An Upper House inquiry has delivered a scathing assessment of the New South Wales Government's "Fit for the Future" process to overhaul councils.

Fit for the Future saw the Independent Pricing and Regulatory Tribunal (IPART) assess whether councils were financially able to stand alone, or whether they should merge with neighbouring councils.

It found more than two-thirds of Sydney councils were unfit, along with more than half of regional councils.

But the Upper House inquiry found that process was flawed from the beginning and that IPART was the wrong organisation for the job.

"While IPART has significant capacity to analyse the finances of local government, it does not have the demonstrated skills or capacity to assess the overall 'fitness' of councils as democratically responsible local governments," the report said.

Another finding relates to the criteria that IPART used to judge councils.

"The scale and capacity criterion was a flawed criterion ... and accordingly assessments of councils' fitness based on this threshold capacity are not well-founded," the report said.

Committee member Peter Primrose said IPART's findings were limited by the terms of reference.

"It was a set-up from beginning to end," committee member Peter Primrose said.

"I don't blame IPART. I blame the terms of reference which were handed to them by the Premier.

"They had to find this illusory thing on the basis of this nonsense called scale and capacity."

The first of 17 recommendations is "that the Premier and NSW Government withdraw the statements that 71 per cent of councils in metropolitan Sydney and 56 per cent of regional councils are unfit".

Another calls on the Government to consider "the removal of rate pegging and allow councils to determine their own rates" provided the community supports any rate rise.

Local Government Minister Paul Toole has seized on that recommendation.

"The report indicates that they want to jack up rates. They're talking about taking the easy way out here," he said.

"Fifty-two councils over the last two years have put their rates up, in some cases by 50 per cent."

Mr Toole skirted around questions on whether the Government would force amalgamations on councils that were refusing to merge.

"We've made it very clear that councils have 30 days to respond to the IPART report," the minister said.

"There are a number of councils across the state that we know of today that are having discussions with their neighbours.

"We know last night that Wyong has moved a motion to engage in discussions with Gosford, but we've made this commitment – that by the end of the year, every council in NSW will know where it stands."