Building a Case Against Unions

What's going on at the Royal Commission into the Building Industry?  The Commission's brief is to investigate unlawful and inappropriate conduct and in this context spectacular examples of shady payments to unions have emerged but what is the general direction of investigation?

An inclination may exist in a paper released summarising 29 private, "tell all" meetings held in October 2001 between the Commissioner and key players in the building industry.  The paper is an outstanding overview of how the building industry operates and perhaps creates a road map for Commission investigations.

The paper describes four levels in the industry;  capital city CBD building sites controlled by about fourteen major head contractors;  many large sub contractors who often, but not always operate on CBD sites;  lots of small subcontractors;  and the housing industry structured around independent contractors.  Sharp distinction is drawn between civil and engineering construction sites (factories, mines, industrial plants) and CBD building sites where most problems seem to exist.  The housing industry is trouble free.

CBD sites are almost 100% unionised and are organised through systems of cascading contracts starting with developers, to head contractors and then sub contractors who employ about 95% of workers.  The overview paper talks of a "symbiotic" relationship between unions and the head contractors where industrial relations agreements protect the head contractors from competitors.  Margins are tight and head contractors extract profit by squeezing sub contractors.

Unions are not a formal part of the contract chain but have critical links and effectively control sites.  For example they are de facto safety regulators although they carry no liability.  Unions appoint their "safety officers" while professional safety officers are banned.  Workers compensation authorities have so little safety knowledge that they cede authority to the unions.  CBD accident rates are high in comparison to civil construction where professional safety officers are appointed.

Bad management is said to be endemic on CBD sites.  Poor coordination of supplies to sites is common as is booking of trades persons when sites are not ready.

Cranes are the critical point of control and are locked up by one branch of the CFMEU.  Enormous commercial pressure backs the smallest of union demands.  A simple blow of a dogman's whistle stops cranes and all work.

Building unions have a commercial problem.  They must extract their membership fees in the comparatively short time a site is under construction.  By comparison civil construction unions secure long term revenue because they take operational control of factories and plants after construction.  The outcome is more militancy on CBD buildings than at civil construction sites, but this collapses at civil sites when unions fight over who has long term coverage.  Civil construction completion has been delayed for years in some demarcation disputes.

Generally though civil construction has less problems and better safety than CBD sites because developers are usually the future operators of the site and demand control of construction.  The developers directly control or supervise construction contracts and suffer the costs of inefficiencies, losses or safety problems.  Typically the developer or head contractor will employ about 65% of a civil construction workforce.

Away from the city CBDs, unions exert some but sporadic influence restricted by an anti-union culture among regional workers, and union officials find the travel difficult.  The outcome is that civil and non CBD construction is cheaper than CBD.  For example Melbourne high rise apartments have about 30% higher construction costs than do Gold Coast apartments.  Melbourne consumers pay more!

Luckily Australia's domestic housing industry doesn't operate like CBD construction.

Of particular interest is the emerging role of the building industry superannuation and redundancy funds which are now successful developers and profitable financiers of CBD construction.  The question is, do CBD industrial relations deliver market advantage and possible future monopoly to these partly union controlled funds?

This is the building industry overview given privately to the Commissioner.  Most contributors claim it would be commercial suicide for them to state their views publicly in evidence.  If a pattern is emerging in the Commissions enquiry, it is perhaps an effort to flush out evidence that gives substance to the industry picture painted in private.  And as always any devils to be found will be in the detail!

ADVERTISEMENT

Just How Many Are There?

Occasional Papers

Employees?  Independent Contractors?
Clarifying the Confusing Statistics

INTRODUCTION AND SUMMARY

It is generally accepted that there has been a shift away from traditional employment to other forms of work engagement, generally known as independent contracting.  There is, however, debate over how large the shift is and what the actual numbers of people are who work but are not "employed".  Based on the same ABS data, different commentators draw different conclusions.  This paper seeks to explain and clarify those differences.

Our conclusion is that there is significant clarity and agreement on the core statistics, but that confusion reigns as to how to interpret the data about some of the subsets.

The following is clear from the 1998 ABS data:

• 79.6% of workforce (6,683,000 people) work in all forms of traditional employment.
• 20.4% of workforce (1,712,000 people) work through all forms of non-employment.

Other categories of "non-employee" worker, however, mean that the latter figure is understated.  The best interpretation to be had is that:

• 23.4% of workers were non-employees.  This amounts to 2,167,000 people, based on the estimates of the labour force in April 2002.

It can also be shown that the share of contractors, entrepreneurs and other non-employees is:

• over 28% in the private-sector workforce.

REASON FOR THIS PAPER

Clarifying the number of independent contractors and other non-employees versus employees is critical to public policy analysis and design.  Having reliable data is essential for:

• Policy formation for tax administration, social security design and administration, education and training policies, occupational health and safety, and workers' compensation issues.
• Design of appropriate private-sector regulation, particularly in the area of competition policy design and administration.

SHARE OF NON-EMPLOYEES IN THE WORKFORCE

THE ISSUES

It is clear that the nature of work has been undergoing change in our society.  This has increased the complexity of defining a "worker" or "employee".

The ABS collects data in three forms:

• The Labour Force Survey (6203) which counts up all employed persons;  this divides workers into three main categories:  employees, own-account workers, and employers.
• The Forms of Employment Survey (6359), which counts workers as non-owner managers, and owner managers.
• Working Arrangements (6342) which deals with employee types.

The issue of what constitutes an "employee" has been in dispute for some time.  The legal definition is that as traditionally defined under the common law -- namely, as a person working under a "contract of service".  This is generally a difficult definition for statistical collection purposes, because many people, such as employers and many professionals who undertake work for which they are paid, would define themselves as "employed".

Aside from some automatic ambiguity about what contractual relationship people have with others who pay them to do work, other reasons behind this stem from particular parties' interests in widening or narrowing the definition.

There are three major classes of interest in the matter.

• Trade unions often have privileged "coverage" of particular classes of employee and seek to ensure that coverage is as comprehensive as possible.  They (and many lawyers and advisers who work with them) are, in general, opposed to workers excluding themselves from their ambit by claiming to be self-employed.
• The Government, and more especially the Taxation Office, has historically been concerned at the capacity for revenue leakage by self-employed workers.  These concerns have been addressed under the new Pay As You Go (PAYG) and Personal Services Income (PSI) regimes.
• Self-employed people themselves and those using their services who are keen to avoid restrictions on their work flexibility and on their remuneration or productivity, and who may perceive taxation advantages in being self-employed.

Various tests used for statistical purposes were made in the past and included:

• whether the contract permits the worker to perform similar work simultaneously for other clients;
• whether the worker is free to subcontract the work, or employ someone else;
• whether the worker invoices for their work or receives wages;
• whether the payment conditions mean the worker could make a profit or loss;
• whether the worker supplies their own tools or equipment;  and
• where responsibility for the payment of injury insurance premiums lies

Source:  Productivity Commission

The definition of what constitutes a contractor has been tested as a result of recent tax changes.  In some respects the issue might be said to have been finalized for tax purposes by the Treasurer's determination that contractors should be allowed to self-assess their status in his determination in July 2001 (Press Release No. 51), that a contractor may so self-assess

where they derive income from producing a result, where they supply their plant and equipment or tools of trade (if required), and where they are liable for rectification.

This tax test has close similarities to that used in common law, although the courts do interpret the tests differently in individual cases.

In order to clarify the categorization, we divide the sub-categories into two components:  employees and non-employees.

Employees	Non-Employees
employees with leave entitlements	Owner managers of incorporated enterprises
self-identified casuals	Owner managers of unincorporated enterprises
other employed persons	Self-employed
permanent employees	Own-account workers
dependent employees	employers
independent employees	independent contractors
paid by an employment agency	dependent contractors
labour hire employees	sub-contractors
Fixed-term contract employees	persons who invoice
Part-time employees	labour hire contractors

THE LATEST DATA ON NON-EMPLOYEES'
SHARE OF THE WORKFORCE

BASE CASE DATA

Under the standard ABS definition (6203), around 87% of working persons are classed as employees, with the rest being employers (3.5%) and own account workers (9.4%).  This indicates that 13% of workers were not employees.

This ABS collection, however, is concerned with matters other than the structure of employment, and it is clear that many of the employees are not employees in the accepted sense.  In determining the employment status of various people, some difficulties include:

• an ambiguity where a person is an employee of her own business;
• cases where someone is classed as an employer even though, in the vast majority of cases, such employers will also be workers in their own businesses and might indeed only employ someone part-time.

GETTING A BETTER FIX ON THE STRUCTURE OF EMPLOYMENT

The ABS survey published as 6359 offers the best fix on the status of workers.  Under this survey, employed people as of August 1998 comprised:

• a hard core of 59% of employed persons, who were permanent employees in so far as they had annual leave and similar entitlements;
• 18% who were casual employees
• "other employed persons" (4%);
• owner-managers of incorporated enterprises, who totalled 7%;  and
• owner-managers of unincorporated enterprises (13%).

The breakdown of employment is shown in the figure below.

Source:  Murtough G. and Waite, M, "The Growth of Non-Traditional Employment",
Productivity Commission, July 2000.

Under this analytical approach, 20% of workers are clearly not employees.

FURTHER REFINING THE DATA

Two aspects of Figure 1 above suggest that the 20% figure is conservative.  These are the treatment of casuals and the "other employed persons category".

One interesting reconciliation that the Productivity Commission published was between the ABS normal workforce data on casuals and that of the Forms of Employment Survey.  This showed that 3.6 % of the 23% of the workforce that the ABS classed as casuals were employers or owner-managers.  In other words, three out of every 20 casual "employees" were owner-managers.  More comprehensive data on this are illustrated below.

1998 Decomposition of ABS Data on Casuals

	Number (million)	Share of employed persons a (per cent)
Standard ABS measure of casual employmees	1.946	23.2
less Owner managers misclassified as casuals:       Incorporated enterprises       Unincorporated enterprises	0.280 0.027	3.3 0.3
less Employees who do not see themselves as being employed as casuals	0.200	2.4
plus People misclassified as:       Permanent employees       Employers       Own account workers	0.041 0.001 0.005	0.5 0.0 0.1
equals Self-identified casuals	1.487	17.7

^a Excludes employed persons who did not work for monetary reward.

Data Source:  ABS (Forms of Employment, Cat. no. 6359.0).

Even if it is assumed that the casuals are appropriately classified within the employee/non-employee categories, an analysis of the category "other employed persons" makes it clear that they are overwhelmingly self-employed.

The most common occupations in the category were professionals (16%);  intermediate clerical, sales and service workers (15%);  and tradespersons and related workers (15%).  The most common industries in which "other employed persons" worked, were:  property and business services (14%);  construction (14%);  retail trade (9%);  and manufacturing (9%).  Many would be in partnerships.  Some of these, of course, would be "employers" and are so classified by the ABS if they employ one or more persons full- or part-time.  Such a wide notion of "employers" is not one that resonates with current practice.  Overwhelmingly, such employers are actually also employees -- as illustrated in the discussion reconciling different concepts of casual worker.

This residual category therefore essentially comprises professionals and contractors.  Hence, on this basis, in August 1998, 23.4% of employed persons were working for themselves as contractors or entrepreneurs.  Relating this back to the Labour Force Survey of April 2002 where 9,261,000 people (seasonally adjusted) were counted as employed, there are some 2,167,000 workers who are non-employees.

NON-EMPLOYEES AS A SHARE OF THE PRIVATE SECTOR WORKFORCE

Having 23.4% of the workforce in non-traditional employment -- neither full- or part-time, nor casual employment -- is a rather higher figure than is popularly envisaged.  This share is higher still if the 1.4 million plus of government employment is excluded from the of 8.4 million people classed as being in employment in August 1998.  The share of contractors and entrepreneurs in the private-sector workforce is over 28%.

TRENDS IN CATEGORIES OF EMPLOYED PEOPLE

Although it is generally accepted that there has been a strong shift over time away from what might be called traditional employment, it is difficult to document this clearly.  Excluding the category of "other" workers (which we estimate to be overwhelmingly contractors and professionals) the Productivity Commission ⁽¹⁾ estimated that between 1978 and 1998 there had been a four percentage point growth (from 16.4% to 20.4%) in the share of "employers and own-account workers".  Other researchers are cited by the PC as generally agreeing that such a trend is evident.

---

ENDNOTE

1.  Waite M, and Will L, Self-Employed Contractors in Australia, Productivity Commission, September 2001.

Power Without Reason

The Kyoto climate control agreement is back in the news.  Under this agreement, countries tentatively agreed to limit emissions of greenhouse gases (mainly carbon dioxide).  The aim is to combat a forecast man-induced trend to increased global temperatures.

But, even if there is a global warming trend, full implementation of the Kyoto agreement would have only a trivial effect on the build-up of global CO₂ levels.  And if increased CO₂ do mean higher temperatures, Kyoto would put back a forecast 2 ºC rise in global temperature from 2100 (under business-as-usual) to 2104.

The pain in achieving even the apparently modest Kyoto goal is now being seen across a great many nations.  In Australia's case, it involves limiting carbon dioxide emission increases to 8 per cent above the 1990 levels by 2010.  This is unattainable given that our present output is 23 per cent above the 1990 level.

Australia's approach to Kyoto involves fostering exotic sorts of power, wind being the most important.  The Commonwealth has penalties to ensure that about 1 per cent of electricity by 2010 will come from these new sources.  The penalties mean a doubling of costs compared with conventional power.

There are suggestions that the efficiency of wind and other exotics will increase over time.  Doubtless this is true, but it is also true of other forms of power.  Over recent years, there has been little or no narrowing of the relative cost of wind and coal.  Moreover, when the wind is blowing, which is 30 per cent of the time at best, modern windmills already draw 45 per cent of the available energy from wind.  The theoretical maximum is 59 per cent.

There has been a rapid increase in new installations of wind generators across the world.  In all cases, this has been on the back of hefty subsidies.

Denmark has been the stand-out case with, on some estimates, up to 17 per cent of its electricity coming from wind.  But this is likely to be pared back by a new government keen to address electricity costs which, as a result of the windmill policy, are three times the Australian level.

Germany and the US are other major users, with wind supplying about 1.5 per cent of Germany's electricity and 0.13 per cent in the US.

If unconventional electricity supplied the targeted 1 per cent of total electricity in Australia by 2010 the cost would be considerable.  It would mean an annual tax on energy amounting to $380 million, with the funds largely diverted to high-cost, mainly wind, solutions.

Each additional percentage point would require another $380 million per annum.  Moreover, these sums do not take into account the further costs that are required to manage the low quality of wind and some other exotic renewable energy sources.

Environmentalists are fond of saying, "If nuclear is the answer (to combating global warming), we are asking the wrong question".  But wind and other exotic sources can only provide answers at very high costs.  We should, therefore make sure that the question we are asking is addressing a real problem.

ADVERTISEMENT

Is the National Broadcaster Biased or Just Doing its Job?

The ABC's is progressively removing itself from mainstream Australian opinion.  The cooperative that ruins "Auntie" largely defines itself by being "anti".  It is anti-Howard, anti-American, anti-globalisation, anti-business, and incapable of promoting the diversity of view that its charter calls for.

Its bias, the denial of which seems to be confined to Chairman MacDonald and a few ABC insiders, is well beyond the mainstream Labor Party.  It provides better platforms to the most marginalised groups than to the democratically elected government.  It takes on, at face value, the flimsiest of evidence to attack its pet hates and promote its agendas.

A recent case is Kerry O'Brien's sally into Western Australia where he "exposed" a totally apocryphal massacre "during our life time" of blacks by the white authorities.  When the evidence for this was utterly demolished, a sheepish O'Brien could only mutter about a disparity of views on the matter.

My forthcoming paper demonstrates how Four Corners was a sucker for the most egregious propaganda fed to it by the World Wide Fund for Nature (WWF) activists concerning an alleged destruction of the Great Barrier Reef.  The program portrayed the WWF as the reef's saviour.  It investigated a raft of causes of the reef's impending destruction:  oil exploration, water pollution, grazing, and sugar cane.  The allegations were utter rubbish:  the reef is expanding and is not threatened but the program fitted the ABC mindset, allowing an opportunity to sensationalise fabricated depredations business is visiting on the planet.

Similarly we have the absurdly named Media Watch hosted by a succession of splenetic radicals with a licence to furnish untruthful and distorted material against any pet bogyman.  I, myself, have been victim of such malice, as most recently the Australian newspaper which is fair game by dint of being controlled by the ABC's bete noir Rupert Murdoch.

One attempt to break out of its far left collectivist mould was to find a "right wing Phillip Adams" to fill a slot on Radio National.  Tim Blair and Imre Salusinszky were the recruited.  Their program was withdrawn after 12 weeks.  There was no review of its ratings out in consumer-land but with a vague suggestion that Radio National would seek to have such mainstream views percolate throughout its programs rather than in a single spot.  Fat chance!

Finally we have had endless episodes of children overboard and scourging the Australian authorities about the treatment of illegal immigrants.  Government and Opposition policy is almost identical yet Lateline's coverage suggests a fierce partisan debate rages through the community.  The program's speciality has been to find three like-minded experts to prattle on about how the authorities are heartless, unfair and discriminate against the unfortunate illegal immigrants.  There is seldom a word that hardly any of the illegals are in fact found to be legitimate refugees.

Some progress is being made.  Michael Kroger has urged greater ABC relevance, particularly in catering for the business community.  At last it is to have an early morning business program.  At last it has found a regular spot for one of the nation's top finance reporters Alan Kohler.

But the ABC remains largely cocooned from the community's values with its public faces being the politically correct Kerry O'Brien, Jill ("John Howard is Pinochet") Singer, and Tony Jones.  The organisation no longer has a person of the authority of a Paul Lyneham to pull it back from the abyss of political correctness.  Sadly, as shown by the loud cheers from the staff that accompanied Russell Balding's appointment as CEO, the situation is unlikely to change.

Generator Market Power and Bidding Rules in Wholesale Markets

An Address to the Conference:
Energy Regulation and the Role of the Regulators,
31 May 2002.

ELECTRICITY AND GAS AS COMMODITIES

The electricity and gas markets are fundamentally commodity markets.

But they differ from other commodity markets in two major respects:

• First the producers have massive mutual interest in the delivery system being maintained in a safe and reliable manner.  It is not usually practicable for firms or individuals outside of remote areas to opt out of the network in either gas or electricity.  And even where it is possible the parties undertake strenuous efforts to avoid it.  Gas in Australia is something of an exception since until recently there were bilateral monopolies operating in both Victoria and NSW with only one producer and one retail/distributor.
• Secondly, the lack of storage of electricity in particular means the suppliers and consumers need to cooperate far more closely than this is required in other commodity markets.

As a result of these differences, the electricity and gas markets did not evolve in the same way as other commodity markets.  Other commodities established markets spontaneously and developed trading rules organically without any government oversight beyond the normal provisions of law.  The high degree of natural monopoly in the delivery system marks out gas and electricity as different.  Both electricity and, to a lesser degree gas, were either taken over and run by governments or heavily regulated.

Other commodities avoided this.  Not only do merchants in other commodities trade on a spot delivery basis with little concern about the means of delivery itself but they have developed future delivery product mechanisms (which we now call derivates).  And they did this with remarkable efficiency:  we seldom hear about a crisis in rubber or oil seed or wool or tin.  The only occasions, aside from in wartime, when supply disruption has occurred is those mercifully rare incidents when producer cartels have successfully operated.  This has been confined to two brief periods with oil.

THE ELECTRICITY CODE

While other commodity markets evolved, the electricity and gas markets have been devised by governments, although early models had evolved particularly in PJM where a meshed system and many suppliers had made it convenient for a cooperative framework to develop autonomously.  This cooperation, and ceding of powers to a central body is essential because not only does the system have a high degree of commonality in transport, but the fragility of that transport medium means it must be constantly monitored and its users subject to central dictates.

The Code is an attempt to set detailed rules and the code change process and policing by NECA is a means by which the rules are refined.  The Code itself largely set out the mechanisms in place in the previously integrated system whereby the different components had to be organised for delivery to the consumer.  The major difference is a more prominent role of price in establishing which units were to be scheduled but in principle that role was already embedded within the integrated utilities.

The Code Change mechanism has introduced dozens of refinements to the original.

These include:

Gazette Notices

• Dispute resolution arrangements (11 April 2002)
• Network and distributed resources (8 March 2002)
• NSW full retail competition derogations (7 March 2002)
• Prudential Arrangements:  Security Deposits (21 February 2002)
• Full Retail Competition (20 December 2001)
• NSW full retail competition derogations (20 December 2001)
• Network pricing and market network service providers (6 December 2001)
• Averaging of transmission loss factors (1 November 2001)
• Extension of Queensland Technical Derogations (25 October 2001)
• End-user advocacy et al. (11 October 2001)
• Victorian Full Retail Competition Derogations (6 September 2001)
• Further Extension to Chapter 9 Ancillary Services Arrangements (23 August 2001)
• Full Retail Competition and Registration of Code Participants (16 August 2001)
• Ancillary services (9 August 2001)
• Victorian Full Retail Competition Derogations (31 July 2001)
• Extension of derogation -- Snowy Hydro Trading Pty Ltd (26 April 2001)
• Pricing under extreme market conditions (22 February 2001)
• Basslink (1 February 2001)
• VoLL, Capacity Mechanisms and removal of the price floor (25 January 2001)
• VoLL scaling (25 January 2001)
• Changes to Queensland derogations (25 January 2001)
• Rebidding and revision of settlement statements (21 December 2000)
• Introduction to Goods and Services Tax (21 December 2000)
• Inter-regional transfer of TUOS charges and the treatment of losses (21 December 2000)
• Extension to chapter 9 ancillary services arrangements (14 December 2000)
• Full retail competition (30 October 2000)
• NSW Derogations for interim transmission network service pricing (13 October 2000)
• Third tranche Code changes -- Queensland ramp rate amendments (20 July 2000)
• Introduction of GST (29 June 2000)
• Capacity Mechanisms (29 June 2000)
• Market network service providers (further clauses) (16 March 2000)
• Third tranche Code changes (2 March 2000)
• NSW network pricing derogations (25 February 2000)
• Trading limits;  funding of compensation for system security directions;  intra-regional loss factors (24 February 2000)
• SA derogations;  settlement residue auctions (3 February 2000)
• Y2K withdrawal;  Queensland Market Network Service Provider derogations (13 January 2000)
• NSW derogations -- regulation of network assets (23 December 1999)
• Removal of zero price floor (13 December 1999)
• Market network service providers (21 October 1999)
• Removal of Queensland rebidding restrictions (23 September 1999)
• Intra-regional loss factors;  SA derogations (15 July 1999)
• Transmission pricing arrangements in NSW (1 July 1999)
• Settlements residue auction;  SA derogations;  interim ancillary services arrangements (28 June 1999)

In addition several are before the ACCC awaiting their review.  These include

Proposed Code changes forwarded to the ACCC

• Review of technical standards:  interim extension of existing derogations
• Code Change Panel:  review of directions in the national electricity market
• Code Change Panel:  stage 1 of integrating the energy market and network services
• Generators' bidding and rebidding strategies and their effect on prices:  revised proposals

In addition, the rules are clarified as a result of particular cases being adjudicated.  The best illustration of this is the recent decision taken in the National Electricity Tribunal concerning bidding in NSW at the time of a system constraint.  On that occasion Macquarie bid its output on a "must run" basis.  This meant it could not set the price but would be assured of a large market share.  "Must run" is designed to allow for situations where a plant is in difficulties or at a testing stage.  In other cases generators bid price/quantity bands.  In the recent case, Delta, having been squeezed out by Macquarie's actions, then adopted a similar approach and other suppliers were left producing less than they expected or less than would have been the outcome if normal price/quantity bidding procedures had applied.  This sort of bidding overrides the normal dispatch and, if maintained for long periods, would bring inefficient market behaviour.

In the event Macquarie was found to be at fault and paid a modest fine.  The case itself was more useful in clarifying when certain provisions can legitimately be used.  It also illustrates the very large difference between the electricity commodity market and other commodities where suppliers need to accept disciplines but can also agree to allow privileged treatment for particular forms of supply under certain conditions.

EVIDENCE OF GENERATOR MARKET POWER

California is on everyone's lips when issues of generator market power are addressed.  And relatively recent material coming out of Enron has indicated a few ways where a clued-up generator could manipulate that market through using market power in special circumstances and make money in ways that were not envisaged and in some cases impose costs.  These were given colourful code names by the traders like "death star" and "get shorty".  I'll come to these strategies a little later.

In terms of the detailed examinations of the market, tracing the causes to exercises of market power has not generally been found to be the main problem.  Certainly Joskow and Paul Kahn ⁽¹⁾ say they have found evidence of strategic withholding which drove the prices higher for three of the eight or nine very high priced months.  Scott Harvey and William Hogan ⁽²⁾ say they could not detect withholding of power and go on to argue that measures designed to prevent this are likely to be arbitrary and to deter new investment.

Moreover, as Frank Wolak has pointed out ⁽³⁾, there is a major ambiguity.  On the one hand, the US Federal Power Act requires prices to be "just and reasonable" and FERC has decreed that prices which reflect unilateral exercise of market power are not "just and reasonable".  On the other hand, US anti trust law, like our own Trade Practices Act, does not regard such action, which we sometimes call "gaming", to be illegal.  Indeed, a firm is required to maximise the wealth of its shareholders and if it does not set prices that maximise that value it is actually operating contrary to company law!  But the shared nature of the network means that rules over and above those set in other commodity markets must be in place.  These rules prevent some forms of gaming and specify behaviour in much the same sort of way that rules of the road work.

The causes of the Californian meltdown were clearly a mixture of

• bad luck (like the NZ counterpart of a 100 year water famine);
• plus NIMBY powers to prevent new plant and transmission line building;
• possibly price suppression at the retail level;  and
• poor design of the market (like the inability to forward contract and the ability to self schedule without regard to transmission constraints)

It is poor market design that we can best focus upon in this setting (leaving politics to dissuade governments from acting foolishly in response to populist cries.

Some of the strategies Enron used to make use of the rules and operate in unintended ways included:

• Inc-ing.  Seeking to get a higher price by manipulating the self schedule, increasing its load schedule but not taking the whole amount and thereby obtaining a higher price where there was a load deficit.  Actually this is only possible because there were two markets, with the imbalance market being a ten minute market.  It could not occur like this in Australia where there is only one market -- essentially the five minute gross pool and its linked ancillary service markets.  Also the activities were actually market stabilizing since they arbitraged price differences, thereby levelling them.  Similar activities occurred by forward selling ancillary services and going short on them buying them
• Taking advantage of transmission constraints to gain payment for phantom energy sent in the opposite direction of a transmission constraint
• exporting energy and re-importing it.  This is a strategy that undermines the price cap put in place in California (and is to be commended!)

Much of this was possible only because the Californian market was a net pool in some respects.  Importantly, a net pool under which firms need only inform the market manager of the sales made other than those off-market is likely to present difficulties where there are transmission constraints and Enron took advantage of these.

ABARE's January paper, Competition in the Australian national electricity market, examined spot price outcomes in Australia and concluded that there were deviations from competitive outcomes.  The knee-jerk reaction of those in the industry would be, "Tell us something new, wholesale spot prices in NSW and Victoria in the past four years have averaged $31 per MWh compared to a long term expected rate of $40."  But the deviations ABARE had in mind were high not low prices!

The average prices in the four main markets are illustrated below.

Average Prices in Major National Electricity Markets ($)

Year	NSW	VIC	QLD	SA
1999 July-June	23.7	25.1	55	49.7
1999 -- 2000	28.9	26.1	45.3	60.6
2000 -- 2001	38.4	45.4	42.2	57.3
2001 July-December	27.4	26.7	28	26.4

The ABARE paper likens the outcome in Australia to Joskow's analysis of California that attributes high prices there to generator gaming.

The best test of claims that generators are driving up prices would come from an examination of their share prices.  Unfortunately most Australian generators are either government owned or not listed.  Loy Yang is the exception and, as one of the largest energy suppliers in Australia, is a decent bellwether for the industry in general.  Loy Yang's shares are trading at less than a quarter of their issue price, while its debt too is selling in secondary markets at a steep discount.  This is not the sort of outcome that might be expected of a firm that is exercising monopolistic powers or benefiting from such activity by other firms.

And while Delta and Macgen had pre-tax earnings of $188 million and $143 million last year, these are modest earnings for firms worth $3-4 billion.

ABARE's analysis also suggests the exercise of market power to be more prevalent in Victoria than in Queensland.  Understandably, the authors find this outcome to be surprising.  Victoria, as the table above shows, has with NSW generally experienced the lowest prices in the national market.  It also has the least concentrated generation supply.  ESAA data shows the four major brown coal generation businesses had 90 per cent of Victoria's generation market in 2000 and that there were five other significant suppliers.  In contrast, Queensland at the time of the study had four state owned generation businesses supplying 99.5 per cent of generation.

University of Maryland Professor Tim Brennan has addressed the methodology, the Lerner index, used in the ABARE study. ⁽⁴⁾  The Lerner index is the price minus the marginal (or average variable) cost divided by the price.  In a perfectly competitive market, the index, measured as that of the last generator despatched to meet the energy demand, it is equal to one.  In other words, the last supplier is bidding its marginal cost, (which can be very high if capacity is reached).  ABARE estimate the marginal costs of each supplier, add 50% to this, and designate all bids above that level to indicate the generator has and is exercising market power.

Professor Brennan criticises the index as it applies to electricity generation on a number of grounds.  He maintains that use of marginal cost as the appropriate bid level does not explain how the generator's fixed costs are met.  He says,

"... when one is trying to discover what the (short-run) competitive price would be in a market where capacity is limited, one would not compare price to the average variable cost of the marginal plant ... In a simple model ... the peak price over the long run would equal that highest average variable cost plus the average capacity cost of the plant.  The actual level of the on-peak price in the short run would be above or below this value, depending on whether demand was higher or lower than that expected when the unit was constructed.

These are among the issues that Stephen Littlechild has addressed in recent paper. ⁽⁵⁾  Professor Littlechild took vigorous steps to combat monopolistic market power when he was the UK electricity regulator.  However he warns against the authorities placing price restraints on firms to prevent them bidding above the marginal costs.  In a world of great uncertainty regarding rainfall, demand and many other changes, he says,

"... it would be commercial suicide for a generator to assume that the market will always be in equilibrium and that it should price at marginal cost.  The world is too risky for that.  Investment in new plant is very expensive and typically takes a long time to recover.  The entrant must reduce its risks and plan to get its investment back as soon as possible.  It will do this by a variety of long term and short term contracts to allocate risk to those parties best able to control them -- which will typically include fuel suppliers and equipment manufacturers as well as retailers and customers.

"... in the real world, competitive markets generally are not characterised by price equal to marginal cost.  That is the wrong benchmark for judging possibly anti-competitive behaviour.  Life is more complex and in particular more risky than the marginal cost criterion recognises."

Professor Littlechild addresses the implications of this for regulatory policy.  He argues that if a regulator were to impose a penalty on a firm even for withholding capacity (let alone for bidding a price bid above short run marginal cost) this may have a disincentive effect on potential new generation, exacerbating later problems.

Market power is an elusive concept.  Almost all businesses in all markets enjoy some ability to raise prices by offering less.  Many firms promote differences, often trivial differences, in their brands in order to improve prices.  Others may find niches within markets in which they can, at least temporarily, charge higher prices than the basic costs would seem to justify.  Still others find themselves in a fortunate position of having supply available that is insufficient to meet demand -- perhaps because of a competitor's sudden failure, perhaps because of an unanticipated upsurge in demand.

Although there may be grumbles about "profiteering" in some such circumstances, actions to prevent the higher prices will normally rebound against the consumer's interest.  Without the ability to charge very high prices to cover rare events, firms may have inadequate incentives to operate so that they have capacity available at the right time.  In addition, these very high prices act as a means of rationing supply to those placing the greatest value on it (we normally refer to this as demand side participation).

The ABARE paper is correct when it concludes the task is to identify underlying causes of noncompetitive outcomes and determine whether mitigating market power delivers sufficient cost benefits.  The trouble is that their analysis has produced a straw man -- while many of us would like to see more disaggregation of generation, the evidence does not point to monopolistic abuse in the market structures we have.

COMBATING MARKET POWER

Fears of market power are endemic.  But examples on a major scale are difficult to find.  Shylock in the Merchant of Venice was able to extract highly onerous terms for a futures contract with Antonio and was only swindled out of his Pound of Flesh by an artful lawyer.  Antonio was, of course, a highly risky supplier and Shylock had market power as the last man left standing who would offer to supply a futures contract to him.  Obtaining high prices for the most marginal supply is essential if that supply is to be remunerative and therefore available.

Those sort of circumstances could equally well bankrupt a supplier (a generator) in today's electricity market in the same way as they ruined Antonio in the Merchant of Venice.  This is avoided by contracting and by ensuring that prices are seen by the customers or their agents so that they can react (or their agents react on their behalf) to very high prices.  Abandoning retail competition or suppressing price levels is counter-productive to this.

More generally we have seen the apparent market power of the two major UK generators lifting prices to well above the levels expected by the regulatory authorities, moves that have brought, in part, their own cure with the construction of considerably more capacity.  The solution in avoiding the losses stemming from market power is to ensure that there are plenty of competitors.  But even then, it is likely that there will be episodes of very high prices, just as there were episodes of blackouts in the past.

The new UK variant (NETA), seeks to offset market power by paying the generator the price it is bid;  most other variants pay the price bid by the marginal supplier to all suppliers.  There is something to be said in auction theory for both approaches, though the UK approach requires considerably more investment in information technology systems.  And it is the structure of competition rather than the bidding system that provides the market power, a matter demonstrated in a report by Wait, commissioned three years ago by the ACCC. ⁽⁶⁾

In reality, however, all electricity markets are fundamentally contract markets (an exception was the failed Californian model where contracts were largely forbidden).  In Australia, the best guess is that 95 per cent of energy is bought under contract.  The reason for this is the strong risk aversion of retailers (and their financial backers) to high price excursions.  The spot market (or, in the UK, the balancing market) is therefore a market for "unders and overs" which settles the small amount of energy that was despatched and used without a contract cover.

Some markets incorporate a capacity payment to encourage high cost capacity to be made available.  While this has ostensible appeal for a market with variable demand, it also involves a central planner determining what capacity level should be made available and how much to pay for it.  In my view the energy only market works better ⁽⁷⁾ though, as with other market design issues, the matter is not settled.

The exercising of generator market power in the UK market was doubtless the reason for changing to the NETA.  The UK had tried to have the generators agree to a Statement of Ethics but the MMC threw the requirement out.  We had our own counterpart to this.  But it withered from lack of support was probably doomed anyway once the UK decision was made.

At the heart of the more recetn attempts to address the matter has been provisions for re-bidding.  Some initial thoughts were:

1. that rebids three hours prior to dispatch may only be made if there are legitimate production or cost reasons;
2. that initial bids must reflect the generator's intent;  and
3. that the price changes in any single period should be dampened by not permitting increases from one five minute period to next to exceed $1,000.

Following meetings and discussions these became:

• require generators' bids and rebids to be made in good faith and therefore represent their genuine intentions at the time they are made.
• accompany this by a shift in the onus of proof so that in any proceeding a generator would be required to satisfy the National Electricity Tribunal that its bid or rebid was genuinely made in good faith;  and
• prohibit bids or rebids that have the purpose, or have or are likely to have the effect, of materially prejudicing the efficient, competitive or reliable operation of the market.

Regarding the concerns that generators are able to ramp up spot prices by shifting load, the dimensions of issue include:

• The original market did not envisage bids being changed except under special circumstances and the residual impact of this can still be seen in the provision which does not permit firms to change their prices on the day but only to shift quantities;
• And the possibility remains that a firm could engage in ‘anti-social' activity that imposes costs on rivals, for example by an erratic bidding approach that forces rivals plant on and off with unwanted frequency.  The market and system is so tightly integrated that this ability of a player to act in a renegade manner needs to be constrained.
• But market experience and developments have shown:
• the spot market is a residual market not the envisaged main market
• the planned day ahead market has developed into a dynamic five minute ahead market which is far more efficient in allowing bids to reflect the physical and market exigencies very close to dispatch
• constraining prices also prevents firms taking action that will effectively lower price by impeding the bringing forth of additional supply;  this is true both of firms that are energy limited and seeking to ration the supply to the occasions where prices are highest (i.e. those when it is most highly valued);  and those firms simply seeking to get into the action to take advantage of a commercial opportunity.  Both NECA and the consultants examining the issue recognised that re-bids normally bring lower prices than originally set.
• In any event the premium prices, if any, resulting from the activity are precisely those needed to encourage more capacity to be brought on stream.  Some argue both that we should stop prices moving up and that we need more new plant than the market is presently creating.  This is possible only by a total abandonment of the competitive market and a return to central planning.

This aside, issues are clouded by a lack of certainty over just what constitutes reasonable behaviour.  Few would now claim that the rebidding we have combined with what is essentially a five minute market, should be jettisoned.  But many would place constraints, to a greater or lesser extent on the activity.

For their own part, the generators adopt an ambivalent approach.  Some claim rebidding is done only in reaction to changes of circumstances.  Others argue that it is an essential stabilizer to ensure the conservation of scarce resources especially for energy limited firms.  Still others argue that rebidding and activity like parking load at bids above $5,000 per MWh is a legitimate strategy designed to force up prices.  Such activity is immensely facilitated by the notorious ETEF system in NSW whereby 80% of the weekend load is uncontracted;  generators can then bid much of their capacity at high prices knowing that they will not be caught short in the event of a price spike.

Those who are seeking to force up prices are, outside NSW, seeking to encourage retailers to enter into contracts and would point to the very low prices that have long prevailed.  They would respond to accusations that they are using market power with a shrug.  It is, they would say, our generation capacity and like every other producer of goods and services we want the best possible price.

Now I have some sympathy with this view, since it is anchored on property rights and action that involves raising prices is self-correcting -- it draws in additional supplies and brings about changed customer behaviour.  It may however give rise to policy reactions.  This is particularly so in the situation in NSW where the relatively small number of suppliers has always offered the prospect of an unhealthy exercise of market power.  The government mandated retail arrangements have severely aggravated this and the best solution is to tackle these the underlying causes:  that is abandon the market stifling ETEF situation and further disaggregate generation in NSW.

These are just the more important matters exercising people's minds in the wholesale electricity market.  Doubtless we do not yet have the optimum set of rules but the market continues to emerge and the great many variations on the basic theme will continue to inform us as to what changes might best be made.

---

ENDNOTES

1.  Joskaw, P.L., and Kahn E., A quantitative analysis of pricing behavior in California's wholesale electricity market during summer 2000, National Bureau of Energy Research Working Paper 8157, 2001

2.  Scott M. Harvey and William W. Hogan On The Exercise Of Market Power Through Strategic Withholding In California, Center for Business and Government Harvard University Cambridge, 2001

3.  see for example Wolak F., Is price gouging really the problem?, San Diego Tribune July 27 2001

4.  Timothy J. Brennan, Checking for Market Power in Electricity:  The Perils of Price-Cost Margins.

5.  Stephen Littlechild Electricity:  Regulatory Developments Around the World, The Beesley Lectures on Regulation Series XI, IEA/LBS, London 9 October 2001 (Revised version 12 November 2001)

6.  Waite, A. Electricity pool market arrangements:  should e NEM adopt a gross or net pool?

7.  See Richard Wood, Marginal Costs and Prices in the Electricity Industry, June 2000

The Inmates are Running the Asylum

Can anyone imagine News Corp or Fairfax or indeed any serious company going six months without a managing director?

The ABC has and the organisation itself was happy about it.  Some of the ABC Board were also unperturbed.

The ABC Board itself is lacking any media experience.  The same is true of the newly appointed Managing Director, Russell Balding;  he is a bean counter from the NSW main roads department.  Balding clearly does not have the media experience or tough personality required to run the wide confederation of personalities that makes up the ABC -- and for that reason his appointment will prove popular in many quarters.

Balding's appointment means business-as-usual.  The fumbling attempt of Jonathan Shier to bring reform and relevance to the organisation is now at a dead halt.  And those who in the past have derided the importance of ratings will no doubt point to the respite in the ABC's steady fall in popularity among consumers as validating the absence of direction!  With its new Managing Director, the public broadcaster remains in the hands of the collective that presently controls it, leaving MacDonald, who has emerged as the collective's St George, as the perceived chief spokesman.

The ABC Board were put there for with one key objective -- to appoint and then support a Managing Director to reform the ABC.  This does not mean making it a Liberal-friendly organisation.  Rather, the task was to ensure that the ABC's coverage relates to and respects the broad range of values and interests in the Australian community.  This means wresting power from the workers' collective that controls the ABC.  Canberra has clearly made some ineffectual Board appointments but the Commonwealth must now live with its decisions.

The Board failed with Shier.  It should have learned in the process that the workers' collective is a formidable opponent and moved to quickly appoint a new Managing Director.  Instead Mr McDonald and his merry friends dithered to the applause of collective.

They sent head-hunters scouring the world for talent but inexplicably could find nobody.  They searched the local talent shops, again reportedly without success.

As it turned out the head hunters either did not have an eye for talent or were operating with a secret blacklist.  Somehow they were told that Nine's massively experienced David Leckie was off the agenda.  Similarly, the process failed to call in the equally experienced (and clearly available) former Packer executive Trevor Kennedy.  When Mr Kennedy actually advertised his availability, the Chairman rejected him without even discussing it with the rest of the Board.

Mr McDonald has become to resemble Sargent Schultz in the American sit-com Hogan's Heroes with regular utterance of "I know nothing, I see nothing, I hear nothing".

Now this is not the local stamp club, it's the public broadcaster.  It not only consumes $700 million of taxpayers' money, but plays a vital role is informing us about ourselves and the world around us and it is giving a distorted, negative view.

But, it appears that the ABC Board after seven months remains at square one and the collective is firmly in control.

Media Watch is back trashing its competitors in the private media with bile and junk journalism.  Four Corners pilgers-on.  Lateline is into its 1000th segment of the children overboard storey.  Radio National is fighting harder then ever for the public sector to reclaim the command heights and to bring back Joan Kirner.  JJJ has become the official voice of M1 alias S11.  John Howard's effigy remains the centre piece of every dart board in the organisation.

There were worse options than the Balding appointment.  In March Mr McDonald reputedly tried to parachute into the job the ABC's Forrest Gump, Max Uechtritz, to the loud cheers of the collective.  He was only stopped by strenuous rumblings from the board.

Clearly the Chairman of the ABC Mr McDonald is not up to the job and should go.  He has failed completely in his main task of finding a suitable Managing Director.  The organisation has been on auto pilot for more than six months.  It is malfunctioning and he apparently has no plans to change things soon.

Mr McDonald is protected from the ire and influence of ABC shareholders -- all of us who pay our 8 cents per day -- and from accountability with a no-sack clause in his contract.  And his contract is not up for a few years.

Perhaps it's time his other Board members did their job, tapped him on the shoulder and told him Paris beckons.  And then start all over, rebuilding our ABC.

The Taxman Cometh

While the 2002/03 Federal Budget was in the main a bland affair, it is likely to give many businesses real grief.

The budget funds for a new army of tax collectors, arms them with new tools of extraction and orders them to go earn their keep.

The Budget gives the Australian Tax Office (ATO) an addition $1.5 billion over four years.  The money is to be used to hire around 2,200 extra staff (on top of the ATO's existing 18,000 employees) and to arm them with new computers and other support facilities.

For this "investment" the Government assumes that it will receive at least $1.5 billion in higher tax receipts.  That is the ATO has been told that it has to at least match each additional dollar received with an additional dollar of tax raised.  The target for big business is higher with $11 in higher taxes for each $1 of new resources.

While the bulk of the new resources will be used for to improve the overall tax collection effort, income and fringe benefit taxes have been specifically targeted.  GST collections (which is not consider as tax in the Budget papers) is also forecast to rise by $140 from better compliance and collection efforts with $45 million to be extracted from small businesses.

To assist in their efforts, the ATO is shifting from "education" to "enforcement" mode.  Their rationale is that the new tax system is up and running, and therefor the ATO can shift its resources away from being Mr. Nice to collecting the money.  The truth is that the new tax system is riddle with uncertainty, ad hoc rulings and other compliance problems.  And many businesses, particularly smaller one, are still struggling to recover from the hit the GST did to their cash flows.  But the election is over and revenue is now king and the ATO knows it.  They have assisted their cause by giving the government a new "independent" report which argues that there are untold riches to be gained by letting the ATO loose on business.

The budget includes a couple of other innovations designed to raise more revenue.  First the government plans to advance some aspects of the business tax agenda.  These "reforms" are expected to raise an additional $560 million over the next four years.  Obviously the revenue neutral principles upon which tax reform was supposedly based has been jettisoned in the post election environment.  On the positive side, the government appears to have assigned Treasury's beloved "tax value method tax system" to the too hard basket and for a good reason, it is a compliancy nightmare.

The other innovation is the decision to combine the BAS and the ASIC registration numbers.  This make sense.  It will eliminate duplication and make compliance easier.  However, it will also make the tax collectors efforts more efficient and effective and assist greatly in meeting revenue raising targets.

We all recognise that governments needs money and that their demands will grow with the ageing of the population.  However, there has to be a better way than fleecing businesses with complex tax laws administered by an army of bounty hunters.

ADVERTISEMENT

Foreign Aid Bodies Need Closer Scrutiny

It's probably just as well the proposed anti-terrorism laws have been scuttled by the Senate.  Otherwise, most of Australia's foreign-aid non-government organisations would probably be out of business.

Of particular concern would be the provisions that give the power to proscribe organisations where, in the opinion of the Attorney-General, that organisation affects the integrity of another country.

Some would view this as proof that there is something wrong with the anti-terrorism bill.  But this tends to prove my suspicion that there is something wrong with many of our foreign-aid NGOs.  It seems that Australia's foreign-aid NGOs are increasingly being drawn into the politics of the countries in which they operate.  The notion of non-politicised humanitarian aid seems to be unfashionable in foreign-aid circles.

A recent edition of Australian Story contained the revelations that the wife of East Timor's President used her paid position in an Australian foreign-aid NGO to support her activism against the Indonesian government, which included spying.  While I have sympathy for that cause, I was stunned by the lack of reaction to these revelations.  Australia's foreign-aid peak body, the Australian Council of Foreign and Overseas Aid, has no reference to this incident on its website or announcement of an investigation.  One would have to think that there is a point where this politicisation degrades the capacity of aid agencies to discharge their core function of delivering aid.

This has serious implications for the foreign policy of countries such as Australia.  Because, increasingly, foreign aid budgets are not being administered directly by governments, but through foreign-aid NGOs.  So these NGOs may be viewed as agents of the governments funding them.  During his last trip to Indonesia, John Howard received a frosty reception from several senior Indonesian political leaders.  Indonesia's powerful parliamentary Speaker, Amien Rais, snubbed Howard, citing in part Australia's alleged support for the independence of West Papua.

The Howard Government has never challenged Indonesia's sovereignty on West Papua.  Deputy Speaker Soetardjo Soerjogoeritno claimed that Australia was helping fund NGOs that backed independence for Papua and Aceh.

Just as it has been hard for Australians to accept President George W. Bush's free trade rhetoric, when confronted by the reality of massive subsidies in the latest Farm Bill, it is probably hard for the Indonesians to reconcile the words of reassurance from Howard over Indonesian sovereignty over its troubled provinces while at the same time being faced with activities of Australian government-funded NGOs actively supporting independence.

Addressing the problems caused by the activities of our foreign-aid NGOs is a problem that the Howard Government doesn't want to confront.  But it is one that it must not shirk if it wants to improve its relations with countries such as Indonesia.  Labor is in no position to enjoy the Government's discomfort.

This is a bipartisan problem.  Its situation is even worse.  Only last year, the ACTU passed a resolution supporting independence for West Papua.  Engagement with Asia has to be problematic for Labor when 60 per cent of your delegates support the separatist movements in your neighbours' backyards.

Clearly, the anti-terrorism bill was in need of revision and needs to be drafted with greater clarity and precision.  As it stands now, the bill would endanger many activities that could easily be argued as quite lawful and legitimate.  Governments have no business in interfering with such activities.  But any anti-terrorism bill has to deal with what Bush described as the terrorist tendency to "oftentimes use nice-sounding, non-governmental organisations as fronts for their activities".

Bush's remarks occurred after Treasury Secretary Paul O'Neil's investigation into the September 11 attack found that Osama bin Laden used a number of NGOs to feed his terrorist network.  NGOs were chosen because they are often "above" suspicion, but more importantly have minimal standards of reporting and unlike government or business have no one scrutinising them.

While Canberra revisits its anti-terrorism bill, it should re-examine the activities of Australian foreign-aid NGOs before other countries do it for us.

ADVERTISEMENT

Submission to the Western Australian Electricity Reform Task Force

INTRODUCTION AND SUMMARY

Electricity is commonly divided into four businesses:  generation, transmission, distribution and retailing, with a fifth function:  scheduling, being retained under some neutral ownership.

Of the four main functions, distribution is best regarded as a natural monopoly.  Its price, therefore, has to be controlled.  Ideally this should be against an external reference point with the average price set using a CPI-X formulation so that the distributor is incentivised to operate efficiently.  Transmission is also commonly thought of as a natural monopoly, although more recent developments hold the prospect that new transmission could become a deregulated, market-provided service.

The Task Force has proposed a vertical disaggregation of Western Power into single businesses covering:

• retail,
• transmission/distribution, and
• generation.

It also envisages an independent System Management, perhaps with its own board, undertaking system operation, market operation and system planning functions.

We consider the Task Force's proposals to be excessively conservative, especially in the treatment of generation and retailing, sectors where competitive provision is widely recognised to be readily achieved.

The major impact of adopting an ultra-conservative approach to the break-up of Western Power will be seen in terms of higher generation costs.  To a considerable degree, these higher costs will stem equally from retailing, as retailing and generation are interdependent.  Retailing is the major driver in bringing about the sort of generator structure that best meets the market's needs.  But this cannot take place unless there are alternative suppliers of generation, because a monopoly will frustrate the structural change in production which competitive provision ensures.

Although it may be appropriate to have the SouthWestern integrated system (SWIS) operated by a single distribution business, we also believe that it is poor policy to combine the local poles-and-wires functions with those of transmission.  We take this view because transmission is showing signs of becoming a contestable service and therefore requires a different corporate philosophy than distribution.  Hence, we would prefer to see the more conventional disaggregation of the poles-and-wires business into transmission and distribution.  That way, there is also greater assurance (additional to that stemming from an independent planning facility), that no favouritism would be shown to the particular solutions of an affiliate over others offered by a rival.

Those opposed to this view might argue that separate businesses give rise to higher overhead costs.  This need not be so and was, in any case, no barrier to such a disaggregation in other relatively small systems such as Tasmania and South Australia.

Finally, Western Australia has long experienced much higher electricity prices than those in other States.  The most recent ESAA data show WA residential customers paying 25 per cent and business customers 40 per cent more than the Australian averages.  Cheaper electricity prices are important both for households in WA and for industry competitiveness in processing where the State sees its competitive advantage.

Although it might be contended that WA prices are higher as a result of underlying costs, competitive provision is likely to prove this not to be the case.  Jurisdictions that have privatised their electricity have experienced massive efficiency improvements.  Over the 1990s, privatised Victorian generators scaled down their manning levels to achieve the fastest growth in productivity among Australian generators and at the same time vastly improved their availabilities.  SPI Powernet, the privatised Victorian transmission business, halved its staff levels post-privatisation and, by greater use of contractors, reduced operating costs by 35 per cent.  SPI achieved this and the lowest average controllable operating expenditure per MWh in Australia, in spite of the average age of its plant moving from 21 to 29 years over the period.

Arguably, improvements like this are achievable under public ownership.  But in practice this rarely occurs, especially over an extended period.  Accordingly, we would urge the Task Force to promote the benefits of a more rapid pace of privatisation than will emerge from simply inviting the private sector to participate in incremental and replacement developments.

THE ROLE OF THE ELECTRICITY RETAILER

As retail margins are only about 5 per cent of prices, many consider that the role of the retailer is not material to the promotion of efficient electricity supply.  Such judgements about the role of the retailer in bringing efficiency and consumer benefits in liberalised markets are incorrect.  This is because, under competitive circumstances, the retailer is the de facto agent of the consumer and therefore the driving force of a market that responds to the needs of the consumer.

That role of the retailer as the consumer's agent is assumed of necessity -- if abandoned, or neglected, a rival will step in.  The retailer is the link between the different elements of production and the customer.  Its functions are sometimes thought largely to comprise breaking down bulk supplies into packages useful to the consumer, reading meters correctly and cheaply, and showcasing producer's goods and making them available at convenient locations.  But even this important list of functions offers an inadequate portrayal.  The retailer's activities must extend to discovering what the consumer wants and seeking out the cheapest sources of supply at optimal quality levels.

The homogenous nature of electricity does not negate this.  Electricity may be undifferentiable but its supply is from highly variable sources.  In terms of assembling inputs, the retailer must decide, based on its customers' and target customers' requirements:

• how much power to contract rather than buy at the day-ahead wholesale pool market
• how much of different sorts of power (baseload, regular peak, needle peak) to buy;
• how much price risk to take for the needle peak;
• how to respond to the customer's relative preference for some less tangible values (such as those associated with "green" power).

In many cases, the retailer will need to assist the consumer in defining her own needs.

This process will also include discovering prices at which interruptability might be rewarded, seeking out the customers who might find compensation for this of value and alerting them to the opportunities, and the mechanism for implementing such interruptability.

Important in achieving this are the vast differences in the value of electricity at known times of the day and the year and on ad hoc occasions.  The consumer, and her agent the retailer, have incentives to discover what cost savings they can make by shifting their demand out of those periods.  The corollary to the value to the parties of tailoring their needs to costs is the benefit of the system having a flatter load.  As electricity can vary in value on the National Electricity Market from $0-$10,000 per MWh, a flatter supply load means a clear social benefit. ⁽¹⁾  The retailer is under great pressure to seek out inputs from all sources.

Generally, retail competition in Eastern Australia has meant that retailers have been better focussed on needs, including time-of-day needs, and have been prepared to pay more for peak power or fast start, thereby encouraging the development of such plant.  This has greatly facilitated the ongoing tailoring of supply to market demand.

The retailer's role may also extend to offering energy-saving services or to offering certain services on condition that the customer undertakes particular actions, for example, installing power-saving globes.  The retailer will also seek out ways of saving money for itself and its clients and needs to be alert to potential economies of scope (or synergies) in bundling its goods together with other similar products, sharing services of specialists such as meter readers, back-office functions etc.  With the onset of Full Retail Competition, at least one Victorian retailer, is seeking to attract customers by offering a steep discount if the customer agrees to direct billing.

The retailer is compelled to be the agent of the consumer, as long as the consumer can move to an alternative agent.  The retailer is an agent in a far more comprehensive sense than any representative body because it has to weigh up the needs against the available product inputs -- and to do so correctly or face replacement.

A retailer, especially one under private ownership, has a very strong focus on profitability.  This means that they will raise prices either to discourage customers who impose too high a cost on the services they can offer, or better to align the costs those customers entail with the prices they charge.  Such activity also performs a valuable social function by better aligning costs and prices.

Of course, this process is stunted where full retail competition is not permitted. ⁽²⁾  It is also greatly facilitated by having more than one retailer.  Simply leaving existing retail functions in the hands of a single retailer is inadequate, even if the market is fully opened to additional suppliers.  A new retailer has to achieve critical mass and, if from interstate, embark upon a learning process, establish credentials and relationships with others in the supply chain and so on.  While all this is achievable, it raises the threshold, and means that the benefits of competition are likely to be muted or at least delayed.

Doubtless, a concern of the Task Force in opting for a single State Retailer is that WA may have too small a customer base economically to carry more than one retailer for the smaller customers.  This may be correct, but at the present time the optimal size of retailers in the energy business is still being determined and the initial decision of the government should not predetermine this.

In any event, it might be expected that out-of-State retailers will eventually seek to establish themselves in WA, either in association with an incumbent or as independents.  This should not be discouraged -- even by a government concerned to avoid privatisation of the electricity supply industry.  Indeed, as retailing under all Australian approaches is to be fully opened to competition, irrespective of the choices made by government owners, it is by no means certain that a State-owned system will prevail over private competitors.

These considerations aside, retail itself should present fewer ideological difficulties for an anti-privatisation administration than is the case with the "essential facility" functions of the poles and wires, or with the capital-intensive generators.

Our recommendation would therefore be for the State to allocate existing customers to one of two retailers.  We would favour both of these being privatised but in any event would not wish to discourage them forming alliances with other suppliers interstate, overseas and with the retail arm of Alinta Gas.

GENERATION

It is not possible to have retail competition operating effectively if there is no generation competition.  A retailer faced by a local monopoly has no incentive to search out the needs of the customer and package energy in ways that meet those needs most cheaply, since the generator's incentive to respond is stifled.

It is true that over time supply dominance will be eroded to the degree that it fails to fully respond to customer needs.  But this can take a very long time.  In the UK, the duopoly of the two major portfolio businesses which inherited the coal-based assets of the CEGB took over ten years to break down, even though this was assisted by the somewhat unexpected emergence of a more competitive fuel (gas) and resolute action on the part of the regulator.

During that period, it is reasonable to expect that the UK consumer lost in terms of the price of the energy available.  Although market forces may eventually extinguish such losses, their impacts are real.  This is all the more serious for Western Australia, because in contrast to the UK, Western Australia's energy and raw materials constitute one of the State's more important competitive advantages.

The potential for competitive provision given Western Australian structure

The Task Force considered it is feasible to separate the generation business into four independent units.  The arguments which it found persuasive against this approach could equally have been put (indeed were put) by every other integrated generation business that has sought to prevent disaggregation as a means of introducing competitive provision.

Chief among these arguments was the Task Force's view about the complementarity of Western Power's units.  In fact, this does not distinguish the WA business from that in any other jurisdiction;  it would be a strange business in any industry that did not develop its different component parts so that they were complementary.

Indeed, whether or not production is horizontally integrated, new capacity will frequently be designed to avoid head-on competition with incumbent capacity.  This is all the more so when the incumbent capacity has high sunk costs and is therefore unlikely to be forced out of production.  Hence, any new player would probably invest so that it was taking advantage of niche opportunities -- in other words, was complementary to the existing providers.

The Task Force's analysis proceeds to examine experiences in other States and concludes that WA is similar to South Australia, which a NEM Task Force in June of last year suggested did not have sufficient competition.

There are, in fact, alternative views about the competitiveness of South Australia.  A report by ABARE ⁽³⁾ observed no incidences of market power in South Australia for the period of its analysis.  South Australia experienced higher prices, but these were simply a function of the State's higher energy costs.  The ABARE report went on to argue, albeit controversially, that the South Australian outcome was in contrast to that of Victoria, where it claimed to have found market power.

Since mid-2001, the price in South Australia has closely tracked that of Victoria, and the tight supply situation has been changed as a result of the commissioning of Pelican Point, changed to such a degree that the Northern Power Station of Flinders Power is presently under-contracted.

South Australian capacity last year comprised:

Genco	Capacity (MW)	Fuel
Optima	1280	gas
Flinders	700	coal
Pelican	478	gas
Synergen	400	Gas/distillate
CUBE	180	gas
Origin	180	gas

There were three businesses that might be regarded as baseload plus the 500 MW interconnect with Victoria (for which firm contracts cannot be bought).

In SWIS Western Australia, Western Power could be divided into:

Genco	Capacity (MW)	Fuel
Muja	1040	coal
Kwinana	901	gas
Pinjar	586	gas
Collie	330	coal
Mungarra	112	gas

Western Australia also has other sources, which account for 20 per cent of the capacity in the SWIS.  It would be no less rivalrous than South Australia in terms of the number of independent players, and does in fact have more competitors than the three in NSW (four if Snowy is included) which by and large have brought vigorous competition.

In this respect, the size of Southwest interconnected market is about six per cent greater than that of South Australia, while generation is some 15 per cent greater.  Although examination of this matter would repay further analysis, prima facie it would appear that Western Australia can expect to see greater competition amongst generators than in South Australia.  The number of suppliers, four or five businesses split from Western Power plus the existing independent suppliers, is far from ideal.  This is, however, sufficient for workable competition.

THE TASK FORCE'S PROPOSALS TO BRING ABOUT INCREASED COMPETITION

Although the Task Force is disposed towards leaving Western Power as a single generation business, it examines certain synthetic structures to ensure that the integrated monopoly operates more as though it was in a competitive market.  Most of these "virtual arrangements", designed to provide some operational independence for particular portfolios of generation assets, are difficult to see as anything but poor alternatives to more genuine independence.

The corporatisation model under a single State ownership is most certainly deficient.  The shareholder Minister cannot realistically divide his own mind into different shareholder Ministers who must avoid divulging commercial in-confidence information from one firm to another for which he is responsible.  Corporatisation is, therefore, a poor substitute for privatisation of a disaggregated Western Power.  But both NSW and Queensland would plausibly contend that their State generators under independent Boards are capable of matching the efficiencies of their privately-owned counterparts.  It is unquestionably true, as a range of indicators demonstrate, that the present NSW generators are more efficient than when they were under a single "not-for-profit" ownership.  The mere implementation of a corporatisation framework would not have provided as potent conditions for promoting efficiency if the single generation business had been left intact.

The Task Force examines some means by which a greater commercial rivalry can be injected into the operations of a Western Power that remained under a single ownership entity.  Among the options considered is leasing the assets -- a course followed in France and in Ottawa, partly to reduce the risk to the government of having an asset that may face volatile market prices.

Leasing could offer the potential of providing equal incentives to full private ownership under certain circumstances.  These would certainly be the case under the South Australian model of very long leases.  Some success is also likely even from shorter-term leases, such as those pioneered in France by the water companies.  To apply these to electricity would need considerable thought, especially where the lessor saw value in putting in new capital.

All this said, if the Task Force take the view that there is inherently inadequate competition given the structure of the generation assets, no amount of tinkering with governance will provide an improvement.

Our own view on this matter is very different.  Our examination of other markets shows that Western Australia can have a workable market based on commercial rivalry.  And commercial rivalry is far superior to other means of trying to bring efficiency.

Reform in other jurisdictions offers blueprints for Western Australia.  Initial vesting contracts to the different generator entities is an important transition tool.  In the fundamentally contractual market that is invariably found in electricity, (except where not allowed, as in the failed Californian model) generators will be keen to ensure that they are contracted.  They will be equally keen to ensure that they are operating at least to the capacity of their contracted load, to avoid having to find replacement energy at potentially very high prices.

The alternative of continued monopoly provision does not provide the stimulus to improved efficiency and lower prices.  Western Australian electricity prices have been 25-40 per cent in excess of those of other major States.  Views differ on whether or not this is as a result of the efficiency of supply rather than intrinsically higher costs.  If monopolistic behaviour elsewhere is a guide, at least some of the costs would be reduced by competition.  The extent of these gains and their realization will be difficult to test unless there is a market with rivalrous suppliers operating beyond the current low market shares.

---

ENDNOTES

1.  In Texas according to a McKinsey article, around 30% reduction took place where metering allowed differential prices to be charged (prices were not specified);  see Power by the Minute, February 2002.  Similarly, Faruqui et al report that Georgia Power saw similar load reductions for their "most responsive' group with interval meters at prices of about 30 cents per kWh;  see Regulation Fall 2001 Getting out of the dark.

3.  See p.30f, of our Submission to COAG's Energy Market Review

3.  C. Short and A. Swan, "Competition in the Australian National Electricity Market," ABARE Current Issues (January, 2002).

Stop Strangling Telstra

Telstra has too many bosses.  It has the Commonwealth government and through them the electorate, it has its shareholders, a group which includes nearly every Telstra employee.  It has the Australian Competition and Consumer Commission, the Australian Communications Authority, and it has its customers.  Then there is the industry self-regulation, the Telecommunications Ombudsman, the Australian Communications Industry Forum and the Telecommunications Access Forum.  The net result is that Telstra shares will continue in the doldrums.  Investors know that Telstra is being pulled in too many directions, serving too many interests.  It is time that Telstra was set free to perform.

The nearer Telstra comes to full privatisation the higher the price demanded by the hold-outs, in particular the rural voters.  Like the proverbial widow sitting in the last house needed by the property developer there comes a time when the premium price is withdrawn, the developer gives up, or goes ahead without it.  There is a shopping centre at Caloundra in Queensland's Sunshine Coast where a little old house sits right in the middle of a shopping centre car park.  Presumably, the owner held out for more money, or just the fear of leaving home, and when the developer could wait no longer, the shopping centre went ahead anyway, complete with a house marooned in a sea of cars and shopping trolleys.

When the time comes you can be sure the beneficiaries of the estate will not reap a premium on the house.  Who would buy it, what rent would it command?  Are the hold-outs of the Telstra sale running the same risk as the shopping centre widow?  Will the desire to regulate and press further obligations on Telstra make it less worth selling and, more important, a less valuable corporation?

The failure to sell Telstra will create the worst possible economic and social outcome.  An inefficient Telstra burdened by increasing Community Service Obligations, a poor return with millions of dissatisfied shareholder-voters, a declining return to government and a weak international competitor with no capacity to raise capital from its principal shareholder.

Some of the old arguments for both keeping and for selling Telstra are looking shop-soiled.  The favourite of the "sellers" is that the government could retire debt.  The government no longer has a debt problem.  Previous asset sales like the first two tranches of Telstra and the Commonwealth Bank and Qantas and CSL and so on, took care of that.  The favourite of the "retainers" is that Telstra is a monopoly and could not be sold as a monopoly.  It now seems clear that is no longer so.  Competition in the sector is fierce, there are over 40 carriers in the market and some have been unable to survive the competition.  The real debate about the sale of Telstra is what is best for Telstra as a telecommunications company.  Not Telstra as a government entity, or a milch cow for the revenues, or as an asset to be realised, or as the saviour of rural Australia, or as the third favourite demon of the regulators after big oil and big banks.  No, just Telstra, Australia's biggest company.  The company being frigged about by every Tom, Dick or Harry who wants a bit of payback against anything big and bountiful.  Governments have to stop mimicking current affairs programs, playing the role of "protecting the little Aussie bleeder".  Australians are extraordinarily well protected in the telecommunications market.  But its time to let Telstra perform without the hobbles.

The regulation of the telecommunications sector is extraordinarily far-reaching.  There is a clear universal service obligation to ensure that standard telephone services and payphones are reasonably accessible to all people in Australia on an equitable basis, wherever they reside or carry on business.  There is continued access to untimed local calls.  There is the customer service guarantee.  There are special benefits for rural and regional customers of carriage service providers.  There is a price-cap regime.  There is a regulatory structure designed to stimulate competition.

The latest report of the ACA on the performance of the major telecommunications carriers demonstrates the very detailed scrutiny under which carriers perform.  There are measurements of how well Telstra performs in making new connections, in fault clearance, and for all mobile networks, call congestion and call drop-out rates.  Call centre performance and mobile number portability is measured for all carriers.

For those worried about foreign ownership there are restrictions on aggregate foreign ownership to a 35% ownership stake in Telstra;  and restrictions on individual foreign ownership to a 5% ownership stake.  Telstra's head office, base of operations and incorporation by law, must remain in Australia and its Chairman and the majority of its directors are Australian citizens.

And there's more!  Telstra and all other licensed telecommunications carriers are required under the Telecommunications Act 1997 to produce industry development plans for the development in Australia of industries involved in the manufacture, development and supply of facilities relating to carrier business;  and research and development activities relating to such industries.

The policy aim in telecommunications is clear, it was set out five years ago when the APEC Telecommunications Ministers endorsed a Fully Liberalised Telecommunications Services Sector.  Users should have a choice of suppliers.  Suppliers should be able to extend their business activity without restrictions on entering the market.  Suppliers and users should be able to benefit from a full range of competitive safeguards that would ensure non-discriminatory treatment of service providers and users.  Investors should have confidence to invest in the telecommunications industry and in companies reliant on telecommunications services.  Governments should have clearly defined responsibility to provide for transparent and non-discriminatory policy arrangements to meet the needs of their economies and provide for a full range of consumer protection measures.

Each of the elements of a liberalised telecommunications system in Australia is in place, including all the regulation required to ensure competition and fairness.  The debate over Telstra is no longer about the shape of the regulatory system, it is about Telstra the company.  It should be left alone to perform to its best.