cameron Partners, Asia Pacific, Risk Management, Treasury, NZ Debt Management office, Reserve Bank and the Department of Internal Affairs. The detailed financial modelling confirmed that the Local Government sector could achieve interest savings in the order of $25 million per annum within five years. This was based on achieving a credit rating at the same level as the NZ Government. The overall design of the LGFA has been based on similar structures overseas. A further Summary of the origins and rationale for the LGFA can be found in part A, sections 4-11 of Appendix 1. This is a copy of the draft Information Memorandum prepared by Hamilton City to support their involvement in the LGFA. 2. DISCUSSION AND OPTIONS A summary of the key features of the LGFA can be found in part B of Appendix 1. This is a copy of the draft Information Memorandum prepared by Hamilton City to support their involvement in the LGFA. The key features are summarised below: 1. The LGFA Scheme involves the establishment of the LGFA entity, which is a company that would provide the Local Government sector with access to funding on more favourable terms than individual Councils could achieve on their own. 2. The LGFA entity will be jointly owned by central and local government with the likely split of shareholders being 20% Government 80% being a wide range of Councils. It s important to achieve a wide spread of ownership. The original proposal was for a minimum shareholding of $500k. In order to facilitate the involvement of smaller Councils this has been subsequently reduced to $100k. 3. The LGFA entity is a Council Controlled Trading Organisation (CCTO). It is controlled by Councils and is designed to provide shareholders with a modest return on their capital investment. The primary benefits of the scheme however are not focused on shareholder profit, but on delivering lower and more stable borrowing margins to Councils. A secondary benefit which is of particular interest to Central Government is the creation of a high quality and low risk fixed rate investment for retail investors. DOCS_n201432_v1 Page 3 of 10

The issue of retail bonds would provide both small and large investors the opportunity to invest in Local Government. Any decision to issue retail bonds would need to be considered by the LGFA board and management based on its commercial merits. 4. The LGFA entity will incorporate a number of features designed to ensure that it represents an extremely low risk investment for its creditors. Without these features and the likelihood of the very high credit rating that they will help to support, it is very unlikely that the proposal would be able to generate significant benefits for Councils. These features are: a. The LGFA will have a significant standby borrowing facility with Central Government to provide it with a backup source of funding. b. All borrowing Councils will be required to secure their borrowings from the LGFA with a charge over rates. Gisborne already uses this approach when securing bank facilities. It is referred to as issuing security stock under our debenture Trust Deed. c. The LGFA will maintain a minimum level of capital relative to its asset base, in line with standard prudential requirements that apply throughout the international banking sector. d. The LGFA will require principal shareholders to subscribe for uncalled capital in an equal amount to their paid up equity contribution (i.e. the Gisborne Council investment would be $100k for its initial shares and the potential for up to another $100k to be paid if all the uncalled capital was called up). e. The LGFA will require principal shareholding Councils to commit to utilise the entity for a certain proportion of their borrowing requirements for an initial period. Initial indications are that this will be a target of 80% of new borrowing and refinancing requirements. This should not be an issue for the Gisborne Council, as we have a need for significant refinancing of current debt to both spread the risk and the debt maturity profile. f. There will be a guarantee structure in place that will require Principal Shareholders and many of the Councils who borrow from the LGFA, to guarantee the obligations of all other guaranteeing Councils as well as the LGFA. The respective cross guarantees will provide for proportionate liability based on the value of rates collected. g. The LGFA will adopt a range of appropriate prudential policies to control the management of financial and operational risk within the entity. h. The LGFA s management of financial and operational risk will include outsourcing arrangements with the NZ Debt Management office (NZDMO). The NZDMO manages the Government s debt and borrowing programmes. i. The LGFA will be subject to extensive monitoring, reporting and disclosure requirements under the Local Government Act as a CCTO. This includes audit by Audit New Zealand. j. Monitoring of the LGFA s compliance, conduct and performance will be by the board, shareholders (including the Crown Ownership Monitoring Unit and the Department of Internal Affairs), trustees, international credit rating agencies and institutional investors. DOCS_n201432_v1 Page 4 of 10

5. The Gisborne district Council will benefit from the decision to participate in the LGFA. There are however in addition to the benefits costs and risks to be taken into consideration. These are fully detailed in part C of Appendix 1 (draft Information Memorandum). The key benefit risks and costs are summarised below: Pricing a. It is expected that over time the LGFA can achieve a cost of borrowing very close to the Governments cost of borrowing. This factor coupled with an expectation that the LGFA entity will achieve sufficient scale means that, by borrowing from the LGFA, Council could reasonably expect to lower its borrowing margin by 0.5% - 0.9% over time. b. Based on Councils expected borrowing levels and the transfer of current bank and debenture core borrowing to the LGFA. Council would realise annual savings in finance costs in the range of $150k to $270k. Once borrowings were transferred to the LGFA these savings would be expected to apply in perpetuity. c. The expected savings are based on initial modelling work that involves a number of assumptions. These models are useful in providing an indication of the scale of potential savings. d. Councils current financial strategy has most of the funding sourced through banks. While these facilities are flexible they are all considered short term (1-3 years). They also come at a cost with bank margins reviewed annually and higher fees charged for longer term facilities. The Councils medium term borrowings are by way of debentures. Council has placed no debentures in the last 3 years due to the high margins demanded by the lenders. This strategy was developed in anticipation of accessing medium to long term funding through the LGFA once it was established. Participation in the LGFA will allow Council to better spread its risk and maturity profile for borrowings. Required initial Equity Investment e. The LGFA proposal requires a high level of commitment from the initial core group of large Councils to capitalise the entity. It is proposed that the entity is established with $25 million of establishment capital with $5 million to come from Government and the remaining $20 million from Councils. The bulk of this would come from the large Councils. f. This report recommends that GDC becomes a Principal Shareholder in the LGFA. The initial minimum investment was set at $500k but in order to encourage smaller Councils to participate as Principal Shareholders, that minimum investment has now been reduced to $100k. This investment will need to be made in the second half of the 2011/12 financial year after consultation for the LTP has been completed. GDC along with all other Principal Shareholders will also be required to subscribe for uncalled capital at the same level to their respective paid up capital contribution (GDC $100k). DOCS_n201432_v1 Page 5 of 10

Return on Equity Investment and additional equity requirements g. Based on the detailed financial modelling that has been undertaken to analyse the viability of the LGFA Scheme, Principal Shareholders are expected to receive a dividend return on their investment at 2% above the weighted average cost of debt raised by the LGFA. In today s market that is estimated to be close to 7.4%. The expected annual dividend on GDC investment of $100k would be $7.4k. h. In addition to contributing initial capital, GDC and all other borrowers from the LGFA, will be required to invest 1.6% of the amount they borrowed back into the LGFA. This is to ensure that the LGFA maintains its capital base at an appropriate level relative to its assets. The return on this form of equity is expected to be in line with the weighted average cost of debt raised by the LGFA. In today s market that is estimated to be close to 5.4%. By way of example if GDC were to borrow $10 million from the LGFA it would be required to invest $160k in additional equity. The expected dividend stream of $8,640pa would mostly off set the borrowing cost on this $160k. i. One of the key objectives in securing Government support for legislative changes to support the LGFA was to enable the LGFA to achieve the same tax exempt status as a local authority. Government officials have supported this requirement. The dividend income streams described above will therefore not be subject to income tax. Guarantee and Uncalled Capital structures j. As a Principal Shareholder GDC would be required to enter into a guarantee arrangement, whereby it would guarantee the payment obligations of all other guaranteeing Councils, in respect of their LGFA sourced borrowings as well as the payment obligations of the LGFA itself. k. Under the terms of the proposed guarantees, in the event that a call is made on the guaranteeing Councils, there will be an associated agreement between these Councils that specifies that each Council s share of any liability is assessed in direct proportion to each Council s rates income. This will work to minimise GDC s contribution in the unlikely event of a default. l. As a Principal Shareholder GDC would also have a contingent liability in respect of its uncalled capital ($100k) in the LGFA. m. The evaluation of the risks that arise under the guarantee and uncalled capital arrangements, has focused firstly on the likelihood of an event occurring that could trigger a call for additional capital and secondly the consequences of such an event, having regard for the various mitigating factors inherent in the proposed LGFA structure. This evaluation is summarised in the following table. DOCS_n201432_v1 Page 6 of 10

Event Likelihood of occurrence Consequence Temporary Shortfall of readily available cash Default by a Council which has borrowed funds from the LGFA Low Very low (it is believed that no Council has ever defaulted on its debt obligations) Minimal consequence owing to the significant standby finding line in place with the NZDMO. The consequences of a local authority default are significantly mitigated by the requirement for borrowers to provide a rates charge. Under a rates charge there are very clear statutory provisions, which provide a receiver with clear powers to collect the funds owed from that particular Council under a special rating assessment procedure. Default by the LGFA caused by an event other than a default by an underlying Council borrower Very low The sort of operational risk that would cause this event cannot be completely eliminated but they can be managed. The LGFA will be subject to comprehensive governance processes. The LGFA will adopt appropriate and prudent internal risk management policies and procedures. These will include the contracting of the NZDMO to carry out certain aspects of LGFA s operational requirements that include back office settlements, systems, borrowing, investing, hedging and treasury risk management. Evaluation of the proposal n. It s not uncommon for any investment offering to involve an element of Commercial risk. In this sense the LGFA proposal is no different from Council other investments. o. The potential long term benefits to Council under the LGFA are significant. It should be noted however that Council along with the other participants, need to enter into a guarantee and uncalled capital arrangements that could in the future result in a call on Council (along with other participants) to provide additional capital. p. As a new venture the LGFA will face challenges in the first 1-2 years of operation. These challenges relate to the need to generate adequate scale in the size of the operation and in achieving a cost of debt reflecting its expected credit rating. The participation of a wide range of Councils in the LGFA will be essential to its success. q. The recommendation in this report that GDC participate as a Principal Shareholder in the LGFA, is based on the attractive financial benefits that the LGFA will create for the sector and for GDC. The risks of involvement in the LGFA are well under stood and are able to be appropriately managed by the LGFA board and staff. r. The proposal will require some minor modifications to Councils Treasury Policy. These changes will be included as part of the Long Term Plan consultation and will dovetail into the formal financial strategy. DOCS_n201432_v1 Page 7 of 10

6. LGFA Lending Policy a. The LGFA will lend only to Councils not to CCO s or CCTO s. The focus will be on medium to long term core funding. This approach fits well with the GDC financial strategy. b. All borrowers will need to provide a rates charge security (e.g. debenture trust deed). c. The LGFA will require at least 3 months notice of debt requirements (otherwise lending is on a best endeavours basis). This is to ensure that the LGFA can manage its assets and liability exposures to optimise its debt terms. d. Councils will Issue bonds/frn S/CP to the LGFA (rather than borrow under loan facilities). e. Councils will be required to comply with financial covenants similar to those below. Failure to comply could see lending suspended and in the event of a default the LGFA could appoint a receiver. GDC s strong financial position means that we are well within the limits set by the LGFA. f. Financial Covenant LGFA Threshold Current GDC Policy Net Debt / Total Revenue < 250% <95% Net Interest / Total Revenue < 20% <10% Net Interest to annual rates income (debit under the debenture) Liquidity (external debt + committed loan facilities +liquid investments to current external debt) < 30% <15% >110% N/A g. No more than the greater of $200m or 20% of any single Councils borrowings from the LGFA can mature in any 12 month period. 7. Options a. There is a range of options available to Council from full participation as a Principal Shareholder through to no involvement. There are two options available to GDC other than their participation as a Principal Shareholder, these provide a more limited involvement in the LGFA but are not recommended. b. The important reason for Council participating in the LGFA as a Principal Shareholder is to help ensure that the scheme generates the support required and to enable it to be established and obtain a high credit rating. The large Councils have already made this commitment. However we can t underestimate the impact that the small and medium sized Councils will have on the success of the LGFA. The LGFA after all is a co-operative and the potential lenders to the LGFA will be looking for wide Local Government support. This support will enhance its ability to raise funds at lower rates. Participation as a Principal Shareholder will also provided a commercial return on the $100k initial investment. DOCS_n201432_v1 Page 8 of 10

c. The second option is involvement by not taking up a Principal Shareholding and without providing a cross guarantee. This is intended for very small Councils. It is proposed that Councils that choose this option will only be able to access funding up to $20m and will be subject to an increased interest charge. They will still be required to invest 1.6% of their borrowing amount in the LGFA. This option is not appropriate for GDC s borrowing needs. It is intended that the LGFA provides the core borrowing requirements of Council. This would eventually have the LGFA providing funding in the $25m - $30m range. Also the increased interest costs would negate much of the benefit to be gained from participation in the LGFA. d. The third option is involvement as a Guaranteeing Local Authority. This involves providing the cross guarantee but not the contribution required by Principal Shareholders. Councils that choose this option will have the benefit of lower funding costs and the low limit on borrowings under the second option will not apply. There is also no target borrowing level set. e. The final option is not to participate. While Council is not expected to have difficulty in obtaining the necessary financing for its operations. It would be limited to the existing sources (i.e. debentures into the wholesale market and bank borrowings). Council being unrated can expect to pay higher margins on it borrowings. There are definitely interest cost and bank fee savings that would be lost by not participating in the LGFA 3. SIGNIFICANCE This decision is considered to be significant under the Councils Significance Policy. 4. CONSULTATION The proposal will be consulted on as part of the 2012-22 Long Term Plan consultation process. If Council wishes to participate in the LGFA sooner, then they will need to follow the Special Consultative procedure and make a minor amendment to the current LTCCP. 5. FINANCIAL The short term financial implications are the cost of the equity investment of $100k in the LGFA. As participation requires that the special consultative process be followed, this would not occur prior to June 2012 when the Long Term Plan would be approved. It is intended to fund the equity investment by way of an internal loan to the Treasury cost centre. The savings in financing costs would build from late 2013 through to 2015 when the last of the current debentures mature. The current borrowing and bank facilities are structured as short term in anticipation of Councils involvement in the LGFA. Interest cost and bank fee saving of $160k - $270k pa would commence from the 2012/13 financial year. 6. LEGAL Section 56 of the Local Government Act 2002 (LGA 2002) provides that a proposal to establish a Council-controlled organisation (CCO) (which includes a CCTO) must be adopted by special consultative procedure before a local authority may establish or become a shareholder in the CCO. DOCS_n201432_v1 Page 9 of 10

Section 102(6) of the LGA 2002 requires any amendment to a liability management policy or investment policy to be by way of an amendment to the Long Term Plan (LTP). Both of these provisions are relevant in the present case. The Council's involvement in the LGFA as a Principal Shareholding Local Authority is not specifically provided for in the Councils Investment Policy. However it should be noted that it is not specifically prohibited either. The specifics of the debt raising arrangements with the LGFA go beyond what is currently provided in the Liability Management Policy and the Treasury Policy (particularly the guarantee commitments). It is therefore appropriate to amend these policies (by including them in the 2012-22 LTP) using the same special consultation procedure required to comply with section 56. (Section 83A of the LGA 2002 expressly authorises combined special consultative procedures.) The Borrowing Bill setting up the LGFA and making the necessary modifications to the Local Government Act 2002 was referred to the Local Government and Environment Select Committee on the 17th of May. The Committee has been given till August 1 to report back. It is not anticipated that any substantive changes will be made to the bill. 7. APPENDICES Appendix 1 Proposed Local Government Funding Agency Scheme Information Memorandum. DOCS_n201432_v1 Page 10 of 10