Economic empathy through a depreciation holiday

Delivering immediate rate relief to ratepayers with little risk.

The enormity of the COVID-19 crisis is hitting home hard. Jobs will be lost and businesses will go under. Local economies will take several months to re-build. Councils across the country are under immediate pressure to demonstrate economic empathy. 

Councils that practise good infrastructure asset management could provide immediate rates relief by leaning into their circa $116 billion infrastructure asset base. I’m talking about depreciation – the concept of which is not up for debate here, but rather the timing and amount of depreciation being funded each year.

A bit of background

According to the Department of Internal Affairs, in 2018 approximately 20% of all council expenditure ($2.1 billion) went to the funding of asset depreciation.

Being a non-cash expense means that upward of 20% of rates are in theory, cash surpluses. These surpluses are typically committed to funding debt (internal or external), asset renewal, or are placed into reserves for future renewals.

The balanced budget requirements of Sections 100 and 101 of the Local Government Act 2002 mean that local councils cannot shelter communities with cash deficits, like their central government counterparts are doing.  However, councils do have the unique power to use funding sources they ‘determine to be appropriate’ for the needs of their community (see below).

It’s important to recognise here that many councils did not begin funding their depreciation until after the 1989 reforms, let alone 2002. Many feel they are in a state of ‘catch up’ following decades of under-funding. That is a different story…

Let’s look into some options…

Option 1: A Depreciation Holiday on New Long-Life Assets

A topical example is why councils fund depreciation on brand new infrastructure.

Typically, the cost of new or upgraded infrastructure is funded through debt. Using debt spreads the cost over long periods and also reduces the immediate impact on rates. This is fair and reasonable, but often once these new assets are capitalised onto a council’s balance sheet, their depreciation expense begins. So, you have an instance where the current generation are paying for both the construction of this long-life asset through the loan and its future replacement through depreciation. 

Is it fair that one generation pays for an assets construction and its eventual replacement, at the same time?

Let’s use an example:

  • A new drinking water reservoir is built and capitalised as an asset worth $1.0 million.  
  • It is paid for with a 25-year loan (for simplicity, let’s assume no interest costs nor income is incurred and price inflation is ignored i.e. nominal values).
  • The asset is also depreciated over its expected useful life of 80 years using a straight-line method.

The charts below (excuse the pencil drawings) show the differences between what typically happens on the left, and what is being proposed on the right.

After 25 years, the community on the left side have paid off the loan of $1.0 million and have also contributed $310k (31%) of the asset’s future replacement (nominal prices only and excludes interest on debt).

However, after 25 years the community on the right side have paid off the $1.0 million only, with the future community left to fund the remaining $1.0 million over 55 years.  

The $2.0 million total represents both the cost of paying for the new asset and saving for its eventual replacement in 80 years.

Option 2: Extending the Total Useful Life of Long-Life Assets

A second and slightly more simple option is to extend, where appropriate, the total useful life of your known long-life assets. WARNING: You must be careful to not simply change the total useful life without having good evidence to do so. 

For example, many reinforced concrete structures, plastic pipes and road pavements nominally have lives of >80 years. These lives can be even greater in dry environments.

Prepare for more pencil stylings…

Any increase in total useful life has a direct and proportionate decrease in annual depreciation.

Depreciation = Gross Replacement Cost ÷ Useful Life

So, in the instance of our example, by demonstrating through regular asset assessments and having good maintenance planning, the total useful life is extended by 20 years to 100 years. The resulting reduction in annual depreciation and rates would be 25%, from $12.5k p.a. to $10.0k p.a.

Option 3: Depreciation Holiday on Long-Life Assets

This is a more progressive variant on Option 2 whereby all depreciation on long-life assets is deferred for 1 to 3 years, providing direct rates relief. This would be best applied to assets that have remaining lives greater than 60% and/or 60 years. In other words, long-life assets where there is a significant period remaining in which to recover deferred depreciation once economic conditions improve.  

Brace yourself…

Option 4: Outsource the Renewals Risk – A More Innovative Option For Debate!

Asset managers have posed this solution amongst themselves as long as I can remember. Essentially, this model mimics an insurance policy or annuity approach. A council would outsource the funding and timing risk of asset renewals to a third-party, perhaps to a CCO owned by many councils or an agency such as the Local Government Funding Agency. 

We may see an immediate improvement to asset management also. The third-party would have to undertake accurate and frequent condition assessments to manage replacement costs and predicting remaining life. They would also work to influence maintenance regimes to smooth out renewals spikes. Like insurance premiums, the third party would pool and invest these premiums to maintain liquidity amidst the coming renewals bow wave.

My final piece of pencil art below demonstrates the vast difference in annual depreciation for our example, based on varying returns on investment of depreciation reserves/premiums each year.

Theoretically, this option would see the biggest councils benefit from a vast reduction in annual depreciation due to the benefits of their annual depreciation being invested and risk out-sourced. However, such a model would take several months to implement.

Arguably, this model is what already happens now to some degree. Many council depreciation reserves are either invested for a return or used for internal loans. All capital incurs an opportunity cost.

Therefore, the real question is…

Is the accumulated depreciation figure for your council’s assets reconciled with the actual amount of depreciation within its reserve accounts?

If not, this implies that depreciation is potentially being over-collected compared to what the value of the future liability is, and thus being used to subsidise other council expenditure.  Sure, this would keep rates down, but it breaches the LGA. This also means that future generations somewhere, sometime will be paying a very big renewals bill.

I must emphasise that all of these options are only possible if a council is maintaining a reliable asset data register and is practising good asset management. This includes having a strong linkage between the asset management and finance functions of council. This is often a weak linkage and prohibits the direct financial benefits of good asset management.

If you’re curious about this article or want to discuss it further, leave a comment or get in touch with Vaughn.

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