Marginal Costs and Prices in the Electricity Industry

Energy Forum Papers

1. INTRODUCTION AND SUMMARY

One of the major efficiency gains associated with the new market-oriented electricity supply industry arrangements results from the fact that consumers can now be charged prices that are more indicative of the costs of supply.  Another advantage of relying more on decentralised markets to co-ordinate the supply and demand decisions of many independent agents is that the evolution of the industry can reflect the wisdom of many more decision-makers.  Entrepreneurs do not have to convince bureaucratic planners of the virtues of new technologies, products or market arrangements in order to discover if those alternatives might improve upon the entrenched ways of doing things.

Many commentators have questioned, however, whether the new market-oriented arrangements send the appropriate signals to suppliers and demanders of electricity.  In particular, a common question that arises is whether what appears to be a very short-run process is capable of inducing appropriate decisions about the long run supply of new generating capacity.  Auction markets set prices on an almost continuous basis to equilibrate supply and demand.  It would appear to be obvious that the prices so established would reflect the short run marginal costs of supply (holding current capacity fixed) and not the longer run costs associated with ensuring a continuing supply of capital to the industry.

We shall argue on the contrary that market prices send appropriate signals not only about the short run costs and benefits of altering industry output but also the longer run costs.  Though prices can fall to the level of marginal costs -- and even less for short periods -- in the long term they must cover all costs.  Failure of this to occur means the market is signalling that there is excessive supply and some capacity will exit or new capacity will be deferred until market growth exhausts the over-capacity.  The fact that price is higher than marginal costs no more indicates that suppliers in the electricity industry have market power than it does in other capital intensive industries like air transport and offices.

As well as inducing appropriate decisions about the time profile of additions to capacity, an efficient set of prices leads to the lowest cost mix of generating plant to satisfy a given time profile of demands.  Most industry observers or participants are familiar with the idea that different types of generating capacity are best suited to satisfying different parts of the industry demand load.  The way that market prices induce a supply of different types of generating plant is closely related to the way markets encourage appropriate long run decisions about the overall supply of generating capacity.

2. PRICES AND MARGINAL COSTS IN THE VICTORIAN ELECTRICITY SUPPLY INDUSTRY

Compared with their expected levels, prices in Victoria (and New South Wales) have been low since electricity markets commenced in 1995 and average prices were pushed lower once New South Wales and Victoria were joined in the National Electricity Market.

Compared to price expectations that were reflected in the vesting contracts ($38-40 per MWh) average prices have been about $25 per MWh.  To a considerable degree the lower prices reflect the de facto increase in capacity since corporatisation/privatisation that has stemmed from the greater efficiency in the industry.  Figure 1 illustrates the prices since the commencement of the national market.

Figure 1 Prices in NSW and Victoria

Figure 2 illustrates the marginal costs of the different plant in Victoria compared with the average level of demand experienced.  It can be readily seen that the average price as in Figure 1, low though it has been, was in excess of the marginal costs of almost all the plant listed.  Between the commencement of the NEM and June 2000, there were however only just over a hundred half hour periods in which the Victorian price exceeded $100.

Figure 2Source:  E.Kee Victorian Power:  New Market Investment, Melbourne, 13 June 2000

3. MARGINAL COSTS IN A MIXED PLANT SUPPLY SYSTEM

3.1 SHORT RUN PRICE SETTING

A competitive auction market without any rules restricting bidding behaviour will always set prices so that the market clears, with both demand and supply adjusting.  In electricity markets, demand has a very low price elasticity.  In consequence, almost all the adjustment in the short run ⁽¹⁾ is on the supply side.  Prices therefore call forth or deter the offering of supply from existing plant.  By contrast, when prices are not allowed to determine supply, demand is rationed either by very high price levels (which, however, are not paid to suppliers) or by more direct and arbitrary regulatory allocation.  This is needed to ensure the load on the network does not exceed the amount of energy supplied to it.

As illustrated in Figure 3, the relationship between prices and production costs in an auction market will depend on the level of demand and the way costs vary with output.  Suppose, to begin with, that current demand (D₁ in Figure 3) is less than the available generating capacity.  If generators can earn sufficient income to cover their marginal operating costs (the fuel and labour costs of producing one more unit of electricity) they will be willing to expand output.  Although supplying output at that price makes little contribution to the overhead costs (particularly the capital costs), if the capital is already in place any contribution is worthwhile.  On the other hand, if total demand equals current generating capacity (D₂ in Figure 3), the price needed to ration demand to the available capacity will exceed marginal costs.

Figure 3:  Prices set in a competitive electricity auction market

The behaviour of average costs as output expands has a critical influence on whether electricity prices in an auction market are likely to be sufficient to cover the costs of production.  This is because the relationship between average and marginal costs depends on whether or not the firm displays economies of scale.  If there are increasing returns to expanding output, average costs will fall as output expands and marginal costs will be smaller than average costs. ⁽²⁾  Conversely, if there are decreasing returns to scale, average costs will rise as output expands and marginal costs will exceed average costs.

3.2 PRICES AND ECONOMIC RENT

When discussing the issues addressed in Figure 3 in relation to the electricity supply industry, we need to distinguish the costs of incrementing generating capacity through new investment from the production of output given an existing level of capacity.  The essentially short run nature of the previous analysis can lead to harmful outcomes if policies seek to enforce a price regime on this basis.

As Figure 2 illustrated, base load plant, such as large coal-fired power stations, that is used almost continuously typically has much lower operating costs than peaking plant such as gas turbines.  Although the operating costs for base load plants are lower, the capital costs are usually much higher.  Constructing base load plant is justified when the saving in operating costs relative to the peaking plant that the base load plant displaces at least compensates in present value terms for the higher up-front capital expenditure of the base load plant.

A wholesale electricity market ensures an appropriate mix of generating plant by ensuring that the base load plant earns "rents" relative to its short-run operating costs whenever plant with higher operating costs is called upon to supply the marginal amount of electricity to the system.  The peaking plant will only be operated if the market price at least compensates for the high costs of operating that plant.  The market price at those times must therefore exceed the operating costs of the base load power stations.  The excess of price above operating costs during those periods represents a "rent".  The discounted present value of such rents anticipated over the lifetime of the plant represents a return on the additional funds invested to provide the capacity in the first place.  Investment in base load capacity will therefore be justified if the expected discounted value of the savings in operating costs relative to peaking plant at least covers the cost of the investment.

A question that naturally arises is how the costs of investing in peaking plant can be recovered.  If generators are always willing to supply electricity so long as their marginal operating costs are covered, it might be thought that prices would, at any one time, be bid down to equal just the operating costs of the highest marginal cost supplier.  Under these circumstances, the owners of the generating plant with the highest operating cost could expect to receive no more than their operating costs at any time.  They therefore could earn no "rents" that could be used to cover upfront investment costs.  In addition, owners of plant with lower operating costs would earn less than they should and therefore also could not expect to earn enough to pay for the capital costs of a plant of the efficient size or design.

Behind this argument is the fact that operating costs consist almost entirely of fuel and labour costs.  The owner of a generating plant is thus imagined as being willing to supply electricity so long as the market price at least equals the cost of the fuel burned and the labour needed.

The defect in this argument is apparent from an examination of hydroelectric plant.  In this case the cost of the "fuel" would appear to be zero, so that short run operating costs would seem to consist entirely of labour costs.  An operator of a hydroelectric plant would not, however, agree to dispatch his generators whenever the market price of electricity rose above only his meagre labour costs.  That would occur almost all the time, and the operator would soon run out of available water.  The operator is cognisant of the fact that using water to generate electricity today, or during the current hour or half-hour period, means that the water will not be available to supply power at some other time.

An implicit cost of using water to generate electricity at any one time is the forgone opportunity to use the water at some other time instead.  This implicit cost is referred to as an opportunity cost.  When deciding whether to dispatch his plant, the owner needs to compare the current market price not with the explicit short run operating costs but with the sum of those costs and the opportunity costs of the water.  Only then would the owner first use the limited supply of water to generate electricity during those time periods when prices are expected to be at their highest.  If water is left over after all the peak periods have been supplied to full generating capacity, the periods with the next highest price would be utilised and so on until the available supply of water is exhausted.  The opportunity cost of the water could then be measured as the excess of price over explicit short run operating costs in the marginal, or least desirable, period when the water will be used to generate electricity.

The "rents" earned on the limited water resource can be measured as the discounted value of the excess of prices earned over the labour and other short run costs over the expected lifetime of the dam and other facilities.  If the hydroelectric capacity is efficiently supplied, the present value of these rents ought to pay for the up-front capital costs of constructing the dam, tunnels, turbines and so on.

3.3 OPPORTUNITY COSTS OF CAPACITY

Just as water has an opportunity cost, so also does the capacity to supply electricity at short notice using peaking plant.  If the peaking plant were not available, some consumers would have to go without power when peak demands are placed upon the system.  The opportunity cost of the peaking plant is thus the value of the opportunities that would be forgone if the plant were not available.  The value of such opportunities is, in turn, reflected in the prices consumers are willing to pay for a marginal unit of supply during peak demand periods.

There would appear to be a fundamental asymmetry, however, between the opportunity costs of water to the owner of a hydroelectric plant and the opportunity costs of the capacity supplied by a peaking thermal plant.  In the first case, the owner is aware that using water at one time precludes its use at some other time.  The owner thus has an incentive to compare the potential value of the water at different moments of time and to choose to supply only if the current price exceeds operating costs inclusive of opportunity costs.  The owner of thermal peaking plant is not, however, constrained by the total amount of time he can choose to operate his plant.  Running the plant now does not preclude running it at some other time.  It would seem that the plant would be dispatched whenever operating costs, excluding any opportunity costs, could be recovered.  Consumers might place a higher value on having the plant available than is reflected in current prices because competing generators bid prices down until they barely cover marginal operating costs.

The answer to this apparent conundrum is that market prices ration demand to equal the available supply.  So long as demand equals the available supply capability of the system during at least some periods, capacity is scarce.  Prices at those times will reflect the marginal value that consumers place upon having additional supply or the opportunity cost of additional capacity.  Prices will be bid up above the short run operating costs of the marginal producer.  The "rents" earned on the available capacity then represent a signal to the market reflecting the value that consumers place upon additional capacity.  If the expected present value of these rents is enough to pay for additional peaking plant, this plant will be constructed.  At the same time, base load generating stations will earn additional rents during the periods when capacity is scarce.  If additional base load capacity can be operated for enough hours of the year, and at prices sufficiently in excess of the short run operating costs, then it is efficient to build the base load capacity and perhaps displace some of the older, higher operating cost, peaking plant.

3.4 OPERATING ECONOMIES OF SCALE

Many analyses of the existence or otherwise of economies of scale are based on the technical or engineering characteristics of the production technology.  Firms using technologies that exhibit increasing returns to scale do not, however, necessarily experience lower costs as output expands.  Firms combine many activities, each of which uses a technology with different economies of scale.  For example, management and supervision are part of the activities of every firm.  Managers need to acquire information, give directions to employees, ensure that directions are complied with and so forth.  These activities are likely to exhibit decreasing returns to scale.  The overall economies of scale depend on the mix of activities, and how that mix varies as output expands.

The way new generating capacity is added to an electricity supply system is likely to result in short run increasing costs as output expands.  Most electricity systems experience substantial daily and seasonal demand fluctuations.  Periods of peak demand may only last a few hours each year.  Plant used only in peak periods therefore usually has a low capital cost but, in consequence, a high operating cost.  In fact, the construction of base load capacity is justified only when the saving in fuel and other operating costs over the expected life of the plant has a present value sufficient to compensate for the large initial capital costs.  Thus, gas turbines are less expensive to build than large coal, oil or nuclear base load plant but use a premium fuel.  Similarly, in a mixed hydro and thermal system, the "fuel cost" of hydroelectricity is the opportunity cost of the stored water.  Consequently, hydro capacity should be used in peak periods when the cost of thermal generation would otherwise be higher.

Older, higher cost plant is also used to produce higher levels of output.  Newer plant often embodies technological advances that reduce operating costs.  The maintenance costs, and lost time for maintenance, for older plants are also higher.

The result of these factors is that increases in the output of electricity in the short run are accompanied by rapidly rising marginal costs.  Empirical analyses claiming to reveal increasing returns to scale in supplying electricity invariably include capital as a factor of production, and thus implicitly examine a long run supply function.

3.5 INVESTMENT ECONOMIES OF SCALE

The fact that new generating capacity is added in "lumps" indicates that there are economies of scale associated with investment.  Many of the costs of adding to existing capacity, such as site preparation, engineering design, arranging transport of materials, procuring construction equipment and, to a lesser extent, the construction time, do not depend greatly on the size of the capacity increment.  By delaying construction of new plant a larger plant size is warranted, allowing lower average construction costs per MW of generating capacity.

Figure 4 illustrates the traditional model of efficient capacity expansion when the capacity of new plant is fixed and demand fluctuates across peak and off-peak periods.  For simplicity, marginal operating costs have been taken as constant at c₁ up to the current capacity q*.

Figure 4:  Efficient capacity expansion

In the left panel of Figure 4, the difference between the demand price in each period and c₁ can be viewed as an implicit demand for capacity expansion.  Since new capacity will be jointly provided for all periods, these demands can be summed vertically to give an aggregate demand for new capacity.  The subsequent discussion will ignore complications arising from the multi-period nature of electricity demand and focus on an "aggregated demand" (simply labeled as D in the right panel of Figure 4).

The right panel of Figure 4 illustrates the "trapezoid rule".  This argues that capacity should be expanded when the trapezoid of consumer surplus gain from expanding capacity from q₀ to q₁ equals the cost of that increment (q₁–q₀)c₂.  This will be true when the areas of the two shaded triangles in the figure are equal.

The efficient capacity expansion path will constrain demand in some periods -- otherwise, the implicit value of new capacity would never match its added cost.  If demand is not rationed by higher prices in "peak" periods it will be rationed through blackouts, brownouts or other reductions in service quality.  As we argued in the text, the "opportunity cost" of new capacity when demand is constrained is the marginal benefit consumers are willing to pay for relaxing those constraints, or the price given by the demand curve at an output level equal to the capacity constraint.

Now suppose that capacity increments can be of any size instead of being fixed at (q₁–q₀).  Since capacity is added in discrete lumps, there must be some economies of scale associated with the production of new capacity.  Eventually, decreasing returns will take over.  The result will be a U-shaped average cost of new capacity as illustrated in Figure 5.

Figure 5:  Cost of capacity increments

Hartley and Kyle (1989) examine a simplified version of this model where investment is the sole cost and where demand grows smoothly over time.  A unit of consumption is defined to equal the amount that demand would grow over one year if the price were kept fixed.  Hartley and Kyle show that the competitive equilibrium in this industry will be a stationary sequence of investments of a fixed size I each made at intervention price p as illustrated in Figure 6.  Immediately after each investment comes on stream, prices will fall to p–I.  Prices then return to p over the following I units of time.

Hartley and Kyle show that the efficient investment path under these conditions will also consist of a sequence of investments of a fixed size, now denoted I₀, and an investment time (or intervention price) p₀.  They show that the efficient investment path cannot be supported as a competitive equilibrium, that is I₀ > I.  Observe to begin with that, if the cost of capital is strictly positive, the resulting sequence of investments will not break even.  Intuitively, the low prices occur immediately after a new investment is added, while the high prices occur at the end of an investment cycle (as illustrated in Figure 6).  The efficient rule, however, will require capacity to be added when the (undiscounted) trapezoid of consumer surplus gain equals the cost of adding the new capacity (as illustrated in the right panel of Figure 4).

Although it is not obvious from the graphical presentation given here, Hartley and Kyle also show that the marginal cost of a new investment is below average cost.  Figure 4 then implies that the efficient investment size is below the level that minimises average investment costs.  Thus, even as r → 0, so discounting makes no difference, the optimal investment size remains below the level that minimises average cost.  As a result, the efficient investment path cannot be supported as a competitive equilibrium even as r → 0. ⁽³⁾

Hartley and Kyle also examine the investment path that is the most efficient that could be achieved given a constraint that the present value of revenue needs to be sufficient to cover investment costs.  They show that the result is again a sequence of investments of a fixed size each made at a fixed intervention price (or implicit value for capacity), as illustrated in Figure 6.  Furthermore, they show that this sequence of investments differs both from the unconstrained efficient path (where costs will not be covered) and the competitive equilibrium path.  Indeed, the investment size under the equilibrium path can be shown to be smaller than under the constrained efficient path, which in turn is smaller than the investment size under the unconstrained path that does not cover costs.  In a sense, therefore, competitive firms can be said to invest "too often" and choose an investment size I that is "too small" relative to the constrained optimum.  Each new entrant effectively has some "monopoly power".  By choosing a smaller investment size equilibrium prices will be higher.

Figure 6:  A stationary sequence of investments in capacity

The results derived by Hartley and Kyle do not imply, however, that a competitive electricity generating market is undesirable.  The constrained efficient path of investments they analyse is in practice unlikely to be achievable.  In particular, there is no reason to believe that a monopolist that is either owned or regulated by the government would choose the constrained efficient path.  Furthermore, there are good reasons, and much evidence, to conclude that such a monopolist would not operate in an efficient way.  Any potential gains in the efficiency of investment that were realised by a monopoly would be more than dissipated by operating inefficiencies.

It is also important to point out in this regard that factors omitted from the Hartley and Kyle model may make the competitive investment path more desirable from an efficiency point of view than their analysis would suggest.  More frequent and smaller investments provide other benefits to offset the higher costs associated with forgone economies of scale.  Consumers value a smoother path of capacity expansion since it is likely to lead to greater stability and predictability in price movements and make it easier to plan their own future investments.

In addition, more frequent investments may lead to greater technological change.  Thus, the rapid technological progress in gas turbine technology in recent years, which has played a part in facilitating increased competition in wholesale electricity markets, may also have been partly a consequence of electricity markets being made more competitive.  Firms in more competitive markets began to look for technologies that had lower economies of scale and thus were suitable for making more frequent investments without raising investment costs.  In summary, our experience with monopoly, and more recently competitive, electricity markets suggests that the overall outcome resulting from competition is likely to be the most efficient that can be achieved in practice.

There are other important implications of the Hartley and Kyle analysis.  First, despite economies of scale in the investment process, they show that a competitive equilibrium is feasible.  Empirical evidence would suggest this must be the case since, as we note in the text, there are many competitive industries that nevertheless are characterised by economies of scale in the investment process.  A second important implication of the Hartley and Kyle analysis is that investment in capacity, and the production of output using a given capacity, ought to be treated as two separate production processes.  Econometric analyses that include capital along with fuel and labor as factors in a "timeless" production process will misconstrue the economies of scale in electricity generation.  In particular, while the model implies that investment levels are "too small" in a competitive equilibrium to fully exploit investment economies of scale, this is no justification whatsoever for combining generating plant into portfolios within a single firm.  The model implies that there would be no reduction in costs resulting from such a combination. ⁽⁴⁾

Furthermore, the above discussion assumed a competitive output market.  If only a few firms own most of the capacity, Green and Newbery (1992) show that the firms will have an incentive to restrict output relative to the available capacity.  The result will be, as happened in the UK, inefficient use of existing capacity and an artificial stimulus to investment.  Aggregating generators into a small number of firms decreases competition in the wholesale electricity market.  The ostensible benefits from exploiting economies of scale, which are supposed to offset the losses associated with gaming in the wholesale market, are illusory.

4. MARKET DETERMINATION OF ELECTRICITY GENERATING CAPACITY

4.1 INVESTMENT CYCLES IN ELECTRICITY GENERATION

The market approach to adding generating capacity is a decentralised process involving many players and potential players.  Any entrepreneur who believes prices are likely to exceed operating costs often enough, and by a large enough amount, over the life of plant is free to add capacity to the system.  If the belief turns out to be mistaken, investors in the project will earn a rate of return that is insufficient to compensate for the opportunity costs of having savings invested in this project rather than some alternative.  If too few entrepreneurs believe that prices will be high enough to justify adding capacity to the system, consumers will be rationed to the available capacity too frequently and existing producers will earn a return on their investments that are above competitive rates of return in the capital markets.  High returns extending over a reasonable period of time will, of course, attract the attention of investors and bring new entrepreneurs to the market to satisfy demand.

The essential characteristic of a competitive industry is freedom of entry.  Competition is a process involving a continual balancing of the costs of meeting the demand of consumers for greater supply and the value of doing so.  Market prices do not reflect marginal costs of supply calculated according to some formula but rather reflect judgments that resources are worthwhile being used for this purpose rather than myriads of other possibilities.

An entrepreneur contemplating building a new generating plant must make a conjecture about the future evolution of the industry.  As in any other business, an investment project has to be justified by a forecast that market demand will be adequate to take the additional supply without an unacceptable fall in prices.  Forecasts need to be made also of the likely behaviour of other market participants.  An investment proposal might be based upon a premise that existing higher cost suppliers will be driven from the market.  Realistic scenarios also need to be developed for the time profile of new investments likely to occur over the life of the plant under consideration.

The fact that an entrepreneur considering an investment in the industry would take account of the likely response of other suppliers suggests to some that the industry is not truly competitive.  Under this view, a competitive industry would be characterised by firms that behave atomistically, making their own decisions independently of what any other suppliers choose to do.  In our view, however, the critical feature of a competitive market is freedom for anyone to enter as a supplier.  Firms can be aware that their decisions depend upon the decisions of other market participants.  They must not, however, be able to control the decisions of other firms, or explicitly collude or co-ordinate their business decisions in a way that disadvantages other actual or potential market participants.

As illustrated in Figure 6, the likely outcome of such uncoordinated decision-making in an industry characterised by freedom of entry is that capacity additions will occur in cycles.  Immediately after the addition of new capacity, demand will match the available capacity rarely if at all.  Prices will therefore rarely rise above marginal operating costs, and the new capacity will earn a very low, or even zero rate of return.

Eventually, as existing plant deteriorates, suffers increasing costs and is perhaps withdrawn from service, or as demand continues to grow, the amount of time when demand is constrained by the available capacity will begin to increase.  Increasingly, demand will be rationed to the existing capacity by high market prices.  The excess of prices over marginal operating costs represents a return to the capacity that has now become relatively scarce.  These returns represent a signal to entrepreneurs that more capacity is needed in the system.  Entrants will be encouraged to build new plant.  Investments could be expected to earn most of their return toward the end of a "cycle" immediately before the high rates of return encourage an entrepreneur to build a new plant, at which point the period of low prices will return.

One finds this process of fluctuating returns to capacity in other industries characterised by lumpy additions to capacity, such as office construction or oil refining.  Office rents tend to decline dramatically immediately after new buildings are constructed and then gradually rise as the excess capacity is removed from the market either by tearing down old buildings or by the growth in demand.  Eventually, high rents encourage another firm to build a new office tower.  Similarly, petrol "price wars" often follow the construction of new refining capacity as wholesalers compete fiercely for the available customers.  As demand grows to more closely match the available capacity, however, one begins to see periods of high prices at times of excessive demand, such as peak holiday driving periods or, in the United States, during unusually cold winters that raise the demand for heating oil.  There is every reason to expect that a competitive electricity supply industry would be characterised by similar cycles of investment and the associated price variations.

4.2 DECENTRALISED MARKETS VERSUS CENTRALISED PLANNING

The picture we have painted of the operation of a decentralised competitive market in electricity supply may appear rather chaotic relative to the process that used to occur under centralised monopoly control.  The differences are, however, more apparent than real.  The risks of mistakenly forecasting demand, or depreciation rates of existing plant including as a result of unexpected technological change, are not unique to competing firms.  Indeed, it could be argued that by relying upon a very few decision-makers who all talk to each other, a monopoly supplier is perhaps more likely to make systematic forecasting mistakes.  A major advantage of a market is that it exploits the information, ideas and forecasts of many independent people rather than assuming all wisdom resides in a few anointed "experts".

By allowing many people to participate as suppliers, a market also encourages experimentation with new technologies and other ways of doing things.  By contrast, a monopolist, particularly one protected from challenge by government legislation, has little incentive to experiment with new approaches.  While it appears more fluid, the more dynamic market environment also encourages greater innovation.  The electricity supply industry is changing from being a low risk, safe investment, to becoming an exciting entrepreneurial business where admittedly risks are greater, but also where new ideas and approaches may earn premium returns.

A related issue is that different individuals bear the risks in a competitive industry than in an industry that is owned by governments, or heavily regulated by them.  In a competitive industry, investors are adversely affected if the demand for capacity is over-estimated.  In a regulated industry, prices are usually determined by assessing costs.  Excessive investments are passed on to consumers in the form of higher prices.  Investors are, however, much better able to bear the risks.  A major function of private ownership and capital markets is to allow those individuals who are most willing to do so to bear the unavoidable risks of doing business.  In the case of an under-estimate of future demand, market prices are likely to be higher in a competitive industry than under a regulated monopoly.  In the case of the government owned or regulated firm, demand is usually rationed by means other than allowing prices to rise.  The outcome is likely to be less efficient than rationing through higher prices, however, since there is no guarantee that the consumers who place the highest value on the limited available supplies will be the ones to receive it.

4.3 CURRENT EXCESS CAPACITY IS A CONSEQUENCE OF PAST MISTAKES

In the current Victoria/New South Wales context, there would appear to be few opportunities for suppliers to earn an adequate return on their investments in generating capital.  It would be a mistake to extrapolate from this situation to the normal state of affairs in a competitive electricity market.  Capacity is undoubtedly in excess supply in the inter-connected Victorian and New South Wales electricity market.  A consequence is that prices are not being set at a level that would represent an adequate return on capital.  This situation is not the result of the operation of a competitive market but rather the consequence of past demand forecast errors made by the former monopoly government suppliers.  The situation will change as demand gradually expands and high prices are more often required to ration demand to equal the available capacity.

The wholesale prices in Queensland and South Australia illustrate prices that are in excess of marginal operating costs for substantial periods of time.  These relatively high prices have stimulated more plans for entering those markets.  Some would argue, following the NEMMCO Statement of Opportunities, ⁽⁵⁾ that in South Australia such stimulation has not been as great as might be expected.  Such a view may be correct but is so partly because potential entrants expect the expansion of inter-state trade in electricity from New South Wales and Victoria.  Indeed, construction of new transmission links to South Australia is projected to help bring about the disappearance of much of the excess capacity in the current Victorian and New South Wales markets.

4.4 PAYING FOR CAPITAL COSTS OF BASE LOAD PLANT

There is debate regarding the capital structure of firms in the electricity business and their commercial behaviour.  In principle, the capital structure of the firm is not relevant to the marginal price of its outputs.  The capital structure is the financial basis on which the firm's assets have been acquired.  For a prudent firm (and a prudent lender) this often means ensuring a ratio of debt and equity that reflects the vulnerability of the firm's cost and revenue.  Normally, where firms' assets are highly liquid or where their revenues are stable, increased debt levels are more acceptable.

That said, the proportion of total assets accounted for by borrowings should not influence the firm's pricing strategy.  Prices should be set to maximise profits whatever the capital structure and profit maximisation occurs at the highest price possible that is in excess of non-fixed costs.  In periods of over-capacity a firm's prices may fail to cover the costs of servicing debt.  Nonetheless the firm will still be obliged to price at these levels since the alternative is an even greater shortfall in revenue net of costs.  There should be little difference in the perspective of shareholders receiving inadequate returns on equity compared to lenders not receiving interest payments.

However such differences may be evident in practice due to two reasons.  First, debt holders by definition expect to incur a lesser risk of non-payment than equity holders.  They are likely to add scrutiny to management and be alert to opportunities for extricating themselves from loss making situations without consideration of the interests of the equity holders.  A loss on the total equity and borrowings of 10%, where there is a 50/50 debt/equity split translates to a loss of 20% for equity holders and zero for the debt holders.  The latter will be alert to opportunities to ensure any such losses are incurred by the shareholders and may therefore be earlier activators to management of remedial steps.

Secondly, government ownership may leave -- indeed normally has left -- management with fewer concerns about incurring losses.  This is especially so where, as is frequently the case, the losses can be sheeted home to political override of commercial judgements.  The inability to go bankrupt is likely to influence the behaviour of management.  It may mean for example a greater willingness to continue incurring losses than would be permitted of a private business.  In such situations the pricing at marginal cost (or even below) may persist for longer than private sector operators would permit.

Such considerations as these may be among the reasons that the NSW government is contemplating having its energy businesses take on more debt.  While two of its generator businesses have performed creditably in terms of returns, one is likely to have seen most of the value of its equity eliminated.

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REFERENCES

Hartley, Peter R. and Albert Kyle, "Equilibrium in an Industry with Lumpy Investment", The Economic Journal, 392-407, 1989.

Green, Richard J. and David M. Newbery, "Competition in the British Electricity Spot Market", Journal of Political Economy, 100, 929-953, 1992.

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ENDNOTES

1.  One of the few loads adjustable in the shorter term are domestic water heating where this has ripple controls that permit demand shifting.  Some industrial users also have negotiated interruptible load contracts.

2.  This follows mathematically from the fact that total costs equal average costs multiplied by the level of output whereas marginal costs equal the derivative of total costs with respect to output.  Hence

MC = dC/dQ = d/dQ (Q.AC) = AC + Q dAC/dQ

so that MC–AC has the same sign as the derivative of AC.  Thus, if average costs are decreasing with output, marginal costs must be smaller than average costs.

3.  Intuitively, the linear demand specification Hartley and Kyle used implies consumers are risk averse and hence value more frequent, and therefore smaller, investments with their associated smaller fluctuations in prices and marginal valuations of electricity supply.  The result is thus likely to apply to other specifications so long as they imply consumers are risk averse, a reasonable requirement based on the empirical evidence.

4.  Unfortunately, this has not prevented the NSW and Queensland governments from relying upon such faulty econometric analyses to justify combining their generating firms into a small number of entities each owning and operating several generating plants.

5.  http://www.nemmco.com.au/nem_resources/polproc/planning/pl_sy1473.htm

On GM Food

Letter to the Editor:

Also published in The Age, 26 July 2000

Your article "It's safety first, but there's not guarantees" (Herald, July 24) gives the misleading impression that scientists are divided over the issue of GM food and its safety and efficacy.  In fact, the overwhelming majority of scientists favour the technology.  Some 3,000 have signed a petition that says the techniques contribute substantially to enhancing quality of life by improving agriculture, health care and the environment, and that the responsible genetic modification of plants is neither new nor dangerous.

To put all fears to rest, in the past few days seven premier scientific academies (including the Chinese and Indian science academies, the British Royal Society and the US National Academy of Sciences) have issued a joint report promoting the benefits of the technology and their need to feed a growing world population with increasing aspirations for food quality.  Present issues, including those before the Australian and New Zealand health ministers, have nothing to do with the health qualities of these products, the development of which is simply an extension of long-established breeding techniques.

All GM food now available in Australia is identical to food previously available.

The only issue is how best to inform consumers of the ingredients in cost-effective and meaningful terms.  In this latter respect, a recent European Union publication estimated that some labelling approaches could bring substantial cost increases.

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Application for Authorisation: Value of Lost Load (VoLL)

A Submission to the ACCC Review of the Electricity Price Cap,
24 July 2000

SUMMARY

In addressing the matters in this application, we make only a short submission, which covers general analytical issues.  However we also append a paper, Marginal Costs and Prices in the Electricity Industry we have authored.  The paper addresses broader issues than those immediately before the Commission, namely that longer term prices, aside from during particular periods of shortage or glut, must reflect total and not just marginal costs.

The paper describes how this process operates just as effectively in a market based on auction prices as it does in the myriad of other markets which constitute the economy.  And it demonstrates how intervention to prevent this market based process from operating will undermine its efficiency and ultimately bring increased prices.

The specific issue before the Commission is best addressed within the framework of "why should there be a price cap" not one of whether it should be set at one level or another.  Affordability of electricity is sometimes given as a reason for placing a cap on the price at which it may be traded.  Whilst governments may wish to address this matter, it is not an appropriate consideration for the Commission which seeks to ensure consumer benefits are derived from competitive markets.

The only two relevant reasons for maintaining a cap are that:

• market supply is highly distorted and the cap's removal will lead to price gouging;
• efficiency best pursued by allowing the cap's removal to be phased-in so that there is a transition to a more complete marketplace.

The NECA proposals address these two issues by recommending a move to a higher cap (implicitly on the basis that there has not been significant market abuse under the existing cap) and a phase-in of the increase.

In reviewing these issues, it is difficult to envisage that the ACCC will bring any superior wisdom to bear on the details of the matter than NECA operating within the ACCC authorised Code framework.  Indeed, this is consistent with the position the Commission took in its December 1997 Determination when it said, "Although the current value of VoLL is arbitrary the Commission is not in a position to recommend the appropriate level.  Instead the Commission accepts the current level of $5,000."

This however indicates a need for more general reform.  As was pointed out by a number of participants at the conference of 18 July 2000, this particular issue has had a long gestation having been addressed by regulatory agencies for over two years.  The re-trial of each case against the same criteria causes unnecessary delay and cost.  In the immediate situation it is preferable that the ACCC confine its review to issues of verifying that a fair procedure was followed and that the outcome does not conflict with competition policy.  In the longer term it may be appropriate to amalgamate the ACCC and NECA processes.

THE APPLICATION

NECA's Reliability Panel has sought to

• raise the price cap (VoLL) from its current level of $5,000 per MWh to $20,000 over a three year phase-in period
• at the same time impose a cumulative cap equivalent to $1,786 per MWh
• introduce an annual review of VoLL.

ADDRESSING THE ISSUES

OVERALL CONSIDERATIONS

The objective of the National Electricity market rules is to ensure we obtain the lowest sustainable price for electricity.  Competitive markets are the only means of achieving these goals with any certainty.  Interventions to force lower prices than the cost reflective prices that emerge from market processes will distort investment decisions and result in higher overall prices.

These conclusions may not prevail under two contingencies:  market failure and the unwinding of an existing regulatory arrangement.

MARKET FAILURE

Market failure is a highly misused rationale for regulatory intervention.  It is sometimes used to define any outcome that does not conform to that which has been expected.  In fact market failure occurs in specific circumstances that, in practice, are almost exclusively associated with market power or monopoly situations.

The issues of market power in electricity markets are more pervasive than in almost any other market.  Electricity's non-storability, a short term demand that is unresponsive to price and relatively few possible supply augmentaions at particular times can lead to potentially frequent occurrences of market power.  This is one reason why markets for electricity have been more highly formalised than those for other commodities.  But there is nothing illegal about "gaming".  Under the Trade Practices Act a firm is not denied the liberty to reduce its supply to the market for whatever reason and under the Code the supplier may simply be asked to explain the reasons for a sudden change in its market offerings.

It has been pointed out that the Californian Public Utilities Commission has set a price cap of US$750 and has investigated a number of high price excursions.  California (like the UK) has a capacity payment approach in contrast to Australia's energy only market.  Arguably, this invites market failure and a consequent need for more aggressive policing on the part of the market controller.

But a potential for monopolistic abuse is seldom best combatted by price restraint.  Indeed such restraint is likely to exacerbate the adverse outcomes of such abuse by restraining new supplies.  This is evidenced by the February 2000 intervention into the market by the Victorian Government in response to power failures.  The lower prices that the intervention created are the opposite of the incentives the market requires.  Such outcomes are sought to be combatted in the present application by ensuring that an investment driver of high prices is maintained.

Much of the framework for current concerns stems from the experience of the England and Wales market where the restructuring of supply into two dominant groups led to prices that were in excess of those considered to be reflective of costs.  It should be noted that the monopoly power in that market has eventually been suppressed by the attraction of new capacity, though few would deny that a superior solution would have entailed disaggregating the industry into more suppliers in the first instance.

Australian concerns are that the continued de facto market separation, for at least some of the time in the southern and eastern states, has resulted in four markets where suppliers have the opportunity to exercise market power.  Even if this were the case it would still not justify intervention by regulatory authorities.  Such regulation would only be justified if those authorities could arrive at a superior outcome than that prevailing with distortion.  And indeed, the UK outcome, flawed though it is, remains far superior to the centralised structure it replaced.

In point of fact occurrences of monopolistic ramping up of prices in the Australian market are rare and perhaps non-existent.  This is notwithstanding that in the case of NSW, Queensland and South Australia the structure of the supply industry is such that some generators potentially have market power.

In the case of NSW, the relatively robust interconnect with Victoria makes the exercise of this market power difficult.  In its overall outcome, the price level in NSW has been characteristic of a supply glut rather than market power -- by any criteria prices have been well below the costs of supply.  Future occasions when market power is exercised of are possible and it would be preferable for the NSW to further disaggregate its generation businesses.  Any future ability by NSW generators to exercise market power will, however, be further tempered as a result of transmission developments linking the state to Queensland.  That said, modelling work by ABARE ⁽¹⁾ has suggested that NSW generators could have market power even in spite of the main QNI link.

As in NSW, the Queensland Government decided to maintain generation portfolios which may have allowed the exercise of market power.  However two issues need to be born in mind prior to a rush to judgement in favour of regulation.  First, Queensland had a tight supply situation stemming from the failure of governments to undertake adequate levels of investment in recent years.  Second, the high price situation is in the process of curing itself with a vast increase in new generation and an increase in transmission links.  One of these transmission links is a world first entrepreneurial link made possible by the provisions of the Code.  In the near future a glut of electricity in Queensland is anticipated and its export into NSW will provide further discipline on prices in that state.

In the case of South Australia, the possibility of arranging for increased numbers of competitors was limited.  Already one third of the State's power is imported and the bulk of the remainder comes from two plants with different cost characteristics.  However, high prices have stimulated increased investment both in plant capacity and in transmission links.  The latter are, like one of those between NSW and Queensland, entrepreneurial and do not require regulators to place a tax on consumers.  The entrepreneurial transmission links place this form of supply on a more level playing field with generation and avoid distortions which are the inevitable corollary of regulatory decision making.

The foregoing indicates that, while improved structures are preferable as means of ensuring markets operate to the maximum benefit of consumers, as long as there is open access and regulatory approvals for new facilities are readily granted, markets are a potent force in delivering efficient outcomes.  In the end these transfer benefits to the consumer.

Part and parcel with the price stimulus that the above addresses, is the need for high needle peak prices.  It appears that the community's toleration of power failures and brown outs is being reduced.  In part this is due to the greater need for constant power due to modern electronics.

A higher requirement for reliability may mean a greater need for peak plant that will seldom operate and hence require high remuneration when it does.  Such plant could be made available by an entrepreneur bidding into the market only when the price is very high.  But more likely it will be provided contractually, rather like the Reserve Trader but contracted voluntarily by retailers and others who wish to avoid exposure to very high prices.  Voluntary transactions between participants in markets are the best insurance against suppliers (or customers) seeking to manipulate prices in periods when they have market power.

THE TIMING OF AN INCREASE IN THE PRICE CEILING

With regard to the timing of the increase, the NECA proposals involve a phase-in and some submissions have sought a further delay.  The case for this rests on the contracting period and the market response.

CitiPower maintained that a slightly longer phase in be adopted in view of the contracting periods and lead times.  These are legitimate issues, which call for judgements and, we maintain, the ACCC is in no position to argue that the timing proposed by CitiPower is preferable to that of NECA.

---

ENDNOTE

1. Economic Impacts of New Electricity Interconnectors by Anthony Swan Charles Rolph and Jane Melanie, paper delivered to Interconncet 99, AIC Conferences.

Signs Point to Trouble Ahead

A few years ago the American humorist Dave Barry presented a vexing scenario to his readers.  Imagine that your wedding ring falls into the toaster, and when you poke your hand in to retrieve it you suffer electrical shock, burns, and mental anguish.  Who do you sue?

You could take action against the shop where you bought the toaster, for selling it to an obvious cretin.  Or perhaps the manufacturer would be a better target, because in the instruction booklet where it says "you should never ever stick your hand into the toaster", they were clearly negligent for not adding the statement "not even if your wedding ring falls in there".

This may give bitter solace to the Makauskas family and their insurers as they contemplate last week's Supreme Court jury decision against them.  Alex and Pam Makauskas were found to be 70 percent responsible for the broken spine suffered by a friend of their son who dived from the fence of their Gold Coast home into an adjoining canal, even though they were overseas at the time.

The unfortunate victim, Paul Borland, claimed that as Mr and Mrs Makauskas knew he was likely to do "silly things", they should have taken steps that would have discouraged him.  They should have erected a warning notice, or not have had a fence which was easy to dive from.

But one of the defining characteristics of people who do "silly things" is their tendency to disregard sensible advice.  A danger sign may only incite them to greater foolishness, and even barbed wire on top of a fence may simply be seen as a challenge to be overcome.  In the hands of a nifty lawyer, the Makauskases could have been sued no matter what steps they had taken to save Mr Borland from himself.

The verdict may well be overturned on appeal.  But it is a worrying indication that efforts by plaintiff lawyers and their academic supporters to chip away at common sense notions of individual responsibility are bearing fruit.  Clearly, the jury's decision shows that at least some ordinary Australians are starting to accept that it is legitimate to transfer responsibility for adversity away from those who are directly to blame, and place the liability on others with "deep pockets".

I have little doubt that the jury members are good people with humane feelings for someone in a tragic situation.  Recognising that Mr Borland will require expensive care for the rest of his life, they probably felt that he did not deserve to be left without financial resources just because of a moment's stupidity.  The Makauskases were obviously insured, so they wouldn't even have to meet the bill themselves.

Unfortunately however, such misguided charity has its costs, and these do not just involve higher insurance premiums.  It can only encourage more people suffering injuries or ailments to cast around for a "no win, no fee" lawyer and some plausible person or organisation to sue, however tenuous their responsibility for the actual misfortune.  While there is still the disincentive that Australian courts usually require unsuccessful plaintiffs to pay the defendant's legal costs -- unlike the situation in America -- the message from the Borland decision is that it is becoming easier to win.

Some lawyers would argue that this all for the good, and not just because it means more money for them.  As the legal commentator Peter Huber noted in his book Liability, the lawyers of the 1950s and 60s who brought about the horrors of America's current litigation morass by revolutionising the law of torts -- or civil wrongs -- were acting at least partly out of idealistic motives.

They thought of themselves as helping the "little guys" who were the hapless victims of accidents or negligence, and making society safer by ensuring that the providers of goods and services would take more care with their products.

That was the theory, but like many well-meaning changes of the past half-century, it hasn't quite turned out that way.  Among the social costs of increased litigation are a corrosion of public trust and a decline in communal enterprise, "because the private right to sue has eclipsed the public power to act and serve".

True, some hazardous products and practices have been discontinued as a result of tort actions in the United States.  But so have many socially beneficial goods and services.  Others have become much more expensive -- and therefore less available to the "little guys" -- as the costs of litigation take their toll.

One area that has been particularly affected is health care, where it is usually difficult for juries to distinguish between the dangers involved in the original ailment from the risks involved in the treatment, creating marvellous opportunities for entrepreneurial lawyers and their paid expert witnesses.

The litigation explosion has also led to a proliferation of very detailed warnings, both to comply with increasing requirements from governments and insurers, and to forestall every possible basis for legal action.  Some of these read as though they have been prepared by satirists.

Last week's New Scientist told of the apparently authentic "precaution number 7" in the manual for a CD player called the Ultradisc 2000.  Purchasers are admonished not to use the Ultradisc "as a projectile in a catapult or similar hurling mechanism".  Such use "can cause personal injury as well as damage to the transport mechanism, and will void the warranty".

But the consequences of this litigation-induced precautionary overkill are less amusing.  Information about genuine hazards is often drowned out by the plethora of trivial warnings.  Faced by endless danger signs many people turn off and ignore the lot.  As Peter Huber points out, "to warn of everything is to warn of nothing".

The effect is to make life more dangerous.  Which creates even more opportunities for lawyers.

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Print's Elite Puts Virtue Above Veracity

Opinion polls tell us that newspaper journalism is the least respected or, if one is harsh, most despised of professions.  Only car salesmen consistently rate lower.  Worse, respect for journalism has declined over the last quarter century:  according to Morgan polling, about 15 per cent of the public in 1976 gave a positive rating for journalist's ethics and honesty, by 1999 it was down to 9 per cent.

Similarly, a 1995 Morgan poll, conducted as part of a World Values Study, found that only 17 per cent of the public had confidence in newspapers, far behind institutions like the police (75 per cent), armed forces (66 per cent) and major corporations (56 per cent).  Twenty-two per cent of the public had no confidence at all in newspapers, 61 per cent little confidence.

Clement Attlee described democracy as government by discussion.  Journalists are purveyors and gatekeepers of public discussion.  A free press is a necessary part of democracy.  Newspapers can convey debate in rather more detail and depth than TV or radio.  If the public lack confidence in the press, if they feel disconnected from it, then the press is that much weaker against assault.  Worse, it makes it more likely the public will feel disconnected from politics and public life generally.

Yet the profession seems unable to learn the lessons of the republic debacle.  Coverage and commentary was overwhelmingly for a "Yes" vote.  The failure to carry a single state gave anyone who needed it a public warrant to ignore the press and press opinion as completely unrepresentative of public opinion.  Yet, with Media as a conspicuous exception, there seems to have been little attempt to grapple with the experience and its lessons for Australian journalism.

Instead, we have had the same hectoring over mandatory sentencing and reconciliation as we had over the republic.  In an August 1987 Review article, Gerard Henderson criticised the herd-mentality of the Canberra "Rat Pack".  Almost 13 years later, the problems have got worse.  Australian journalists appear to be the Bourbons of our times, forgetting nothing and learning nothing.

A certain amount of pack behaviour is understandable.  The problem with journalism is one's mistakes are so very public (don't I know it).  Safety in numbers leads journalists at crises or on Leader road-trips to check each other's copy so they are not out-of-step with the common "line".  Journalists also suffer isolation from their audience -- this is particularly so with the Canberra Press Gallery.

It is fellow-journalists with whom they socialise, most regularly interact and who hire and fire them.  Hence a socially isolated profession -- after the Republic vote, one experienced journalist told me that he did not know anyone who was going to vote "No" -- and look to each other for approval of their output.  In day-to-day terms, journalists' most important audience are fellow journalists.  And, in this status-conscious age, the easiest thing in the world for journalists to agree upon is their shared virtue and then write to display that virtue to each other.

This only works, of course, if one agrees about what virtue is.  But they have similar social backgrounds, similar educational experiences.  It is not hard to signal to each other what virtue consists of, especially as a watered-down version of the typical indulgences of humanities academics is there for the taking.  And they are wordsmiths, so virtue is naturally defined as having the right opinions.  The consequence is the hectoring we have seen over Hanson, over the Republic, over mandatory sentencing and over reconciliation.

Peter Manning's recent piece in Media (April 20) relating a conversation with John Howard provides, as sociologist Katharine Betts from Melbourne's Swinburne University of Technology has noted, an excellent example of the use of opinions as status-markers.  From Manning's report, John Howard is clearly asking Manning to explain the criteria by which he judges what is racist:  Manning takes the fact that Howard even asked as a sign of Howard being tempted by racist perdition.  Being of the virtuous in contemporary Australia is like being a gentlemen in 19th century England:  if you have to have the criteria explained, then clearly you are of a different (inferior) class.

There can be few things more preposterous than members of a disrespected profession putting themselves forward as members of a moral elite.  Yet that is precisely what any regular reader of the "quality" press is constantly confronted with.

Journalists can only seek to claim an authority they don't have by trading away the only authority that they can or should have.  Journalist's proper authority is truth -- that they report Australia to itself;  that we see ourselves and our place in the world through the eyes and ears of journalists.  The dictum that comment is free but facts are sacred is not some precious tosh;  it is the only basis on which journalism can stand proud as a profession, can claim authority.  It was thus particularly disappointing to see The Australian's political editor, Dennis Shanahan, writing that a Government submission to a Senate inquiry that pointed out the facts that not all the removed Aboriginal children were stolen and that 10 per cent hardly constitutes a generation, represented "a politically unnecessary and dangerous attempt to impose intellectual rigour on the debate".  (The Australian, April 8).  The lack of critical analysis over the "stolen generation" has shown that journalists have learnt nothing from their collective embarrassment in falling for the Hindmarsh concoction.  When the Hindmarsh royal commission found the ludicrous story in the "secret" envelope was cooked up over a few beers one night, where were journalists to say "sorry, we got it wrong"?  Why were the "dissident women" (such a revealing phrase) such as Dulcie Wilson so ignored by the press?  As a friend said, where was the gutter press when you needed them?

But if journalism becomes an exercise in display of a common virtue based on having particular opinions, then views and truths awkward for those opinions become threatening to journalists.  Journalism becomes polemic and reporting becomes propaganda.  Worse, since elite status can only come from being different from the common herd, journalists are driven to parading how different their views are from common opinion, from those of the public they are supposed to be serving.

Hence one gets the startling phenomenon of journalists such as The Australian's national affairs editor, Mike Steketee (The Australian, May 29) berating an elected Prime Minister for having the same opinions as those of the public who elected him.  Leadership becomes defined as agreeing with the commentariat and disagreeing with the public:  ask Paul Keating how electorally clever that is.

Pamela Bone in The Age (October 21, 1999), turned a mere seven percentage point difference in majority approval of Jeff Kennett between men and women into a paean to women's superior wisdom yet, a mere 19 days later (November 8), she dismissed the 55 per cent vote against the republic as a case of ignorance and apathy.  Instead of looking to genuine lessons, all we got was a display of conspicuous virtue, of journalism that serves the writer, not the public -- indeed, denigrated the public.

The problem extends to far more serious journalists, such as the Nine network's political editor and Bulletin columnist Laurie Oakes.  Oakes is undoubtedly a first-class journalist whose memory for political facts and events is simply terrifying.  Nor is he an ideologically-driven soul.  Yet he, too, is apparently infected by journalistic conformity.  Why else would Mr Hard-Edged Analysis predict terminal trouble for John Howard on the basis of an issue which barely rates in the public eye?  Such was his analysis (The Bulletin, November 16) of Howard's win on the Republic -- an issue whose nomination by the public, according to Morgan polling, as an important issue peaked at 4 per cent.  Meanwhile, he derides paying attention to popular concerns as "wedge politics" which fractures "national unity" (The Bulletin, April 11) -- the latter observation looking suspiciously like press conformity.

The republic and reconciliation are clearly terribly important to the press.  But why, except as ways to display virtue?  They are far less important to the general public.  It is typical of the isolation of journalists that, to the extent this disjunction is reported, it makes the general public appear to be moral cretins.

The Australian's Paul Kelly is the doyen of his profession and clearly one of Australia's finest journalists.  Yet he pulls the race card again and again:  against Howard in 1988, against Peacock in 1990, against Howard over Hanson, against Howard over reconciliation.  He is against the evils of "race-based" politics -- apart from race-based apologies and property-rights.  If Kelly and co.  had allowed mainstream politicians to openly discuss difficult issues of national identity and race, there would almost certainly have been no space for Hanson to make her destructive play.  You cannot convince those for whose concerns you do not allow a voice.

Indigenous issues are genuinely difficult.  But the central problem is cultural distance -- hunter-gatherer cultures do not equip their members well for industrialised society -- and cultural collapse.  Journalists parading their anti-racist virtue provide no answers and divert attention from the hard questions.  Australia vividly lives up to black American writer Thomas Sowell's comment (Jewish World Review, January 4, 1999) that if one believed that everyone should be under the same rules, that labelled you as "a radical 60 years ago, a liberal 30 years ago and a racist today".  But such peregrinations are a natural result of using "racist" as a moveable tag to define virtue by stigmatising other people and views.

The key point is not political ideology:  The Australian Financial Review columnist Brian Toohey is a journalist of obvious Left sympathies, yet that does not get in the way of his getting to the facts.  The point is about quality of reportage and diversity of comment.  The Bulletin's Virginia Trioli, infected with the commentariat's moral self-indulgence, fulminated at length against mandatory sentencing (for example, in the February 29 issue) but showed no signs of having wrestled with the elementary and journalistically central question:  why is mandatory sentencing popular?

The Age's Tim Colebatch did note that popular suspicion of judicial leniency was behind the popularity of mandatory sentencing (The Age, April 6).  But this was a rare bit of common sense from the commentariat, and an even rarer one from that newspaper.  Why, for example, after the dispute in 1998 between stevedore company and Patrick and the Maritime Union of Australia, did The Age's dispute on-line archive provide links to the websites of the MUA, an MUA-support group and the Commonwealth Department of Workplace Relations and Small Business, but not Patrick, even though its website was very informative and accessible?  Better journalists well-understand that moralistic self-indulgence is purchased at the expense of journalistic quality.  An Age journalist once confessed to me "but Richard, we make our living from gratuitous left-wing crap".  A former senior Age journalist noted that its news coverage during one period of the Kennett era was so one-sided it left its readers trying to decode whether the latest anti-Kennett piece was a real one or just another Age anti-Kennett propaganda piece.

The Sydney Morning Herald has similar problems.  The problem is not one of ownership:  the Australian Financial Review is a much better newspaper than either of its Fairfax stablemates -- the Monday after the May 28 reconciliaton march across Sydney Harbour Bridge, it alone permitted dissident opinions on its opinion page.  The problem is their internal cultures.  The Australian provides an interesting intermediate example, in that it can be as hectoring and lecturing as any, but the wry wisdom of Frank Devine, the informed incisiveness of Alan Wood, the cool common sense of Nicholas Rothwell, the perception and independence of Glen Milne, the intelligent understanding of Asa Wahlquist and, on his better days, Dennis Shanahan provide counterbalancing voices to indulgent conformity that are missing from the Fairfax dailies.

It is a sign of the narrow-minded provincialism of the Australian intelligentsia that there is so little willingness to concede a place for conservative ideas in the spectrum of public debate.  There is a lack of conservative voices in the media.  Many of those demonised as conservatives are just grumpy sceptics:  left-libertarians mugged by reality.  Conservative is used as a "boo" word.  Since cultural and national identity issues are the prime areas for display of progressivist virtue, social conservative is a double-boo phrase and a sign of perdition.  (And as an opposer of censorship, and supporter of the right to pleasure, of legalisation of narcotics and of gay marriage and adoption, I am hardly a social conservative:  my concern is with the health and diversity of debate).

John Howard is rhetorically challenged.  This gives him a problem when he is being assessed by the wordsmiths of the media, but does not create it.  As the most prominent social conservative in Australian public life, John Howard becomes the Great Satan, the definer of what is not virtuous.  The difference between Howard's "sincere expression of sorrow and regret" over the past treatment of Aborigines and a formal and apology for what others did in past generations is not worth all the ink spilled on it except for virtue-display purposes.

Even the normally independent Glen Milne recently pontificated (The Australian, May 22) on the potentially serious consequences for Howard from backbench nervousness of offending the press and, in the process, repeated the tired old saw (15 years old and counting) about Howard being "yesterday's man".  At least Milne promised to talk another time about whether it was right that the press should have such apparent power (Glen, we are still waiting).  The Sydney Morning Herald's Margot Kingston's recent dialogue with Philip Adams on Radio National's Late Night Live -- dissected by Piers Akerman (The Sunday Telegraph, May 21) who noted the factual errors, and was rightly scathing about the slandering of the Howard Government as being indifferent to the possibility of Aboriginal deaths (which was not in prospect) from a waste-water spillage at Energy Resources Australia in Kakadu -- is a particularly grotesque example of the abandonment of serious journalism for indulgence in moral vanity.

The commentariat and the public face each other across gulfs of mutual contempt.  The difference is, the public's contempt is justified.  But neither is healthy for Australian society and Australian democracy.

The press has become too dominated by the indulgences of journalists.  It is time for the editors to step forward and ensure a much wider diversity of views, less self-indulgence and more professionalism;  and a greater respect for the reading public that that entails.

GM Labelling: Impossible and Unnecessary

Unless we throw a crowbar into its wheels, GM technology will reduce costs to farmers and eventually consumers.  The technology allows plant output to increase while reducing use of herbicide, water and nutrients.  As the technology develops we will see healthier food (and vitamin A enriched rice is about to become available with immense benefits in reducing infant blindness) and food with more appealing tastes.

All cultivated plant food we now eat has been created by the application of breeding techniques.  Previous techniques could bring haphazard changes and unwanted side effects.  The new technology ensures this does not happen by excluding genes that might have such effects.  Moreover, unlike any previous food product, GM foods undergo exhaustive testing prior to general release.

Contrary to Louise Sylvan's claims [AFR, 13 July], countless scientific studies have demonstrated there is no health issue with these products.  Nor have any herbicide superweeds been created.  The noted US expert Dr C S Prakash, who visited Australia two weeks ago, has launched a web site which 3,000 scientists have signed saying the "techniques ... can contribute substantially in enhancing quality of life by improving agriculture, health care, and the environment".  And that, "The responsible genetic modification of plants is neither new nor dangerous".  To put all fears to rest, in the past few days, seven premier scientific academies, (including the Chinese and Indian science academies,the British Royal Society and the US National Academy of Sciences) have a issued a joint report promoting the benefits of the technology and their need to feed a growing world population with increasing aspirations for food quality.

What then of the labelling issue?  The technology's most fanatical opponents are engaged in crop burning to prevent the products being proved effective.  Others are seeking to use red tape to hamper the technology's spread.

Some are opposed to things that are "unnatural", "not necessary", "may create unforeseen consequences".  These terms sound familiar to food historians because they were used by those opposing pasteurisation of milk.  Proven effective in 1908, it was not until after 1945 that the objections of the faddists and knee-jerk opponents could be overcome to allow widespread use of pasteurisation, a technology that has saved countless lives.  Those opposed to GM technology, like those who sought to prevent pasteurisation and other earlier advances in food quality, are seeking to demonise it.

Requiring labelling so that consumers can make their own choices sounds innocuous enough.  But a moments thought unveils the difficulties this entails.  First, a great deal of food comprises fresh food which carries no label.  Much is consumed in restaurants and fast food outlets where labelling is also impracticable.

Other difficulties of labelling occur because almost all the GM foods presently available are identical to the foods they replace.  The characteristics of the GM plant which produces the food are not found in or difficult to detect in the food itself.  This is because the technology improves the insect repelling qualities of the plant or allows it to grow on a shorter stem.  To make a clear statement that a product does not contain any GM material (and processed foods contain hundreds of ingredients) would entail a vast cost.  We would, in fact, be introducing a GST on food but collecting no revenue and bringing no benefit in terms of health.

If some consumers want to avoid GM foods,sufficient demand for the absence of these ingredients will cause suppliers to make the products available.  This already happens with "organic" foods.  But organic food producers could not agree to a standard that guaranteed their produce to be 100% organic, since it is impossible to be certain of an absence of an admixture of modern technology.

Hence, the best solution is to leave niche suppliers to market non-GM products to the customer (if they can do so truthfully).  The rest of us can also buy the products we want without having a needless tax imposed.

These issues are of immense importance to Australia with our considerable highly competitive agricultural industries.  Some claim that "GM free" might prove a winner in markets overseas.  While there may be niche markets, as there are for "organically" grown foods, they can never be sufficient to offset a loss of farm productivity.  Already, GM technology brings cost savings to the farmer of about 6 per cent.  These savings will be doubled as the technology becomes more sophisticated, a saving that few Australian farmers could afford to reject.

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Supplementary Material for the Victorian Industrial Relations Taskforce

Submission

THE IMPORTANCE OF TRANSACTION COSTS

In his classic 1937 article The Theory of the Firm, Nobel Laureate Ronald Coase argued that the boundary of firms is determined by what have subsequently been labelled "transaction costs" -- search and information costs, bargaining and decision costs, policing and enforcement costs. ⁽¹⁾  Coase argued that, if it was cheaper to organise something within the firm than purchase it on the open market, then production would take place within the firm.

The importance of transaction costs in understanding how well, or badly, societies work is increasingly clear.  Economists such as Nobel Laureate Douglass North, Jack Powellson and Mancur Olsen have sought to explain long-run differences in economic performance between societies in terms of matters including how well their institutions reduce transaction costs.

Perhaps the most powerful single demonstration of the importance of differences in transaction costs has been from the work of Peruvian economist Hernando de Soto.  De Soto conducted an exercise where graduate studies attempted to get the approvals to open up a small clothing factory in Lima, Peru (it took 290 days to get the relevant government approvals) and then repeat the exercise in Miami, Florida (a few hours).  The comparison made it obvious where there was going to be more economic activity.  It expresses with eloquent simplicity a key reason why the US is richer than Latin America.  Higher transaction costs mean less transactions, which means less economic activity, which means a lower standard of living.

In Latin America, the privilege of legal operation in the economy has been handed out by the State, creating tight-knit groups of highly privileged elite "insiders".  Regulatory complexity benefits the insiders, but impoverishes the society.  Regulatory complexity is a direct tax on transactions -- it raises their cost and restricts their scope.  Transactions are the fundamental building blocks of economic activity and thus prosperity. ⁽²⁾

If the state increases the regulatory complexity, and thus raises the transaction costs, for a mode of employment -- such as permanent, full-time employment -- then that eats into the possible mutual gains of providers and users of labour.  Both users and providers of labour services acquire an incentive to seek other modes of employment which avoid or lessen those costs.  As such transactions costs rise, so does the attractiveness of means which allow the parties to avoid those costs, and so mutually appropriate the resulting gains.

Raising transaction costs of, for example, permanent employment not only leads to looking for other modes of employment, it may push labour services outside the firm.  Restricting movement to other modes of employment does not solve the problem of high transaction costs, it merely reduces the capacity to evade the transaction costs, so will increase the overall depressive effect on employment activity.

Increasing transaction costs decreases economic efficiency, decreasing transaction costs increases economic efficiency.  Given the long-term pressures on Australian governments, particularly the fiscal pressure from the expanding welfare state -- pressures became particularly strong in Victoria in the late 1980s and early 1990s -- any policy of increasing economic inefficiency in the most important single market in the economy has dubious long-term prospects precisely because it has real and immediate costs for economic activity, with consequent implications for government revenues and costs.

Graph S1

There are reasonable grounds for suspicion that the deterioration in Victoria's relative labour market performance from 1987 onwards, and its improvement since 1993, might have some connection with changes in relative transaction costs in the Victorian labour market as a result of regulatory changes.

Graph S2

Unfortunately for rational debate on these matters, drawing attentions to costs and difficulties gets in the way of the game many play in parading their "virtue" by their commitment to ever-wider legislation of rights and entitlements.  In order to protect their moral assets, they seek to de-legitimate such discussion or contrary positions.  But not only are such rights and entitlements not without their costs, using regulation to impose them itself has costs.

FALSE HISTORY

Another problem in these debates is the prevalence of false characterisations of recent history.  While some will be genuine error, there is reasonable grounds for suspicion that others have sought to characterise events in ways that defend what might be called the writers' "moral assets" in upholding particular opinions.  Sensible policy recommendations can only flow from an accurate understanding of the context policy must operate in, including the actual pressures policy makers have been under, and have sought to respond to.

(1) Empty Definitions of "Economic Rationalism"

In his Concise History of Australia, Professor Stuart McIntyre, Ernest Scott Professor of History and Dean of the Faculty of Arts at Melbourne University says of economic rationalism (pages 239-40) that it was

was remarkable not so much for devotees capacity to incorporate almost every form of human behaviour into its syllogisms as for the assumption that there could be no other form of reason than the logic of the market.

This is in a similar vein to the definition offered by Professor Michael Pusey, Professor of Sociology at the University of Sydney and author of Economic Rationalism in Canberra:  A Nation-Building State Changes Its Mind:

Economic rationalism is a doctrine which says that markets and prices are the only reliable means of setting a value on anything and, further, that markets and money can always, at least in principle, deliver better outcomes than states and bureaucracies

I never encountered anyone in the Canberra bureaucracy who could be so described by either definition.  Nor am I aware of having encountered such a person since.  When Dr Michael Keating, then head of the Department of Prime Minister and Cabinet and econocrat par excellence, was asked at the conference in which Professor Pusey's paper was delivered if he had ever encountered someone in the public service who conformed to Professor Pusey's definition, he equally replied in the negative.

Changes in economic policy over the last 15 years have been responses to particular pressures, not some weird outbreak of economic fundamentalism that those of particularly high moral sensitivity and intellect easily (sic) see through.

(2) False Characterisations of Government Cutbacks

Professor Ron McCallum, Professor of Law at the University of Sydney, seems to share the common delusion that the last two decades have seen a shrinking of government activity, saying in his Whitlam Lecture that:

They [the economic reformers] advocated labour market flexibility at a time when federal and State governments were shrinking their public sectors and reigning in their spending.  Governments bought the idea that greater labour market flexibility would limit unemployment.  At this time, the social capacity of governments to cope with welfare programs and payments was diminishing, but if it would limit unemployment then deregulation was worth a try.

In fact, government outlays, including State Government outlays, have increased markedly.

Graph S3

The real issue has been the fiscal pressure from the expanding welfare State, and the varying ability or willingness to deal appropriately with that pressure, in the light of other constraints.

Graph S4

Graph S5

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ENDNOTES

1.  Dahlman, Carl J., "The Problem of Externality", The Journal of Law and Economics 22, no. 1 (April 1979):  148.

2.  For example, Murphy, K., Shleifer A. & Vishny R. (1991) "The Allocation of Talent:  Implications for Growth", Quarterly Journal of Economic 106:  503-30 found that a ten per cent increase in law graduates reduced economic growth by 0.3 per cent (by contrast, a ten per cent increase in engineering graduates increased economic growth by 0.5 per cent)

Many are disenchanted with ABC's Correctness

If anyone should be a natural defender of the ABC it is John Howard (and if that makes you laugh, that is revealing in itself).

After all, like myself, he comes from a middle-class family where ABC was part of the furniture, a respected part of life.

In the Wood household, commercial TV barely existed.

"What's on TV?" was a question which applied only to the ABC.  The first commercial series we watched with any regularity was Dynasty:  apart from that it was the ABC (mainly in its role as the local BBC relay station) all the way.  One doubts it was much different in the Howard home.  John Howard is traditionalist and a conservative.  The ABC of the Argonauts, of quality and of quality (overwhelmingly British) TV should be one of those Australian institutions and traditions he is keen to defend.

It is a sign of the deep and longstanding problems of the ABC that many middle-class people such as the PM have become very much not fans of the ABC.  The source of John Howard's disenchantment is obvious enough.  According to The Bulletin, when in Opposition he used ask his family regarding ABC News "shall we watch Labor's home video?"

It is only a very naïve viewer who would think that the ABC has treated John Howard in a similar way to, say, Paul Keating PM.  It was always willing to have Howard on -- he has always been good on-air -- but that is not the same as being balanced:  particularly considering who is chosen for comment, what they are asked and what comments the journalists make.  Under intense scrutiny during the 1998 Federal Election campaign, the ABC's efforts (in the last three weeks of the campaign) to be balanced were so studied as to be almost painful.  One could see this was not their natural, or preferred, state of affairs (though, to be fair, the effort was successful).

My process of disenchantment with the ABC lacks the depth of bitter personal experience of John Howard.  It was international affairs and American-Soviet rivalry which led me down the path of questioning the ABC's culture and approach.

The more I learned about such matters, the more shallow and sneeringly one-sided the ABC's coverage and commentary seemed.  As I become more involved in public-policy issues, I noticed the same pattern in other areas of public policy -- though you had to build up a certain depth of knowledge before the pattern of what was left out became blindingly obvious.

Recently, I was on Neil Weise's 5ADN Adelaide program to talk about the Telstra-ABC deal.  The discussion quickly turned to ABC balance.  Mentioning this to a friend who also appears periodically as a commentator, he immediately laughed and said "What, you were outnumbered five-to-one?".  That was not the situation, it was just me and a woman from Friends of the ABC, but his reflexive comment bespeaks a phenomenon many of us are well experienced in.  You are invited to speak on a subject and find that the numbers are three, four or five to one, with you the lonely voice.  You are both outnumbered and clearly labelled as an ideological fringe-dweller the ABC has deigned to allow on to show its "balance".  (Though I can report being in a majority on Radio National a couple of times recently).

Alternatively, you are put with real fringe dwellers.  Hence the experience of being on 3LO Melbourne to discuss ABC balance when it was me, the presenter, the show's media academic, the national Head of ABC Radio and an anarchist.  The voices of respectability and two "nuts".

There are issues where, to quote John Howard, there clearly is an ABC "line":  immigration (opposition is wicked), multiculturalism (ditto), indigenous issues (more money, more special arrangements), global warming (impending disaster), industrial relations (deregulation wicked), privatisation (wicked), welfare (more spending is always required, restrictions are nasty miserliness), economic rationalism (wicked) and so on.  This is not to say every ABC person always parrots every element of this, but you can tell where most of them are coming from most of the time, particularly when you look at the balance of commentators and at the documentaries run.

Unfortunately, some of the most revealing vignettes of this sort of thing cannot be made public, because the sources could be identified and would be punished -- the ABC disposes of a very large amount of patronage:  in funding, publicity and retail access.

To be sure, many of the sins of the ABC in this regard they share with the journalistic profession in Australia more broadly.  A lot of journalism is conducted, particularly from the Canberra Press Gallery, particularly on totemic issues like indigenous affairs and the Republic, as if there is only one possible correct view.  But the ABC does so more intensively than the wider profession:  and it is not a productive use of well over $500 million of taxpayers' funds a year to intensify broader journalistic sins.

One of the sillier ideas brought up to defend the ABC is that, as a public broadcaster, it is free of conflicts of interest.  As a tax-funded body, low-tax political agendas are not in its interests.  As a public sector producer, privatisation agendas are not in its interests.  As the dominant purveyor of quality broadcasting, liberalisation of the broadcasting market -- generating greater capacity for commercial exploitation of niche markets -- is not in its interests.  As an exemplar of political provision, pro-market agendas generally are not in its interests.  The ABC does not come disinterestedly to many of the central policy questions of our time.

Moreover, the obvious conflict of interest in having the government own a major media outlet is one of the biggest barriers to an accountable ABC, since we want media organisations to be independent of the Government of the day, yet such independence makes the ABC independent of its legal owner and of the only effective executive agent of its notional owners (us).

This lack of an effective owner makes the ABC very prone to staff capture.  We live in an age of status-mongering, where people use the parading of approved opinion to demonstrate their superior moral status -- which is what political correctness is all about.

A staff-captured national broadcaster is an ideal venue from which to engage in this status-seeking behaviour, which is why the ABC is so relentlessly PC.  Writer and former ABC program host Robert Dessaix says the political correctness of the ABC is extraordinary.  There's no leeway in anything to do with race or gender or politics.  There is only one attitude you can have to Aborigines, to multiculturalism and to feminism.

As Katharine Betts has explained in The Great Divide:  Immigration Politics in Australia (Duffy & Snellgrove, 1999), a style of language and approved opinions can be used to make a distinction between insiders and outsiders.  The point about being PC is being seen to be a member of the moral vanguard.  Such use of opinions as status-markers is deeply inimical to free debate, since if the opinions are merely arguable they are not status markers.

And if they are status-markers, then the opinions become moral assets to be defended, so disagreement must be a sign of moral inferiority, and thus illegitimate.  Hence the term "conservative" (and particularly "social conservative") is loaded with implications of intellectual vacuity, moral cretinism and base self-interest.  Any anti-PC commentator is automatically labelled as "conservative".

Which brings me to Norman Abjorensen's piece in The Canberra Times on July 4.  If it is so debatable that there is not, as I claim, "a single conservative, libertarian or even classical liberal voice" on the ABC, why did he not simply nominate one?

Of course, if such a person was so publicly "outed", they could find themselves in some bother, as the ABC has been notably intolerant of dissent.  As for being a "discredited plagiarist", I have now published more words apologising for my error and negligence than were in the original article, which was the only such case in my published works.  The use of personal attack is not a sign of someone confident in the facts of the case.

It is true that market-reforming ALP figures (such as Paul Keating Treasurer and Bob Hawke PM) are also likely to run foul of the ABC's preconceptions but can always use social progressivism to get back into the good books (such as Paul Keating PM did).

That ABC viewers are more likely to be Coalition than ALP voters makes the problem worse as far as the Coalition is concerned.  One Coalition figure pithily summed up the Coalition's alienation from the ABC:  "the ABC is our enemies talking to our friends".  And using taxpayers' money to do so, no less.

Any political party can fall afoul of ABC investigative reporting (ask former NSW Labor Premier Neville Wran).  But even here, the reports that don't get done are revealing.  Where is the hard-hitting program on the Hindmarsh Island concoction?  The insightful revelations of the misuse of science by Greenpeace and other environmental advocates?  The use of spurious or exaggerated health scares to promote donations and support for advocacy groups?  The frustration of accountability for education performance by unions and bureaucrats?  The vast exaggeration of civilian deaths in East Timor and Serb-held Kossovo?  Why the periodic discovery of mass graves in the former Soviet Union is a non-event?  Where is the evidence now available of covert Soviet support for the peace movement which helps explain its one-sidedness?  All far too non-PC, or critical of the media itself.

Last year, the ABC's Independent Complaints Review Panel (notice the oxymoron, the panel is appointed by the ABC) upheld a complaint by David Bennet QC about the ABC's use of "stolen generations" in reference to the PM's statement of regret (which was about the past experience of indigenous Australians and made no specific mention of stolen generations).

According to subsequent newspaper reports, ABC staff were unhappy both at the decision and that then Managing Director Brian Johns had sent out a memo directing that they be more careful in the use of language.  (At this point, we remember Bertrand Russell's definition of a pedant:  a man who prefers his statements to be true).

ABC staff objected to being told to be careful (use of language for moral display unhindered by ratings being an ABC perk) and argued that it was perfectly OK because other media outlets had also used the term in the same context.  (Such display is hardly a monopoly of the ABC).  The ABC had argued before the Panel that the link "could be made".  Indeed it could be.  The question was, should it have been?

That it was simply untrue that the statement was about the stolen generations apparently moved them not at all.  And that is what is wrong with the ABC.