The Queenstown Lakes District Council's application for $1.6 million to part-fund an alternative use for the sludge has been turned down by the Ministry for the Environment.
The council earlier received seven tenders from throughout the country for a sludge disposal contract and had selected a "preferred option" to replace the current system of sending the sludge to the Victoria Flats landfill at Gibbston.
QLDC solid waste manager Stefan Borowy would not disclose what the preferred option was or the total cost of the project, as it was still commercially sensitive and subject to negotiation.
The council would now have to review its options and consider private sector or ratepayer funding for the project instead.
The ministry told the council 77 eligible applicants had sought a total of $53 million from its waste minimisation fund, which was "significantly more than the pool that was available", Mr Borowy said.
Just 16 proposals had been invited to proceed to the next stage.
The council had been given some "informal" feedback on why its application was unsuccessful, but Mr Borowy declined to comment on the reasons until they had been discussed further with the ministry and the council's senior management.
Deputy Mayor Lyal Cocks said the ministry's decision was "very disappointing", particularly considering the high standard of the council's application.
"We thought we put in a good proposal and it would have been good for our district ... it's what we need to do to move on and increase the amount of diversion from the landfill," Mr Cocks said.
In the year ended June 2012, 990 tonnes of sludge from Project Pure was sent to landfill, at a cost of $178.70 per tonne.
Mr Borowy said the decision was made even more frustrating because the district's communities had been paying an extra $10 per tonne "waste disposal levy" to dispose of waste to landfill since July 2009, which amounted to about $600,000 up to June.
"It is disheartening that the community will have to continue to pay this $10 per tonne levy and perhaps more in the future, but that the ministry does not see the value in funding a project to divert a significant amount of organic waste from landfill."
Projects supported by the waste minimisation fund in 2011 included $370,000 for an Auckland-based wood waste processing facility supplying cement kiln fuel, $52,000 for glass recycling in Kaikoura and $200,000 for the Glass Packaging Forum to install commercial recycling bins throughout New Zealand.
