A brothel licensing scheme recommended by a parliamentary committee to protect sex workers and eliminate "criminal elements" from the industry has been rejected by the New South Wales Government.

Key points: Concerns sex workers are being exploited as criminal organisations run illegal brothels

Concerns sex workers are being exploited as criminal organisations run illegal brothels Councils want licensing scheme to improve sex industry regulation

Councils want licensing scheme to improve sex industry regulation Opponents to scheme say it could push elements of sex industry underground

The decision has angered the state's local councils, which say the existing "ridiculous state of affairs" means they are forced to hire investigators to entrap illegal sex workers.

But Labor and Greens MPs have welcomed the Coalition Government's move to reject the recommendation of the Government-controlled Lower House committee.

The Select Committee on the Regulation of Brothels' report, tabled last year, said the licensing scheme would help enforce planning laws, better protect sex workers from exploitation and ensure only fit and proper persons operate brothels.

Its inquiry heard evidence that unapproved "massage parlours" offering sexual services had opened in parts of Sydney "at an alarming rate", including near schools, and that it was likely that criminal networks were operating in the industry and workers were being exploited.

The Government's response, tabled in Parliament by Innovation and Better Regulation Minister Victor Dominello, said the licensing proposal would not be supported by the Government.

"Reintroducing such significant regulatory burdens and police involvement risks creating similar outcomes to recriminalising sex work," the report said.

It said the Government would keep working closely with councils to "reduce any criminal activity or influence" in the industry, and councils had recently been given stronger powers to inspect non-residential properties.

Local Government NSW president Keith Rhoades said the Government had missed an opportunity to put a watchdog in place to properly regulate the industry.

"We have the ridiculous state of affairs in which councils are forced to waste ratepayers' money hiring private investigators to go undercover and actually buy sex from prostitutes to obtain the necessary proof to launch a prosecution," he said.

"It's not about trying to impede the sex workers, but it's simply to regulate the owners of these brothels that we come up with a better system."

Labor MP Jo Haylen, who was one of three committee members who dissented from the licensing scheme recommendation, said she was pleased the Government had seen sense.

"We had real concerns after listening to all the evidence it was very clear that a licensing regime would have sent elements of the industry underground and that would have undermined the great work that we've had in New South Wales."