Council-owned and operated water suppliers should be merged and corporatised if they can't improve on their own, the Productivity Commission says.
It says the three-waters sector needs "fundamental" reform, and noted the government is considering extensive changes to the sector's regulatory framework and how it is funded.
"Considerable evidence shows poor performance of the three waters sector in many parts of New Zealand, in terms of their impact on human health, the natural environment, productivity and costs to consumers and ratepayers," the commission said in a draft report on local government funding arrangements.
"However, some councils and providers are taking the tough decisions needed to improve performance, including Auckland's Watercare, Tauranga City Council, Kapiti Coast District Council and the five councils involved in Wellington Water."
The draft report cites the Commerce Commission as a natural fit to be the industry watchdog given its experience regulating other monopoly industries. The draft view is for the government to task a regulator to set a deadline for councils to lift their game, and if they didn't meet the minimums, come up with a backstop arrangement.
"The backstop would take the form of compulsorily merging water businesses, placing them in CCO (council controlled organisations) structures with independent financing and requiring them to move to being fully funded directly from water consumers rather than from council rates," it said.
"This approach would provide the government with a set of workable reforms that will achieve what matters – tackling the unacceptable performance levels for three waters – while constraining fiscal costs. It avoids the government becoming unnecessarily involved in the specifics of how to lift performance and navigating every local circumstance."
Local Government Minister Nanaia Mahuta has previously said she would take proposals for major reform of three waters funding to Cabinet in June of this year, with a view to making a final decision by the end of 2019. Local Government New Zealand has urged the government to focus on drinking water first, and allow new freshwater management standards set in 2017 to run their course through to 2025.
Local authorities already spend a large proportion of their funds on the management of water, stormwater, and wastewater, and improving those systems will add to existing fiscal pressures.
The current framework imposes weak disciplines and incentives on council-led water suppliers to meet safety and environmental minimums, with limited oversight of charging and costs.
The commission said the natural monopoly features of three waters isn't the reason for their poor performance. Rather, because councils have often put a priority on keeping direct control, they haven't been able to achieve the necessary skills needed.
"Councils ought to be focused on service performance, which for many will require the requisite expertise and much of that may only come from increased scale. This could come from merging with other providers and/or pursuing expansion opportunities," the report said.
Other than Auckland's Watercare and Wellington Water - a joint venture of five councils in the region - water suppliers' governance is carried out by elected councillors and their officials.
The commission says that "will be compromising supplier performance and muddying their accountability to councils". It also reduces accountability, which ultimately flows through to weak performance disciplines and incentives, as does funding water systems through rates.
The commission said effective regulation would impose significant financial penalties for breaching performance requirements, and force councils to confront their short-comings.
"The government should focus on establishing an effective regulatory regime that strongly incentivises councils to make those tough decisions, and on offering financial assistance to communities in ways that encourage performance, and which are targeted to situations where a high level of assurance is needed and would be used wisely," it said.
The report said lifting the performance of the three waters sector will also assist the government's well-being framework in that safer drinking water will benefit people's health, while better waste- and stormwater systems will help the natural environment.
"More efficient and cost-effective provision of three waters services will contribute to improving the country's productivity. It will also contribute to New Zealand's international reputation for being 'clean and green' by reducing the incidence of tourists becoming ill from drinking water and by reducing pollution of coastal and freshwater catchments," it said.