A Helensburgh coal mine has been given approval for a mining program that involves excavating under the catchment that is the sole water supply for the area.
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But an environmental group is looking to launch legal action to overturn the decision.
The NSW Planning Department quietly approved the proposal from Peabody Energy-owned Metropolitan Mine to develop three new longwalls.
Two of the longwalls would go under the Woronora Reservoir, which drains into the Woronora Dam and supplies water to the Sutherland Shire and areas of the northern Illawarra.
According to WaterNSW the dam is the sole water supply to Helensburgh, Engadine and Lucas Heights.
In a letter to Metropolitan Mine dated March 16, Planning NSW executive Mike Young wrote that this would be the first mining ever conducted under the Woronora Reservoir.
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For that reason it was important the plan was "sufficiently robust" to manage any subsidence impacts on water quality in the reservoir.
In the letter it was acknowledged that the risk of leakages from the catchment was "an issue of significant concern" to the public.
However, the letter said the department considered there was a "very low and therefore acceptable risk of leakage" from the reservoir.
The letter also contains a list of conditions the miner must meet, which include monthly monitoring of the reservoir, with regular reports to be sent to the Planning Department and Water NSW, and flow gauges and other measuring devices set up at various locations.
The Nature Conservation Council is opposed to the decision and is considering its legal options to reverse the decision.
"We are very concerned that the mine will not be able to meet the conditions placed on the approval, which would have dire consequences for water supply," NCC chief executive Chris Gambian said
"It is possible to support the coal mining industry and still believe that mining under drinking water supply is a step too far."
A Peabody spokeswoman said the approvals would allow it to continue to supply coal to the Port Kembla steelworks and keep its employees in work.
"Metropolitan is proud of its proven track record of protecting the environment and our conservative mining techniques have ensured there has been no connective cracking between our underground mining operations and the surface and therefore no loss of surface water from the Sydney Water Catchment into the mine," the spokeswoman said.