Sate government documents suggest Water NSW and Infrastructure NSW will instead consider offering compensation if biodiversity is lost in the heritage-listed Blue Mountains area and surrounding national park.

The compensation could involve establishing a new national park or funding a conservation program which experts argue is a loophole created by the NSW government to avoid expensive offset costs.

Read more: 'Wonderland at risk' from higher dam walls

The plan to raise the wall at least 14 metres would allow additional floodwater to be captured and temporarily held back in the national park before a controlled release.

Up to 1000 hectares of world heritage area and 3700 hectares of surrounding national park would be inundated for up to two weeks, which environmentalists argue could destroy a globally-significant ecosystem and some rare species.

The wall raising is being assessed under the Framework for Biodiversity Assessment which requires environmental impacts to first be avoided and minimised through mitigation measures.

Remaining impacts must then be offset through the protection of similar ecosystems and threatened species elsewhere.

Under regulation, flooding is considered as land clearing which is defined as a direct impact and offsetting is required.

However, AAP understands Water NSW, Infrastructure NSW and the former Office of Environment and Heritage (now the Department of Planning, Industry and Environment) have agreed the project will be assessed as an indirect impact.

It's understood this decision was made in part because the offset costs could exceed $1 billion.

The agencies will instead assess the damage after a flood and then consider any potential compensation but will not offset the biodiversity destroyed by the flooding.

Ecologist Dr Steve Douglas argues this is not common practice and reflects the government's conflict of interest in the project.

"They have created a rule for themselves they wouldn't allow for anyone else," he told AAP.

"It's exceptional."

He claims the government is creating a loophole for itself to get out of the offset payments.

Dr Douglas warned a big flood could cause significant damage and the government may not be able to secure the offsets needed.

"In some cases they won't be able to get offsets because they don't exist because they've wiped out species," he said.

"It gives them a get out of jail free card."

NSW Labor MP Penny Sharpe described the project as an "environmental catastrophe".

"The fact they're considering not offsetting those impacts is completely unacceptable," she told AAP..

Environmental group Give A Dam claims Infrastructure NSW and Western Sydney Minister Stuart Ayres, who is overseeing the project, are bending the rules.

"If Environment Minister Matt Kean and Premier Gladys Berejiklian are to maintain any credibility they must bring Mr Ayres and his department under control," spokesman Harry Burkitt told AAP.

Infrastructure NSW said the draft environmental impact statement is being completed in line with Department of Planning, Industry and Environment requirements.

The statement includes a biodiversity offset strategy which is in line with regulation, a spokeswoman told AAP in a statement.

The statement is expected to be released to the public later this year. It will then be subject to federal government approval.

The project came under scrutiny after AAP revealed the Berejiklian government was actually planning to raise the dam abutments at each end of the wall by 17 metres to allow for future modifications to hold back additional water.

A NSW parliamentary inquiry has been established into the project with a hearing to be held on Tuesday.

Mr Ayres has been contacted for comment.

Australian Associated Press

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