The government’s Three Waters reform aims to make sure Kiwis have access to safe drinking water, and to close an investment gap worth $185 billion.

Another crucial matter for the reform, which has received little attention so far, is housing affordability.

For decades, city councils have been reluctant to free up land to build houses. They have tied developers in red tape. The result is the worst housing market in the OECD. New Zealand has seen its house prices increase faster than any other developed country since 1991.

But land use restrictions and red tape are symptoms of a deeper problem. Growth is expensive for councils. One reason is that water infrastructure is poorly funded. Councils have used their control over planning and resource consents to manage their financial exposure to the cost of water. The result is a persistent under-supply of land.

Let me explain.

Fixed infrastructure businesses are fairly straightforward. The owner builds an asset and earns revenue from it by selling services. She uses debt to pay for most of the asset. Debt converts the large upfront cost into a series of much smaller payments over the working life of the asset. The company uses its services revenue to pay back the debt with interest, with an extra margin as a return on capital.

This is the basic funding model for everything from electricity lines to airlines.

This model has the advantage of being self-contained. Air New Zealand does not need to turn to government for help every time it wants a new plane. Consumers pay for the asset. Lenders bridge the gap between the upfront cost and revenue which comes later.

If the asset is natural monopoly, a gas pipeline or an airport perhaps, then an economic regulator will oversee the business. The regulator’s job is to encourage monopoly-like businesses to behave competitively. The firms may earn a commercial return on their investments but no more than that.

When users pay for the cost of their services, something extraordinary happens. The infrastructure just turns up, as if by magic wherever there is sufficient demand. Nobody thinks twice about it.

Water infrastructure is different. Users of water, wastewater and stormwater systems do not pay the full cost of building and maintain those systems. Water must compete with other council services for funding.

Which means ratepayers end up footing part of the bill for growth. In effect, growth depends directly or indirectly on cross-subsidies from ratepayers. If cities grow too quickly, councils can run out of money. Ratepayers can vote out councillors who push for too much growth.

Water’s funding model limits its scalability. That is one reason why the average house price in Auckland is now $1.4 million.

Pricing, not ownership, is the fundamental issue for water. The government’s plan to strip councils of water assets worth $54 billion without compensation solves the wrong problem.

The reform at least has the advantage of relieving ratepayers from cross-subsidising urban growth. And the government is looking at a new economic regulator for water, which is welcome.

But there is a real risk that when all is said and done after the reform, it will still be too hard to build a house. Water will continue to hamper growth so long as it is mispriced and therefore depends on subsidies.

Economies of scale are the government’s main rationale for reform. It believes taking assets from 67 local councils and placing them in four new entities will lead to cost savings.

The promised savings are extraordinary. Without reforms, Aucklanders will pay $1,910 per year for water in 2050, says the government. Reforms would reduce that to $800 per year.

Far North and Kaipara Regional Council residents will pay over $8,600 annually for water in 2050, but only $800 after the reform, a saving of over 90%.

These numbers, which come from the consulting arm of the Scottish water regulator, look fanciful.

Economic consultants Castalia have carefully reviewed the government’s evidence.

According to Castalia, larger water owners have better asset management processes. These achieve some efficiencies. But the study found little evidence to support large reductions in capital and labour costs due to scale.

Change is absolutely required in water. But ownership is not the main issue. Councils should keep their assets.

The essential task is to put three waters on a commercial footing, at least in urban areas where housing is least affordable.

Two changes are needed. First, the price for water services must be set so that users pay for the full cost of the service, including a fair return on capital. This is how electricity lines and other essential public infrastructure are priced.

Second, water should not compete with other council services for funding. Existing ratepayers should not be funding growth. Water should be ring-fenced within councils and be able to borrow on its own terms.

As a result of these changes, water services will go wherever there are willing customers. The pipes will just turn up, just like they (almost always) do for electricity lines, gas pipes, and telecommunications cables.

The transition to a commercial model will make things simpler for councils. They will own water assets, but no longer face pressure from water on spending or debt limits. Councils will be able to upzone land without working out how to pay for new pipes and other plant.

Households will pay more for water services than they do now. But households need not pay more overall. Each year, councils will receive a healthy return on investment from their water divisions. They can use their dividend to reduce rates. This is a re-balancing, not a cost-of-living increase.

The transition to commercial funding will not be easy. Prices for new connections could adjust immediately. This has the potential to free up land and moderate the growth of house prices almost immediately.

But existing households will require a more gradual transition, possibly over a decade or more, given the need to maintain popular support.

The shift to a commercial approach will also help to resolve the $185 billion deficit.

People from overseas find it hard to believe water could be the reason we cannot build more houses in New Zealand. It is as if the idea that pipes could be an enduring bottleneck for land use had never occurred to them before.

There is no reason water distribution and treatment should be any more difficult to build and maintain than other infrastructure. It is a matter of getting the pricing right and unlocking access to finance. This is fixable.

Unfortunately, the government is focused on ownership with its Three Waters reform, not scalability. The government has said the new water entities will not pay dividends. This suggests funding for growth is still going to be a challenge after the dust from the reform settles.