The report, on the effectiveness of the Biodiversity Offsets Scheme, said core elements underpinning the government scheme, were poorly designed.
The scheme came into effect five years ago and required that developers clearing land conserve habitat elsewhere in the state through the buying and selling of biodiversity credits.
"The Department of Planning and Environment (DPE) did not establish a clear strategy to develop the biodiversity credit market or determine whether the scheme's operation and outcomes are consistent with the purposes of the Biodiversity Conservation Act 2016," the report said.
Proposed development involving the clearing of native vegetation, and meeting certain thresholds, is required to undertake a Biodiversity Development Assessment Report.
These reports determine an offset obligation, in biodiversity credits, which is then included in the conditions of development approval.
"Key concerns around the scheme's integrity, transparency, and sustainability are also yet to be fully resolved," the report said.
The report noted that 59 per cent of threatened ecological communities will vanish in the next century if no structural changes are made to the current scheme.
Habitat destruction and native vegetation clearing are the greatest threats to biodiversity in the state according to the NSW State of the Environment report published in February.
Conservation advocates have described the auditor-general report as an indictment of the government's favouritism of developers over the environment.
"It is failure by almost every measure," Nature Conservation Council CEO Jacqui Mumford said.
"The government's biodiversity offsets scheme treats nature like a magic pudding that developers can keep eating forever if they throw some cash into the government's tin.
"It reduces nature to a bunch of financial formulas that can never capture the true value of our unique and rapidly disappearing wildlife and bushland."
Greens MP Sue Higginson also criticised the scheme describing it as "catastrophic to nature".
"The report ... confirms that we are facing an environmental crisis and the government's current policy is broken and contributing significantly to it," she said.
"Right now the offsets scheme is trading biodiversity that doesn't and can't exist anywhere else."
The Australian Land Conservation Alliance estimates over $1 billion a year is needed to restore and prevent further landscape degradation nationwide.
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