Privatisation: lessons from public utilities

FOREWORD

Privatisation, the transferring of property rights (generally in major utilities) from government to private hands, is now being recognised by governments across the political spectrum in many parts of the world as a practical way of reducing waste, inefficiency and economic loss to the community.

Despite growing concern about the need for Australia to improve its economic performance, there are ominous signs that it is being left behind in a fast-changing world.  After its long history of good fortune, ossified attitudes and structures of privilege are not dislodged easily.

Those with a vested interest in opposing privatisation -- career and status-conscious administrators, feather-bedded employees, suppliers and users of subsidised services and other special client groups and beneficiaries -- remain major obstacles to reform, even as Australia's long-term economic malaise continues to deepen and it becomes increasingly plain that changes must be made.  We have the odd spectacle today of government monopolies spending large budgets on television advertising to defend their performances, and by implication their privileged, protected positions.

It is tempting for politicians to protect obvious advantages for a few voters even if it means greater but diffuse and less obvious economic harm for many.

The community at large which stands to gain from privatisation is not, election results indicate, opposed to it at the polling booth, but more than vague or glib political rhetoric is still needed to establish its credentials.  It must be seen as being immediately realistic, workable and effective.

In this study Richard Wood goes beyond rhetoric to examine the effects of privatisation with detail and economic rigour.  He examines the performance of some major public utilities and the unacknowledged motives that may be behind some of their policies.  His conclusions are realistic rather than Utopian, and the lessons he draws make important reading for those with an interest in political and economic decision-making, and in the future of Australia's economy.

Hal Colebatch

INTRODUCTION

Examining the output, employment, prices and wages policies of publicly-owned utility industries (such as those which supply electricity, telecommunications, postal services, natural gas, rail transport, and so on) provides insights into both possible gains from privatising government-owned enterprises, and some trade-offs involved in choosing different methods of doing so.

In this paper, we first review some of the evidence on the operation and management of public utilities with particular emphasis on electricity supply and telecommunications.  We then argue that the common elements in the policies of various state-owned industries arise from the fact that they are organised along similar institutional lines.

In particular, we focus on the incentives inherent in organising production in government-owned monopolies.  The incentives faced by management and employees in a government-owned monopoly are then contrasted with those in a privately-owned firm operating in a competitive market.  Using these insights, we are able to elaborate on some potential gains from privatisation.  The discussion also highlights some possible difficulties with privatisation, and demonstrates that the gain cannot be expected to be independent of the chosen method of privatisation.

Since we are interested in analysing the effects of institutional arrangements per se, we do not base our argument on assumptions of systematic differences in the attitudes, personalities or abilities of politicians, bureaucrats or private sector workers or managers.  This is not to say that individuals don't matter.  Neither is it suggested that there are no altruistic politicians, or dedicated bureaucrats.  Rather, we argue that incentives point in other directions, and that not only does this explain much about the general features ⁽¹⁾ of the behaviour of government monopolies and private firms, but suggests that the only reasonable approach to an evaluation of the consequences of different institutional arrangements is one which focuses on incentives.

PART 1
CASE STUDIES OF PUBLIC UTILITY OPERATIONS

This section summarises some important features of the operation of two publicly-owned utility industries in Australia.  It is based on research done at the Centre of Policy Studies and shall be used in the next section as a bench-mark against which theories of the operation of publicly-owned utilities can be judged.

In a report prepared for the Victorian Government, ⁽²⁾ staff at the Centre of Policy Studies made a simplified model of the State Electricity Commission of Victoria grid to obtain an idea of the costs of supplying incremental or marginal units of electricity to customers in Victoria in different "representative locations" and different "representative periods" of the year (See figure 1).

Figure 1:  The concept of marginal cost

It is important for consumers to know these costs if resources are to be used to our greatest benefit.  If consumers underestimate the cost of obtaining access to electricity they will tend to overuse it.  Conversely, if prices exceed marginal costs, consumers could use more electricity at a cost to the community which falls short of the benefit to consumers.

An important issue to consider in the context of providing goods like electricity and telephone service is that many of the facilities are jointly provided for more than one consumer.  For example, consumers wishing to use the telephone or electricity transmission system at one time of the day can use the same facilities provided to consumers at another time.  Also, a major transmission link operating with excess capacity will simultaneously serve a group of consumers.

Given that it is costly to expand capacity, it would not be efficient to ensure congestion never occurs, or, in other words, to ensure that the marginal benefit of access capacity was always and everywhere zero and thus below its marginal cost.  To ensure efficient use of community resources, it is important that prices charged at times or in locations where current facilities are congested reflect the marginal costs of expanding capacity or excluding other consumers from using the facility.

On the other hand, at "off-peak" times or locations, efficient prices will be lower since capacity is then essentially a "free good" (it has to be more than required by off-peak consumers in order to satisfy peak demand -- see figure 2).

Figure 2:  Peak and off-peak marginal costs with discrete sized units

Further, marginal operating costs are likely to be higher in peak periods when gas turbines, oil-fired plants, or older, less efficient, plants are used to produce electricity.

While the Centre of Policy Studies model produced approximate estimates of the marginal costs of electricity supply in Victoria, it showed divergences between SECV tariffs and marginal costs and some important determinants of SECV costs.

The most important observation is that marginal costs of electricity generation and high voltage transmission vary by location and time much more than do tariffs.  Further, while low voltage distribution, metering and billing costs vary by customer classification, the variation could not be large enough to account for the differences in tariffs by customer category:  tariffs do not appear to be closely related to marginal costs.

While it might be possible for consumers to be categorised and charged different prices so that the average revenue raised from a given category of customers approximated the average costs of supplying that category, the actual tariffs charged by the SECV are not closely related to such categorised average costs.  For example, the cost of electricity used for industrial, commercial and general lighting is much higher than marginal costs at any time.  Even if tariffs were related to average costs, so that, for example, consumers in a particular group who made heavy demands on the system when it is operating at peak capacity were charged a higher average price, the prices would still be inappropriate.  Total demand may be constrained in periods when costs are greatest, but no individual consumer would have an incentive to shift his demand through time.

Similarly, many tariffs charged by the SECV (and other Australian electricity supply authorities) are "block-declining".  The larger the quantity of electricity purchased, the lower is the price charged for an additional unit.

One might be able to justify block-declining tariffs, and higher prices for customers with few alternatives to electricity as an energy source (and thus a lower sensitivity or elasticity of demand to price increases), as a relatively efficient means for raising revenue to cover losses in an industry with large economies of scale.  In such an industry, marginal costs will be below average costs so that efficient pricing (prices equal to marginal costs) would not raise sufficient revenue to cover total costs (average cost times output -- See figure 3).

Figure 3:  Costs under economies of scale

Costs can be covered with least sacrifice of efficiency by charging highest prices to consumers who are least sensitive, thereby reducing demand below the efficient level by the smallest amount (See figure 4).

Figure 4:  Prices under economies of scale

However, we believe this is not the explanation of SECV tariffs.  Firstly, the tariff structure is too different from the pattern of marginal cost variation over time, and the differences between prices and marginal costs are too great, for the tariffs to represent an efficiency-maximising deviation from marginal cost pricing.  Secondly, our experiments with the model of the SECV grid suggested that the system was being operated in a region of decreasing returns to scale.  As one would expect, there is little evidence of economies of scale (in the relevant operating range) in the generation of electricity.  On the other hand, there are likely to be economies of scale in the distribution network.  Overall, it seemed to us that marginal cost pricing, given the current pattern and level of demand, could very well raise sufficient revenue to cover costs.  However, this assessment is qualified by the fact that the pattern of demand, and hence marginal and total costs, would be altered by the introduction of marginal cost pricing.

We argue further that block-declining tariffs actually used not only do not represent an efficiency-maximising attempt to cover total cost, but in fact lead to efficiency losses compared to marginal cost pricing.  The theoretically ideal block-declining tariffs would have all consumers paying the same price for the last unit of electricity consumed.  In fact, different consumers are charged a different price for the same product supplied at the same cost.  For example, the average commercial customer of the SECV, purchasing electricity for uses other than lighting, would not consume beyond the second step of his block-declining tariff, whose price is more than double the price paid by other consumers.  By charging different prices for the same product, the tariff produces inefficiencies since electricity is not consumed where its marginal benefits are greatest, or conserved where the benefit falls short of the cost.

Figure 5:  Price discrimination to raise total demand

While it appears that high tariffs for customers with a low elasticity of demand have little to do with efficiency, it is probably not coincidental that they are a good means of raising revenue to subsidise consumers whose demand is more sensitive to price, so expanding overall demand for electricity.  Similarly, while the SECV offers some very limited off-peak tariffs for some commercial and industrial customers, these appear to be designed to "fill in the valleys" in the weekly and daily patterns of demand more than to "lop off the peaks".  In short, the deviation from marginal cost pricing represented in the current tariffs serves to increase the demand for capacity in the system.

The subsidy to rural customers of the SECV embodied in the current tariffs might be thought more directly the result of political influence on SECV policy.  While the political influence of rural consumers is probably relevant, as we shall see, such a tariff differential may also operate to increase the geographical extent of the distribution of large quantities of electricity.  Hence, it may not be inimical to the interests of SECV bureaucrats and engineers.  Furthermore, maintenance of cross-subsidies to rural customers gives politicians a good reason for supporting the state-wide monopoly of the SECV and, for this reason alone, would be an attractive strategic policy for SECV bureaucrats.

Other features of SECV operations as well as pricing policy are of interest.  For example, why does the SECV not offer more specialised contracts allowing for interruptibility or the repurchase of excess privately-generated power at its marginal value to the system?  Such contracts would facilitate better management;  their under-utilisation suggests economising on system capacity is not important to the management.  The use of brown-outs or black-outs instead of interruptible supply contracts appears to raise the (political as well as economic) cost of shortages of capacity, leading to a greater demand for reserve capacity than would otherwise be the case.

Some commentators on the SECV (and other public electricity supply authorities in Australia) claim there is extreme over-manning in both the construction and operation of power stations compared with foreign and privately-owned Australian plants using a similar technology.  The Australian public utilities also appear to have less incentive to reduce construction costs than do private firms undertaking comparable projects.  Maintenance of SECV power stations appears to be worse than maintenance of the privately-owned station at Anglesea.  Finally, the workforces in public electricity authorities appear to be organised into strong and militant trade unions which have often met little resistance from their government employer to their demands.

If we examine the pricing and production decisions of Telecom Australia, ⁽³⁾ we can see similarities to the policies of the SECV discussed above.  First, the tariffs do not appear to be closely related to marginal costs.  While there is some variation in trunk charges ⁽⁴⁾ by time, this would not match the variation in marginal costs. ⁽⁵⁾  As with the SECV this would tend to raise the demand for system capacity.  An offsetting factor in the case of Telecom is that the revenue raised from trunk calls as a whole appears to exceed the costs of providing the service.  While some of this may come from off-peak trunk charges being considerably in excess of off-peak trunk costs, it is also possible that peak trunk charges could exceed costs.  The complicating factor is that peak trunk calls are likely to be made principally by businesses and hence the elasticity of demand may be much lower for this group of customers.  The twin aims of subsidising the demand for capacity and raising most revenue from customers with the lowest elasticity of demand would in this instance come into conflict.

On the other hand, there is no doubt that rural connections to the network are subsidised.  As in the case of the electricity industry, we shall argue that this cross-subsidy no doubt owes much to political influence.  Nevertheless, Telecom management and employees probably are not opposed to its tendency to expand the geographical extent (and possibly labour intensity) of Telecom's operations.

Another similarity between Telecom and the SECV is the use of non-price as opposed to price rationing.  In the SECV, non-price rationing takes the form of increased black-outs and brown-outs, a less stable supply and less prompt service in rural areas;  and the lack of flexible contracts (with interruptibility or buy-back provisions for example).  In Telecom, we find variations in the quality of service and speed with which maintenance is performed, as well as queues for connections.

An interesting difference between Telecom and the State electricity authorities is that competition with Telecom is explicitly prohibited by legislation, whereas only in some states of Australia is it necessary to get the permission of the electricity authority before power can be privately generated.  This differing legal situation may be related to differences in the economic structure of the two industries.  In the electricity industry, only in the power distribution grid is there a reasonable presumption of large economies of scale (or natural monopoly).

However, with government ownership of the grid, private generation can be discouraged by paying a very low price for electricity supplied to the grid.  In addition, the state electricity authorities are not called upon to pay income tax, are given preferred access to "dedicated" coal deposits, may borrow with government guarantees, and are generally able to use the state as an insurance agency if pricing and investment decisions should turn out to have been mistaken. ⁽⁶⁾

In contrast to the electricity industry, it seems that trunk-line operations in telecommunications may exhibit approximately constant returns to scale.  In telecommunications, natural monopoly elements in the industry are most likely to exist in the local networks, and government ownership does not suffice as a mechanism to squelch competition in the decreasing or constant returns to scale part of the business.  Instead, competition has to be explicitly excluded by statute.

PART 2
A MODEL OF PUBLIC UTILITY OPERATION ⁽⁷⁾

In this section we discuss a simple model ⁽⁸⁾ of public utility operation and show how it can account for the regularities discussed in the previous section.  The purpose of such a model is that we can use it to analyse the likely consequences of altering institutional arrangements.  In fact, any assertion about the likely result of institutional changes must at least implicitly be based on some theory about the way different institutions alter incentives to produce different results.

Our starting-point is the assumption that decision-makers (both politicians and enterprise managers) are concerned about non-pecuniary benefits as well as monetary payments.  A traditional assumption in economic models of bureaucracy is that bureaucrats want to maximise the output of the bureau.  Others have suggested that engineers working in the bureau may desire to maximise the amount of engineering input into projects.  More generally, we could think of managers as desiring some combination of inputs (which could correspond to output but may include plush offices, and fancy technology).  However, managers will also have to contend with employees, who will have their own goals.  Economists studying trade unions have suggested that a good characterisation of the aims of union leaders is that they attempt to maximise some combination of the wages paid to their members and the level of employment of their members.  (As a special case, they may be interested in the total wage bill paid to their members).  Depending on the relative bargaining strengths of the managers and workers, enterprise employees as a whole will be attempting to increase employment and wages with varying degrees of emphasis on each goal.

We would expect politicians to be concerned with the decisions of the utility and therefore to have an incentive to monitor it.  However, it will not be in the private interests of politicians to ensure the enterprise operates efficiently.  Each politician will be attempting to maximise the personal satisfaction and benefits from being an elected representative, but his actions will be constrained by the requirement that he gain enough votes to remain in office in the face of electoral competition from a representative of another party. ⁽⁹⁾

While we might expect electoral competition would tend to result in policies favoured by a majority of voters, there are several complicating factors.  Information is costly to obtain and disseminate, so that both government and opposition parties will always be uncertain of the effects of policies.  As a result the status quo is automatically accorded an advantageous position.  Also, voters will have an incentive to discover most about those policies most likely to affect them.  It would not be very wise for a voter to attempt to determine the effect of policies which he expects, a priori, would have only indirect or minor relevance to him.  Therefore policies which impose costs of minor relevance on a large number of voters, but bestow major benefits on a few, are likely to be successful.

Finally, in a majority-rule system, politicians, and thus their supporters, must compromise to form a winning coalition.  Even if voters knew certain policies had small detrimental effects on them, they would agree to such policies if, in exchange, they could get others to support policies with large beneficial effects.

In short, a representative political system based on majority rule will result in government policies which favour a coalition of minorities at the expense of voters not in the coalition.  A party could gain (and hold) office by proposing and implementing inefficient policies if the costs were dispersed across many voters and there are significant benefits to a politically influential group.  We should also note that inefficient policies may be far more effective at disguising the transfer than more efficient alternatives, and so may actually achieve a greater redistribution for a given political cost.

When establishing a public enterprise, politicians will have an incentive simultaneously to establish some procedure for monitoring it (such as reports to Parliament or accounting practices) to ensure it behaves in accordance with the political goals of the government.  Since private ownership of the net income of the enterprise is absent, profitability, or an adequate return on capital invested in the enterprise, will not be the most important goal.  The implication is that the goals will be diverse and may change over time.

It will be much more costly to monitor the achievement of a diffuse and poorly defined set of goals than to check on profitability.  Further, monitoring or accounting procedures effective for furthering one goal may not be effective for others.  The most desirable level of investment in any one set of procedures will depend on the anticipated returns.  Since the goals of the monitors of public enterprises can change from period to period, the optimal investment will be less than for a private firm with an unchanging goal.  Finally, when the enterprise is being established, it may not be in the interests of the incumbent party to make it too easy to force the enterprise to behave in accordance with the governments' objectives.  Supporters of the government may prefer to under-exploit their power to control the enterprise so that the opposition might also be less effective if it became the government.  In short, the preferred degree of monitoring or control of public utilities by politicians may be quite small and aimed at more diffuse goals than profitability or an adequate return on the investment in the enterprise.

Given that the quality of service provided by the utility can be varied in many dimensions, politicians will find it very difficult to determine the level of service being provided to consumers.  On the other hand, it will be much easier to determine the prices consumers are being charged.  Parliament can also impose on the state enterprise the requirement that its total revenue equal total operating costs (or differ from them by some fixed tax payment to Treasury or subsidy from general revenue).

Based on these considerations, we could approximate the goals of management ⁽¹⁰⁾ of state enterprises as some trade-off between increased employment and higher wages.  However, managerial discretion is limited by markets arid politically-imposed constraints.  First, politicians could be reasonably assumed to be capable of forcing the utility to keep total costs equal to total revenues net of taxes.  The taxes are payments to Treasury which could represent, for example, turnover taxes or "artificial" (typically artificially low compared with comparable private returns on capital) legislated rates of return on capital assets.  Second, politicians are assumed capable of specifying prices for different consumer groups.  In effect, the costs to politicians of monitoring prices are assumed to be much lower than the costs of monitoring levels of service.  By spending more on monitoring, the politicians are assumed to be able to force the utility to supply a level of service closer to the demand of customers at the politically-set prices.  Managers will also be constrained by markets.  Wages paid to employees must be at least as great as they could earn elsewhere, while output is limited by the amount demanded by consumers at the prices set by politicians.  The conferring of monopoly status on the utility could be seen as an attempt to increase demand at each price.

In turn, ⁽¹¹⁾ the politicians are assumed to set prices, a tax rate and a level of monitoring so as to maximise a "political support function" subject to the constraints that:

• employment, output and wages for a given setting of prices, tax rates and monitoring expenditure are chosen by the utility managers;
• wages do not fall below the competitive payments employees can receive in alternative employment;
• output does not exceed demand at the prices set by the politicians.

The "political support function" depends on the consumer surplus received by special interest groups, and the overall net contribution to general revenue after allowing for monitoring costs.

This set of assumption yields a model of the management and control of government-owned enterprises.  While such a model is necessarily a rough generalisation, we can nevertheless show that it implies government enterprises would tend to behave in many of the ways we see them behaving.  This in turn gives us confidence that the model can be used to investigate the likely consequences of organising production into public monopolies as opposed to private competitive firms.

One implication of the model is that output may equal that achieved under average cost pricing.  But for a firm whose technology displays short-run decreasing returns, average cost pricing will lead to an over-expansion of output, which is consistent with our observations in the previous section.  The over-expansion of output arises because the returns to capital are used to fund current operating expenses.  Compare this with the situation of private firms.  They have to compete for investment funds by offering a competitive return on capital.  Equity and bond markets can be viewed as markets which trade rights to corporate profits.  The prices of a firm's shares or bonds give an easily-observed measure of managerial performance.

In addition, individuals who can improve on managerial performance can buy a majority interest in the firm and gain financially from any improvements they make.  Similarly, taxpayers might be thought of as the nominal owners of a government firm.  However, rights to the return on capital in a publicly-owned firm cannot be traded.  It is more costly to monitor managerial performance than for a private firm and there is less incentive to do so.  The return instead tends to be dissipated on current expenditures with taxpayers called upon to finance investment.

The model is further able to demonstrate how output may deviate from the output achieved under average cost pricing depending on the influences of four factors. ⁽¹²⁾

• The degree of political support enjoyed by different groups of consumers can influence the structure of prices, with favoured groups being charged a price below average cost and disfavoured groups taxed.  When customers are a favoured (disfavoured) group the size of their subsidy (tax) will vary inversely with elasticity of demand, holding the effect of other influences constant.
• Non-price rationing may arise in response to differences in costs of monitoring prices and services.  In particular, the utility may find it optimal to ration those consumers the politicians attempt to favour by lower prices.  Non-price rationing may reduce output closer to the level which would be forthcoming under marginal cost pricing, but the non-price rationing may itself introduce inefficiencies as customers expend resources to move up queues, and services may be provided to those who value them less.
• To the extent that there are non-pecuniary benefits depending on something other than output, inputs will not be chosen to minimise costs.  In this case, output will fall short of the output supplied by a cost-minimising firm pricing at average cost.  However, the fact that output is not supplied at minimum cost will represent an inefficient use of resources.  We should also note that the absence of an incentive to cost-minimise may lead to a de-emphasis of commercial skills in the internal incentive structure of the enterprise.  On the other hand, any technical advance which enables a given output to be produced with fewer inputs will be of value to the managers, since then they can produce extra non-pecuniary benefits or make higher factor payments without altering output.  This may explain the fact that many public utilities have internal management structures which reward technical but not commercial expertise.
• Finally, employees may be paid in excess of their competitive market wage, and this too will raise costs when compared with a cost-minimising firm which takes all factor prices as given.

Deviations between average cost pricing and actual tariffs were noted in our discussion of public utility policy in the previous section.  These deviations can be related to each of the four factors just outlined.  We observed that the relative prices charged to different customer groups were related to differing degrees of political support and differences in elasticities of demand.  We noted that non-price rationing is often observed in publicly-owned utility industries.  There is also some evidence that capital may be chosen in part to provide non-pecuniary benefits while employees are paid in excess of their competitive return.  The apparently complex and inexplicable behaviour of publicly-owned utilities can in fact be explained as quite rational choices within the institutional framework.

The ability to use public utility prices to cross-subsidise favoured groups of consumers will give politicians an incentive to support the existence of a government monopoly, even though it is less efficient than delivering the same service using privately-owned competitive firms.  Achieving the same cross-subsidy through explicit taxation may be less desirable for politicians.  It is much easier for the taxed individuals to perceive the costs when taxes are explicit than when the taxes take the form of divergences between prices and marginal costs.  Also, if competition with the public utility is allowed, the ability to charge some consumers in excess of marginal cost in order that other consumers may be subsidised is severely curtailed.  The "taxed" consumers will instead purchase from private competitors leaving the public utility making operating losses on the services it provides to subsidised customers.

PART 3
THE PRIVATELY-OWNED FIRM

A series of recent papers, such as those by Jensen and Meckling [1976] and Fama and Jensen [1982], have examined the incentive structure of private firms.  In owner-managed private firms, the owner-manager has an incentive to maximise the present value of his assets and generally reduce the cost of production.  In large private firms, managers will normally be employed by the owners (share-holders) and this separation of ownership from management may reduce pressures on management to run the firm efficiently.  So long as his individual share in profits remains small, any one owner will not have a great incentive to force managers to operate the firm efficiently.

However, competition between managers, and more particularly transferability of ownership, will limit the divergence between the aims of managers and share-holders.  Furthermore, it will be in the private interests of those first establishing the enterprise to set up effective, low-cost mechanisms by which the share-holders can monitor the behaviour of managers.  Only then will the value of shares in the enterprise be maximised.

It will also be in the private interests of subsequent share-holders to carry out the amount of monitoring implicit in the share's purchase price, for to do otherwise would result in a fall in the value of the shares.

If ownership becomes very diffuse and managerial efficiency declines, individuals (or other managers on behalf of individuals) will have an incentive to purchase a controlling interest in the firm, increase efficiency, and realise a capital gain in their shares.

In summary, transferable property rights will encourage the pursuit of profits and hence the search for ways of reducing production costs or producing more valued outputs.  By contrast, we noted in the previous section that the absence of explicit claimants to the returns to capital in publicly-owned firms produces a bias in such firms towards an over-expansion of output and a general under-valuation of capital inputs.

PART 4
SOME LESSONS FOR PRIVATISATION

Having achieved some understanding of why publicly-owned firms behave the way they do, and compared their operation to privately-owned firms, we can outline some of the potential benefits and costs of privatisation.  The monitoring of profit-maximisation tendencies of managers by share-holders is likely to produce more cost-effective production than the political monitoring discussed in the previous section.

However, privatisation alone is not sufficient to deliver the benefits of a market system.  The other crucial ingredient is competition.  While private ownership provides an incentive to maximise profit, and hence reduce cost, without competition the private firm will be able to charge a price in excess of its marginal cost.  This, too, will result in an inefficient level of output.  The cost to society of increasing output of the good in question would fall short of the benefits to consumers from doing so (See figure 6).  While a publicly-owned monopoly will have a tendency to over-produce, a privately-owned one would have a tendency to under-produce.

Figure 6:  Monopoly pricing and efficiency

Thus, many of the potential efficiency gains from privatisation may not be captured if the public firm is turned into a private monopoly.  For many public utilities this might be thought to cause a serious difficulty.  It is often argued that the technologies in these industries are such that even if a large number of competing firms start out in the industry there will be a tendency for just one of them to become dominant -- the industry is characterised as being a natural monopoly.  The basic requirement for an industry to be a natural monopoly is that the average costs of producing output continually decline as more output is produced (See figure 2).  In that case, the largest firm will always have the lowest cost and thus, it is argued, can undercut its competitors and drive them out of business.  It is also argued that the economies of scale in setting up distribution networks turn many public utility industries into natural monopolies.  However, while such economies of scale do appear to pertain to the establishment of an electricity distribution grid and a local telephone network, they do not apply to electricity generation or, particularly with recent technological innovations, the trunk telephone network.  Thus, while the natural monopoly argument may provide a prima facie case for regulation of firms involved in providing local telephone networks and the electricity distribution grid, no such case is provided for regulation or public ownership of firms engaged in electricity generation or trunk telephone services.

In addition, the natural monopoly argument has itself come under increasing questioning in recent years.

Even if the largest firm has a cost advantage and drives its competition from the market, it may not then act as a monopolist.  As soon as it attempts to charge prices in excess of its marginal costs it will provide an incentive for competition to enter the market and attempt to capture some of the monopoly profits.  So long as the costs of entering and leaving the market are not too great such potential competition will limit the extent to which prices can exceed marginal costs.  In short, the threat of competition might be nearly as effective in enforcing low prices as the presence of actual competitors.

Nevertheless, if maximum efficiency gains are to be obtained from privatisation, attention must be paid to the competitiveness of the resulting market structure in addition to the ownership of the firms.

The second lesson to be learned from the above analysis is that it will be virtually impossible to privatise most government enterprises without affecting adversely both the employees of the enterprise and some groups of consumers.  The inefficiency of government ownership is associated both with the production of rents for employees and cross-subsidisation of some consumers by others.  If we attempt to privatise while avoiding losses for these groups we will probably forego many, if not all, the efficiency gains.  The efficiency gains from privatisation mainly take the form of a set of prices which more closely match marginal costs, a use of technology which minimises economic costs as opposed to employee welfare, and a level of output which more closely matches marginal costs with marginal benefits.  One way of reducing costs for the affected parties is to phase the changes in gradually.  However, this also delays the gains from the change, and may give opponents of the policy more time to prevent or obstruct its implementation.

The third lesson is that criticisms of privatisation on the grounds that only the profit-making parts of the business will be sold, leaving the taxpayers to fund the losses, largely miss the point.  At the moment, taxpayers are called upon to fund investment in government-owned enterprises which earn less than the competitive return on invested capital.  What should be a return to investing in the enterprise is instead dissipated in over-expansion, over-payment of employees, the use of inefficient technology or the subsidisation of some consumers.

In addition, the loss-making parts of the business are often cross-subsidised from other consumers.  It is not as though privatisation introduces a new need for tax revenue -- if the cross-subsidised consumers continue to be subsidised, privatisation changes the form in which existing taxes are paid and who pays them.  The advantage of privatisation, however, is that it reduces the cost inefficiencies which lead to a greater need for subsidisation in the current institutional framework.

The fourth lesson is that the way privatisation is carried out could make a difference to the efficiency gains.  In particular, if shares in the new firm are widely distributed to consumers and former employees in an attempt to avoid disadvantaging them, the ownership in the new firm will be very diffuse.  While it might become more concentrated over time, the Bell Group takeover bids for BHP in 1985 and 1986 illustrate that it can be difficult to discipline management in a widely-held firm.  In consequence, the owners will place less pressure on management to maximise profits and hence reduce costs.  In general, the government should choose a method of privatisation, and accountability of managers to share-holders, which maximises the sale value of the shares.

The final lesson from the above analysis is that the industries we choose to privatise should yield benefits concentrated on some influential groups in addition to the more diffuse efficiency gains.  Since politicians appear to gain from government ownership it will be politically unpopular to privatise.  How can the politicians gain even though the institution is less efficient?  The basic reason appears to be that the costs are diffused over a large number of individuals (consumers and taxpayers) while the benefits of public ownership, while lower in aggregate amount, are concentrated on smaller groups (employees and favoured consumers) who are apparently more influential.  Conversely, the benefits of privatisation will tend to be diffuse while the costs are concentrated.  The most successful privatisations will therefore be those firms where government monopoly has begun to impose increasing costs on politically influential groups of consumers.  For example, government monopolisation of Australian coastal shipping has gradually imposed greater costs on certain regions or industries (such as mineral processing).  These groups might be expected to provide a political counter-balance to the employees who would be adversely affected by privatisation of the ANL coupled with an opening of Australian coastal trade to free entry.  Similarly, those living in more distant parts of the continent might provide a powerful advocacy in favour of privatising TAA along with deregulating the domestic airline industry.  As another example, the introduction of AUSSAT has provided an opportunity for AUSSAT and the trunk network of Telecom to be privatised, with the likelihood that a reasonably competitive long-distance telecommunications market could be produced, benefitting, in particular, users of such services for data transmission.  In the case of the electricity industry, it would appear that considerable efficiency gains could be reaped by encouraging more private generation.  This could be quickly done if co-generated power (that is electricity produced as a by-product from some other industrial process) were paid its marginal value to the system.  Advances in electronic technology now make it more feasible to pay a time-varying price for privately-supplied power, while firms in a position to supply co-generated electricity might be expected to be strong advocates of a change in policy.

PART 5
CONCLUSION

We have argued that many of the peculiar features of utility operations result from the incentives inherent in government ownership of a legislated monopoly.  These same incentives lead to the efficiency losses associated with government-owned firms.  Privatisation of many government enterprises can lead to efficiency gains so long as care is taken to ensure the resultant market structure is competitive, that is, subject to freedom of entry and exit.

Privatisation is also likely to involve losses for those currently advantaged by government ownership.  Attempts to reduce these losses by making the private ownership diffuse and expensive to trade will also reduce the pressure on management to behave efficiently.  This, too, will be less of a problem if the markets are competitive.  Other firms will then put some pressure on management to control costs even if shareholders have little incentive to do so.

Finally, we noted that privatisation is likely to be politically unpopular.  We suggested that for this reason the best firms to privatise are those where some concentrated interests stand to gain from the increase in efficiency and/or removal of cross-subsidisation.  In Australia, the most obvious candidates would appear to be the ANL and TAA.  One might hope that those living in more distant parts of the continent would provide a political counterweight to the current beneficiaries of government ownership and regulation in the transport sector of the economy.

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ENDNOTES

1.  In contrast, some particular decisions of governmental (and private) bodies do appear to be explicable only if we also take account of some particular facts about the personalities or attitudes of important decision-makers.  No model of private or public enterprise would be capable of ruling out magnificent, or disastrous, decisions in either enterprise due, say, to the presence of a brilliant, or hopeless, administrator.  We cannot hope to explain all, but just theories which may illuminate the inherent features of the organisational form.

2.  Centre of Policy Studies [19821, see also Hartley and Trengove [1984].

3.  See Trengove [1982].

4.  The costs of metering may exceed any benefits from peak-load pricing of local calls.

5.  Under marginal cost pricing, demand would equal capacity in several periods so capacity costs would be spread over all these periods.  Relative prices in the different periods would then be set to ration demand to the available capacity.

6.  Recent changes of government policies, such as required rates of return on assets, valued at market prices, may have tipped the scales somewhat in the direction of private companies.  Nevertheless, the price paid for private power has not been changed to reflect its marginal value to the system and many of the concessions to the state electricity authorities remain in place.

7.  For further details of this model see Hartley and Trengove [1986].

8.  The model can be complicated in various ways to increase the extent to which it accounts for the behaviour of public utilities -- see Hartley and Trengove [1985].

9.  See for example Downs [1957], Breton [1974] or Mueller [1976] for similar models of the representative political system.

10.  See Hartley and Trengove [1986].

11.  Following Peltzman [1976].  See also Hillman [1982].

12.  For further details see Hartley and Trengove [1986].

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BIBLIOGRAPHY

Breton, A., The Economic Theory of Representative Government, Chicago, Aldine, 1974.

Centre of Policy Studies, Monash University, Energy Pricing Issues in Victoria, A report prepared for the Long Range Policy Planning Committee of the Victorian Government, Victorian Government Printing Service, January 1982.

Downs, A., An Economic Theory of Democracy, New York, Harper and Row, 1957.

Fama, E. and Jensen, M., Residual Claims and Investment Decisions in Organization, Mimeo, July 1982.

Hartley, P. and Porter, M.G., Pricing of Electricity and Questions of Ownership, paper prepared for the conference on the Economics of Electric Power Systems, AGSM, July 1983.

Hartley, P. and Trengove, C., "Who Benefits From Public Utilities?", forthcoming, in Economic Record, 1986.

Hartley, P. and Tengove, C., "The Marginal Costs of Electricity Supply in Victoria", Economic Record, December, 1984.

Hillman, L., "Declining Industries and Political Support:  Protectionist Motives", American Economic Review, December 1982.

Jensen, M. and Meckling W., "Theory of the Firm:  Management Behaviour, Agency Costs and Ownership Structure", Journal of Financial Economics, Vol. 3, 1976.

Mueller, D., "Survey on Public Choice", Journal of Economic Literature, Vol. 14, 1976.

Niskanen, W., Bureaucracy and Representative Government, Chicago, Aldine, 1975.

Peltzman, S., "Towards a More General Theory of Regulation", Journal of Law and Economics, August 1976.

Porter, M.G., (ed.), The Australian Monetary System in the 1970's, Monash University, 1978.

Swan, P., Pricing of Electricity to Alcoa at Portland, Victoria, Submission to Senate Standing Committee on National Resources, 1981.

Trengove, C.D., Telecommunications in Australia:  Competition or Monopoly, Centre of Policy Studies Special Study No. 4, 1982.

Environment: conservation and economics

FOREWORD

When asked to provide a foreword to this publication I welcomed the opportunity on the grounds that any improvement to the environmental impact assessment (EIA) process should be supported and encouraged.

There is no doubt that the EIA process is in disarray and some of the reasons are detailed in this particular presentation.  However, it is also true that there are some heartening and significant changes in the process taking place, partly due to the efforts of individuals like Richard Wood who clearly perceive problems and persevere with their exposition.

The author has a philosophy containing elements with which I personally disagree.  I cannot agree that uses of the environment and the value of such uses are fixed according to their effects on humanity.  Nor can I agree that the environment has no fixed value.  The environment is that which supports not only man, but all life in the biosphere.  Thus it has a clear primary value -- survival of life, which must make other values secondary.  I believe environmental value extends beyond human use only.

I cannot conceive the environment is a scarce resource, but readily agree that some aspects of the environment are scarce resources and must be treated accordingly.

Despite my minor quibbles, the important points made by the author are:

• That the EIA process in Australia tends to be a case-by-case process and so tends to ignore the totality of the community and its indirect collective and synergistic effects.
• That environment is significantly undervalued when cost analyses are done.  This relates very much to the case-by-case process and the lack of total awareness, both by the authors of EIA documents and the decision-makers working with them.
• That the timescale involved in the EIA process is not only consuming and costly, but many small or marginal projects are adversely affected by this timescale.
• That the prescriptive role of the decision-makers (the government) is not backed by any responsibility role should the prescription fail.

These and other evident (to some) facts about current environmental assessment processes are contained in this publication and all who work in, or have a general interest in, this vital area will find the document particularly valuable.

Further, the author discusses one possible solution in the form of emission taxes which involve the polluter paying, based on the amount of emission to the environment.

Another possible solution offered is pollution rights which can be leased or acquired by developers with an entitlement to carry out pollution up to a pre-determined level which turns the right to pollute into an economic structure governed by open market factors.

In passing, it is pointed out that standards set by many decision-makers do not encourage development of new or varied methods of treating pollution control or environmental damage.  In fact, they mitigate against these because the decision-makers prefer to rest on protocol and precedence, rather than on the value of alternative methods.

For more than thirty years I have professionally worked in the field of environmental damage mitigation, prevention and restoration with some success.  In that time I have seen massive changes in the bureaucratic overburden of development in the name of the community.  At the same time I have seen a growing trend towards the socialisation of decision-making with the general public being invited to address environmental issues.

This is not necessarily a bad thing because it can bring out many aspects of problems and help final decision-making.  However, it can be very bad indeed when professionally organised and funded groups of anti-developers, or people with a particular political leaning, skilfully use the media to divert public attention from the environmental issues of the case into sociological or ideological issues which really have no bearing on the matter.

Environment is the sum total of resources that surround and support man and other life in the biosphere.  Development is the utilisation of any of those resources for any purpose at all by mankind.

Conservation is the management of development in such a way as to yield the greatest sustainable benefits to the present generation of mankind, while maintaining potential to meet the needs and aspirations of future generations.

Thus, the underlying message of this document is that ideally environmental impact assessment would be another name for conservation -- not preservation, but management of the human use of the biosphere and its components.

The process has a long way to go before it reaches that ideal, but publications such as this one move towards the clarification and eventual achievement of that ideal.

And that achievement is urgent.  In today's world we have sufficient awareness, technology and ability to carry out conservation for now and for the future, but we lack incentive and initiative.  Individuals who work in the environmental area are aware of the major problems facing humanity across the world today.  Unless adequate action is taken quickly to remedy the extinction of species and the degradation of the natural environment, there will not be a human future, and therefore no concern with the EIA processes.

W.H. Butler

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INTRODUCTION

With increasing population, growth in Gross National Product and changes in technology and in human and social values, pressures on the natural environment are increasing.  There is a problem of how to allocate the environmental resource among competing uses for the maximum benefit.

This paper concerns choice among alternative uses of the environment.  It concentrates on the implication of public policy framework for choices ultimately made, and specifically on the Environment Impact Assessment (EIA) process.

Environmental policy is usually deemed the domain of engineers and physical and biological scientists, who determine the technical parameters, and of politicians, who choose or are pressed to choose among the identified options.

However this paper is written from the perspective of an economist.

I will argue that the dominance of political and technical considerations at the cost of economic ones has resulted in a generally inferior public policy framework and a waste of potential benefits.

This paper discusses the economic approach and then examines shortcomings of the Environmental Impact Assessment process.

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CHAPTER 1
THE ECONOMIC APPROACH

In economics the environment is seen as a composite asset providing a wealth of "services".  Raw materials are transformed into consumer products, energy, and consumer goods.  The basic necessities of life -- food, drink and shelter -- are all received directly or indirectly from the natural environment:  the life-support system which sustains our existence.

The environment is, however, limited in its capacity to accommodate all the uses society demands of it, which range from numinous and aesthetic consciousness via farming and mining to waste disposal.  Not only must society choose between alternative uses of this scarce asset, but it must also prevent undue depreciation of the environment's value so that it may continue to sustain us and our children.

Demands, often conflicting demands, on the environment will continue to increase with growth in human population, technology and leisure.  Such demands will in turn further enhance the value of the environment as an asset.

The issue is not the simplistic one of whether or not to preserve the environment for preservation's sake.  Rather, we must identify the optimal use of the environment over time.  The rational approach is to maximise the value of the environmental asset by finding a balance between high future value and preservation, and the present uses of that asset.  To do this it is necessary to attach some sort of value to the various services received and services foregone.

From the economic point of view, this attribution of value is decidedly anthropocentric or human-centred.  The uses of the environment are given values according to their effects on humanity.  The environment has no fixed value:  its value derives from the uses to which it is put.  It must however be stressed that "effects on humanity" include for example the pleasure one takes in unspoilt landscapes, the pleasure one takes in the mere thought of unspoilt landscapes and all sorts of other "psychic" effects.  Likewise "uses" include wildernesses, national parks, and possibly (in the case of the South American rain forests) global oxygen sources.

The concepts of substitution and opportunity cost are fundamental to the ascertainment of values.  People are willing to make substitutions amongst alternative goods.  For instance, even most conservationists would be willing to give up some amount of amenity value of the Franklin River if the reduction enables them to get greater access to that environment in the future.  There are seldom all-or-nothing choices.  People do not consume goods in fixed and unchanging proportions but change the proportion in which goods are consumed or used in response to circumstances.

The necessity of substitution among scarce resources provides us with a concept of value that is based on the observable behaviour of individuals in making choices.  Value can be measured by the amount of other goods one is willing to give up to obtain a good.  Value of goods is measured by the opportunity foregone to obtain them.  Lest criticism is made of the use of money as a proxy for value, let us clear up any basic misunderstanding of the role of money values in economic analysis.  Essentially what economists try to do is to record people's preferences by observing their willingness and ability to forego a resource.  While choices in the market-place are the most obvious and comprehensive source of information, individuals choose between alternatives every day of their lives.  They make choices about both market and non-market goods, such as environmental and religious goods.  The principles involved in studying such preferences are no different whether there is a market or not.  The absence of a market makes the practical task of preference evaluation more difficult, but not less essential.

Implicit in the idea of preference is that people make choices to improve their lot in life.  Economists assume people make choices with the purpose of increasing their satisfaction or well-being.  People are assumed to act rationally, being able to determine within limits what they want and trying to fulfil as many wants as possible.  People do make mistakes, mainly because they have incomplete information, but this does not negate the assumption of rational behaviour.

The assumption that individuals make choices to improve their lot does not suggest that these choices are always materialistic.  Environmental conservation itself, for example, owes a great deal to individuals who have voluntarily foregone material advantage by refraining from environmentally destructive (but potentially profitable) actions, or by spending their time working actively for conservation (for the sake of endangered wildlife, for the community, or for posterity) with little or no material reward.  Nonetheless, these are courses of action they have voluntarily preferred and chosen believing they will confer the greatest good.

All that economics assumes is that individuals have desires.  These may include desires for material things but also "things" that are purely aesthetic, intellectual or spiritual.  Even when purely non-materialistic criteria are used, there may still be a process of choice between conflicting or competing ideas and values:  a wilderness or swamp may be thought by some better left alone than transformed into a garden or parking lot.  An historic ruin may be thought by some better left alone than restored and transformed into a lifeless museum.  In Britain the Department of the Environment has been coming under criticism for, with perhaps the most non-materialistic of intentions, "packaging" ancient monuments like Stonehenge to the point where their quality of "otherness" is, albeit inadvertently, destroyed.

In the treatment of a scarce resource such as the environment, choices are inevitable.  Consequently there must be criteria for judging the desirability of different uses and these must be based on human use values.  A primary criterion for choosing amongst the various uses is called allocative efficiency.  An action is said to satisfy the efficiency criterion if the net benefit from the use of the resource is positive.  Actions are inefficient when the benefits are less than the cost.

One may mention here two other efficiency concepts:  technical efficiency and administrative efficiency.  The former refers to the least costly method of producing a given level of benefit, while the latter refers to the method that yields the minimum administrative cost for a given action.  Technical and administrative efficiency are necessary but not sufficient conditions for allocative efficiency.  To produce a particular good at least cost (thereby achieving technical efficiency) does not necessarily imply an efficient allocation of one's limited resources across all goods.  Technical efficiency (which does not only entail using the smallest amount of particular input) is only part of the story.  For example it is often said that one type of farming is more (technically) efficient solely because it uses less energy than others.  But energy is only one of the inputs in the farming process:  all inputs have costs which must be accounted for, for example the cost of pesticides or fertilisers.

There is in economics the idea of methodological individualism:  how individuals, rather than groups, respond to opportunities that exist is a subject of study.  When considering what is done in the name of an Environmental Protection Assessment we should analyse the choices and actions of the individuals that make up that EPA.

One can then evaluate the effect of institutional setting on human behaviour and recommend how institutions may be rearranged.  The task is to suggest changes in institutions rather than in behaviour.

ALLOCATIVE EFFICIENCY AND COSTS/BENEFITS

Allocative efficiency turns on the social costs and benefits of alternative uses of the environment.  Measuring demand and supply also lets us measure these costs and benefits.

The demand curve measures the marginal benefit derived by a collection of individuals from the use of the resource, while social costs are depicted by the marginal cost or supply curve.  Imagine for example a steel mill dumping chemicals into a nearby stream, reducing the cleanliness and value of the water for, say, swimming downstream.  The problem is the allocation of the water resource amongst two competing uses, steel production and swimming.  In Figure 1, the demand for the use of the water as a receptacle for chemical by-products in the production of steel is represented by the line DD.  The quantity of water used in production of steel is measured along the horizontal axis.  The vertical axis measures values, in terms of willingness and ability to forego some scarce resource, or, if one wishes, by the willingness and ability to pay for the use of the given quantities of water in steel production.  The demand curve thus shows the amount one is willing and able to give up for each additional unit of a good (water).  Note, the demand curve is downward sloping.  This means that the more of a good one possesses the less willing one is to give it up for another unit.

FIGURE 1
Alchian and Allen (1983)

Water, however has an alternative use.  The collective value of the alternative use is shown by line SS.  Starting from the lower left and going to the upper right, it shows the increasing value for lesser amounts of fresh water.  SS depicts the cost of using water to produce steel in terms of opportunities (swimming) foregone.  In contrast to the demand curve, the value of water for swimming is an increasing function of the amount of water used and polluted in steel production and not available for swimming.  This illustrates a fundamental characteristic of supply:  that the cost of additional units of any good or resource will eventually begin to increase.

The optimal level of pollution and clean water is the level where net benefits are maximised.  This is achieved where the marginal benefits from, and the marginal cost of, using water in steel production are equal.  Assuming that the stream is to be restricted to only these two uses, X is the most efficient level of water quality;  any other quality level would result in a lower net gain to society.

The ethical basis for the efficiency criterion is derived from a concept called Pareto Optimality.  An allocation is said to be Pareto Optimal if there exists no rearrangement of that allocation that would benefit some people without any deleterious effect on someone else.  Allocation of environmental assets are sub-optimal under this definition when it is still possible to reallocate the asset among competing uses so that some people are better off and no one is worse.

As indicated at the onset, this choice of the criterion is normative.  Though the Pareto Optimal criterion seems reasonable it is not universally accepted, because the concept involves personal judgement.  First it rests on the assumption that each person has the right to judge what is best for himself.  Secondly it assumes that present income and wealth are equitably distributed.

PROPERTY RIGHTS

When the environment is used inefficiently, the benefits to society are not maximised, and this is today a major problem.  To understand why this problem is so prevalent we must have some understanding of the concept of property rights.

Property rights refer to the bundle of entitlements defining the users' rights, privileges and limitations in the use of the resource.  By examining such rights we can understand how the environmental problems arise from both market-directed and government-directed uses.

In a market system individuals can exchange goods and resources for mutual gain.  Since Adam Smith articulated the concept of the market's "invisible hand", it has been recognised that under certain conditions markets where goods and resources are freely exchanged lead to efficient allocation.  One of the prerequisites for effective markets is private or exclusively held property rights to goods.

If property rights to goods and resources are well defined, enforceable and inexpensive to transfer by sale, the market system, in controlling the use of goods through prices, induces individuals to act in their own, and in society's, best interests.  Society's best interests are served because an individual who maximises his gains also maximises society's gains.

Since it is the individual who receives the benefits from the use of the resource he will seek to maximise his gains in rational pursuit.

If, however, the private property rights are not exclusive, the individual who pursues his own interest, does not necessarily act in society's best interest.  If the gains from or costs of a specific use of a resource are not exclusive to a particular individual, he will only consider those gains or costs that accrue to him in deciding on the uses of the resource.  The gains or costs external to him (called externalities or spillovers in economics literature) are not taken into account by him even though they are borne by other individuals in the society.

An externality thus exists whenever the welfare of any individual depends directly not only on his or her own activity, but also on activities under the control of some others as well.  Externalities can be either negative or positive.  For example, a positive externality arises where land is left vacant and those living on adjacent properties enjoy the open space of the vacant land.  The benefits to adjacent occupants are not likely to be seriously considered by the owner of the vacant land when deciding the use of it.  A negative externality arises in our previous example of steel production and water pollution -- which also illustrates the role of property rights.

What output of steel would result, if the property rights to the water body are not held exclusively by the steel producers?

Naturally, the steel producer, in its desire to maximise profit, will not consider the effects this activity will have on the water body unless it suffers the effects of this action.  Accordingly the steel mill will produce a maximum level of polluted water.  This scenario translates into Figure 2 which shows the effect of this external cost on the steel industry.  The demand for steel is shown by the demand curve DD and the marginal cost borne exclusively by the producer of steel is depicted by S_p where the horizontal axis depicts quantity of steel consumed/produced and the vertical axis depicts price/cost.  Society, however, also considers the cost of the poorer water quality and the cost of controlling or abating it.  These additional marginal costs when added to the private marginal cost (S_p) yield the true or social supply curve (S_s).  If, as we have implied, no pressure is brought to bear on the steel producers to control their dumping of waste, they would seek to produce Q_p level of steel.  That level would maximise its private gains.  But clearly the Q_p level of production is inefficient, since societal gains are maximised at Q_s (i.e. where the value of another unit of steel equals the costs of production of that unit) not Q_p.

A number of conclusions about a market allocation of environmental resources in the absence of exclusive property rights over the asset may be drawn from Figure 2:

• The output of the commodity is too large.
• Too much of the environmental resource is used.
• The prices of the products responsible for pollution are too low.
• There is no incentive to avoid ways to yield less environmental resource per unit of output.
• Research into means of production which use less resource are discouraged since the alternative provided by the environment is so artificially cheap.

FIGURE 2

The effects of market imperfection derived from externality end up affecting the demands for raw materials, labour and other inputs.  The ultimate effects are felt through the entire economy.

Two types of resources give rise to externalities.  The major type is common property resources.  Common property resources are not exclusively controlled by a single individual.  Access to the resources is not restricted, and therefore, the resources can be exploited on a "first-come, first-served" basis.  The environmental asset is a common property resource so no one person has an incentive to ensure that the resource is used in a manner which maximises society's welfare.

Public goods too give rise to externalities.  Many components of the environment such as air, water and biological diversity are public goods.  Public goods exhibit consumption indivisibilities:  they can be used without payment or contribution to the production costs, once they exist.  Each individual therefore, has an incentive to obtain a "free ride" on another's cost of producing the good even if each individual values the public good highly.  As this "mis-representation of true values" is characteristic of public goods, there is no incentive for an individual to produce or indeed maintain a public good for which no price can be charged or cost recouped.  Neither the market nor any government directed allocation is likely to yield an efficient amount of a pure public good.  Naturally some goods, defence and education for example, vary in the extent to which they are public (the spill-over effect of research associated with higher degrees is a public good from education, while defence is a private good to an individual when his life is in immediate danger from an invader).

Some public goods may be privately supplied.  In the matter of environmental conservation, for example, individuals may take it upon themselves to work voluntarily and without financial reward for such things as the preservation of wildlife or historic monuments, creating a good for many other people.  However the amount of public goods privately supplied in this way is likely to be less than optimal.

Other causes that may contribute to market failure in allocating environmental resources efficiently include monopoly power, lack of information, and a divergence between societal and individual time preferences.  While these causes often make it necessary to support or supplement the market in the allocation of environmental resources, some primary causes of inefficient allocation are the concepts of "common property resource" and "public good".  And although they are seldom articulated as such, they form the raison d'etre of environmental regulation.

All sources of market failure should be explicitly considered in formulating environmental policies.  Not only may secondary sources of such failure affect the misallocation of resources, but they may do so in a rather perverse manner.  For example, a major characteristic of monopolies is that they result in too little production and, therefore, inefficient use of inputs.  By contrast, a common environmental problem is the "over-use" of the environment in the absence of well-defined property rights.  Thus unless environmental controls are such as to take into account the inefficiencies inherent in monopoly production they may worsen resource allocation.

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CHAPTER 2
CONFLICTING OBJECTIVES

Up to this point, we have considered only a single normative objective -- efficiency.  However, in nearly all instances decision-makers are confronted with conflicting objectives.  A distinction is sometimes drawn between "objectives" and "functional objectives" where "objectives" are the higher and broader goals and "functional objectives" are the more immediate and operative goals.

There are at least two other crucial objectives of economic decisions:  those of growth and equity.

The growth objective generally embodies maximisation of market activity.  Conservationists often dispute this objective by insisting that society should safeguard the environment by politically restricting the use of it, thereby restricting market activity.  However, this argument neither comprehends the meaning of wealth nor recognises that the use of a good can convert it into even more valuable forms of wealth.  Furthermore, it confuses economic growth with a particular proxy of economic growth.

Wealth is the value of all goods and services in any economy.  It includes the environment and other non-human assets.  People are a wealth too, as are cultural values and morals, a stable government, and respect for property rights and the certainty of their continuance.  Any asset or good which yields a net benefit to society constitutes part of its wealth.  The wealth will naturally depend upon the mechanism employed to allocate the available goods and services amongst their various alternative uses.  We know that wealth, for a given distribution of human and non-human resources, is maximised when allocated efficiently.  Growth deals with a tertiary concept, of how wealth can be increased, that is how consumption of goods and services increase over time.

We also know that preservation of the environment is not necessarily most efficient.  Converting a body of water from a habitat for flora and fauna to a dump for steel waste or a substrate for housing may indeed yield greater collective gains, and constitute the greatest improvement to society's wealth.  Alternatively preservation could be the highest valued use, and as such this would constitute the largest contribution to wealth.  The problem with the formation of wealth via markets is, we know, the failure of markets to consider the full consequences of all alternatives.  Market-generated wealth is not likely to be an optimal mix of resources in such a case, for certain benefits and costs will not be considered in decision-making.  Therefore, an objective encouraging the increase in wealth, as measured by markets, is likely to cause a further shift from goods and services such as the environment which are undervalued in the market place towards those more fully valued.  This should be the centre of concern for more rational conservationists.

The problem is not that there is anything wrong with the growth of society and wealth as such but rather that growth in market valuation of output, if considered in isolation, often decreases rather than improves efficiency of resource use, particularly as far as environmental resources are concerned.  An efficient allocation of resources over time should result in an optimal growth rate, in which all costs and benefits are fully and accurately assessed, and in which growth is part of efficiency.

DISTRIBUTION OF INCOME

There are two reasons for paying attention to the distribution of benefits and cost of a given allocation -- one ethical and the other pragmatic.  The ethical dimension concerns the distribution of benefits in accordance with people's feelings of what is fair.  The desire for just policies is a conventional complement to the desire for an efficient allocation of resources.  The pragmatic dimension concerns the effect the distribution of the burden has on the enactment and implementation of any allocation.  The feasibility of any policy is ultimately determined by the political support for it.  A policy which is of great disadvantage to a small group but which improves slightly the lot of a larger group may be of net benefit to society but may not obtain political support.  Distributional considerations are thus critical to an understanding of political, bureaucratic and market behaviour.

In economics as in other disciplines, the norms of fairness are not well defined.  The object to be distributed (be it wealth, income or opportunities), its measurement, and, most importantly, the relationship between distribution and generation of wealth are by no means clear.  Nonetheless, concepts of fairness are often broadly agreed upon by many people within a society.  For instance, the re-allocation of some income, wealth and resources to the "have-nots".

Bringing about some particular distribution or re-distribution of income should, however, not be a major objective of environmental policy.  There is no clear and widely-accepted concept of what is a fair or, more particularly, an optimal, distribution of income.  Loose specification of an equity goal will only encourage each decision-maker to canvass his own personally-desired distribution.  The several views can be expected to conflict, and none will represent an optimum.

It is also important to know what the optimal resource allocation would be if distributional considerations were left aside.  It is important to know the cost of the trade-off between redistribution of environmental benefit and a reduction in total environmental services available to society.  But it will be impossible to know what this reduction in output is if we cannot say how the value of the environment can be maximised by an efficient allocation of resources.

Another major problem is the failure to consider all the costs of the use of environmental resources.  The problem is one of allocation rather than of inequitable distribution of benefits and costs.  With pervasive inefficiency of environmental use, further inefficiency in the name of justice is not necessarily in the best interests of the community or of the environment.

GOVERNMENT INTERVENTION

Although market failure resulting from the absence of strong and wide-ranging private property rights causes the recurring problem of inoptimal use of the environment in markets, such a system should not necessarily be abandoned.  We should address ourselves to the best choice from a set of imperfect alternatives.  The most common remedy suggested is government intervention in order at least to modify market behaviour.  Indeed, our society is so conditioned to look to government intervention as the panacea for environmental problems that it is conceptually difficult to look beyond it.

But government intervention has two major problems.  First, the substitution of centralised bureaucratic decision-making for the free market does not tackle the underlying causes of market failure.

Unfortunately, and ironically, bureaucratic and political decisions reduce the level of information about individual preferences, and therefore about what society wants, by eliminating or distorting market prices.  What we see in countries without free-market systems is partly a result of this:  a lower standard of living than necessary, human unhappiness and no particularly good evidence of environmental conservation.  Among others, the African countries which inherited from colonial bureaucrats and early London School of Economics theorists traditions and thought-patterns of bureaucratic intervention provide examples.

Second, there is no reason why government should be identified with society.  The actions of government cannot in fact be regarded as the outcome of decisions to maximise society's benefits.  Government "behaviour" is the sum of decisions and actions of individuals, politicians, bureaucrats and members of interest groups, each of whom acts, as do all members of society, in his own self-interest.  This in not to suggest that they are always, or even often, venal or corrupt, but that they act, at best, in accordance with some narrow brief.

Political or governmental allocations are imperfect for at least three reasons:

• The decision-makers often do not have sufficient incentive to implement efficient or equitable solutions, if they are not likely to gain directly or maximise their own net benefits.

• Social preferences are filtered in the government decision process.  For government decisions to be efficient, voters or individuals need equal information on, and access to, the issues and the decision process, and all views would have to be represented without bias or weighting by advocates.  Such a condition rarely, if ever, exists.

  Obtaining information on the issues, and then lobbying for a point of view, involve costs.  People are unlikely to invest time, effort and money in the participation process unless the expected gain from it is positive.  Only those parties or some of those parties who perceive themselves as significantly affected by the government action will be likely to participate in the information-gathering and preference-revealing process.  But the preference of these significantly affected parties is not necessarily that of society's as a whole.  Those parties who do not participate, though perhaps not greatly affected as individuals, may in aggregate be the majority of the total effected parties and indeed receive the greatest effect of whatever decision is taken.

  Those parties who do expend time, effort and money in information-gathering and lobbying do so to different degrees.  Even if the net benefit from participation is positive, it will vary among individuals as will the extent of their influence over the decision-maker.  In our previous example of the steel mill polluting a body of water, the steel producer would have a greater incentive than an individual unhappy about the pollution to participate in the decision-making process and to engage in activity designed to affect the decision-maker than those who each use the water for occasional recreation.  The asymmetry of influence is not simply related to the availability of information on a particular issue:  for example the decision-maker may be influenced by political leverage from the steel producer in the form of employment or community funding.

• Unlike market decisions, political decisions may be affected by biased information on people's preferences.  In a perfect market, there is no incentive to mis-state preferences since the consequence of mis-statement is a loss in the form of higher prices or a surplus or scarcity of goods.  However, under a political system, it often pays individuals to give a distorted view of their true preferences.  Political or government decisions give rise to externalities.  That is, the cost and benefit of political action is not necessarily borne by the actor.  For example, if I am a recreational user of a body of water, and I exaggerate the effect of industrial pollution, I do not have to suffer all or even a perceptible part of the loss caused by this exaggeration.  Instead all share the cost of my exaggeration.

The political system is such that not all the gains possible from government action are likely to be achieved.  Participants in the political process often fail to impose criteria of efficiency or fairness in the use of environmental resources.

Under conditions where market externalities are significant, as with an environmental resource, the choice of a solution must be between an imperfect (for this purpose) market and imperfect government action.  One cannot comment a priori on the relative efficiency of the two alternative systems or on possible combinations of them.  Any comparison is essentially of the respective benefits of each to groups of individuals, plus the costs of making political and market exchanges.

ALTERNATIVE GOVERNMENT PROCESSES

The processes available to governments to improve the use of environmental resources can be divided into planning and impact assessment.

The planning process has a broad scope, wherein all uses, present and future, of an environmental resource are considered, adopting a cost-benefit methodology and employing indirect remedies (which will be explained below).  Few planning processes in Australia exhibit all these characteristics, particularly indirect remedies, but this categorisation serves as an alternative with which the impact assessment process can be compared.

In the following I will discuss the impact assessment process and compare it with the planning process.

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CHAPTER 3
THE IMPACT ASSESSMENT PROCESS

The Commonwealth and each of the six States have Environmental Impact Assessment requirements and procedures.  The Commonwealth process is directed at uses of the environment within its jurisdiction and extends to the activities of its agencies.  In recent years the Commonwealth has enlarged the jurisdiction of its EIA structure by liberal interpretations of the powers of its own agencies, and by inducing the States to model their EIA structures on its own.  Despite the Federal-State division of jurisdiction, the Commonwealth has become directly involved in controversial environmental issues such as those of the Franklin Dam and Fraser Island.  Commonwealth governments may be expected to attempt to carry intervention in State areas further in future.

The several EIA systems have generally similar features.  The Environment Impact Statement (EIS) process calls for a preliminary review of all major development proposals (often called a Notice of Intent) to be prepared by the developer or proponent, identifying the main environmental impacts of the proposed development.  On the basis of a proposal the government may direct the proponent to undertake an EIS if it considers such an in-depth study necessary.  The EIS is reviewed by the bureaucracy;  often comment from the general public is invited, at least as a political gesture, before a final decision is made (this "public comment", which may be well- or ill-informed and expressed, or emanating from what are actually narrow interest groups, is not, on the one hand, necessarily representative of real feelings in the affected society, and on the other hand can be either selectively used by the decision-makers or simply ignored).  The EIS is then often released to the general public or made available to selected people (see Porter 1984 for full discussion for the EIA process in Australia).

SCOPE OF E.I.A.

The EIA process deals with environmental matters case by case.  It focuses on specific major projects and specific users rather than on the totality of uses and all users.  With the EIA process being depended upon as the primary mechanism for all environmental control this focus on specific projects is a major shortcoming.

As we have seen, all uses and users of the environmental resource must be taken into account to find its optimal allocation.  The opportunity cost of the project and its inputs cannot be determined without considering alternative uses.  Lesser users may be ignored only if they have in the aggregate little significance or bear only marginally on the cost of controlling the externality.  Although externalities in most cases involve major users, a larger number of small or lesser users cannot be disregarded.  Automobiles, for instance, are a major source of air pollution in our cities;  households and many small industrial concerns contribute to water pollution.  Over-fishing and the destruction of marine ecosystems may be caused by small-scale fishermen and recreationists as well as by large industrial users.

The case-by-case approach of the EIA process also incurs relatively high administration costs.  The EIA process is based on the study of the unique circumstances of each project and therefore requires frequent and overlapping studies and procedures.  Expenses such as those incurred by the many agencies and individuals submitting evidence, the cost of the institutional structure and so on, are higher than for the alternative planning system.

Another characteristic of the EIA process is the time it takes.  Porter (1985, p.182) put the average time for fulfilling all these requirements from large projects at 17 months.  This period will force significant delays to a number of projects.  Such delays in combination with the additional risk imposed on the project by the EIA process could force marginal projects to be abandoned, even though they might be viable with quicker and cheaper environmental approval.

The cost to a project of the risk imposed by the uncertainty of the EIA process should not be under-estimated.  The EIA process affects not only the timing of the project and the use of environmental resources, but also the ability to undertake the project at all.  Such risks add costs for any investor, whether it be a lender or an equity holder.  The additional cost imposed on the project in the form of higher risk and uncertainty often augments the cost of delays to the project.  The delay and risk caused by the EIA process is a major complaint of developers in both the public and private sectors.

The most controversial aspect of the EIA process is its use as a means of procuring the collectivisation and public control of private goods.  The EIA process allows this by focusing on (and controlling) the inputs used in a project rather than on the environmental resource.  The cost of the collectivisation of private goods is apparent in their inefficient allocation.  Collectivised goods become either in fact public goods or common property resources.

The EIA process is restricted by law to considering environmental factors.  In most States and in the Commonwealth, however, the definition of environment is interpreted very broadly to include all "social, economic, physical and cultural aspects of mankind".  Even in Tasmania and Western Australia, where EIA legislation restricts the definition of the environment to physical and aesthetic impacts, the definition is interpreted very liberally.  Thus in the cases of the Argyle Diamond Mine (Dames and Moore 1982) and the South West Aluminium Smelter (IACWA 1985) non-physical and non-aesthetic factors deemed of public concern were looked into.  Likewise the Commonwealth, through liberal interpretation of its EIA powers, can conduct parallel reviews in which non-environmental factors are explicitly considered for political reasons.  The market is thereby replaced by the political process:  a potentially optimal regime by a necessarily inefficient one.

An argument offered by the proponents of the EIA process is that governments with macroeconomic goals of full employment and growth need to have a direct influence over major projects.  This argument is demonstrably weak.  Firstly the EIA process should be aimed at rectifying the specific problem of inefficient use of our valuable environmental asset.  Enlarging its scope to encompass vague macroeconomic objectives subverts its central objective.  Among other abuses, it could lead, not to efficient use in the sense we have been considering of maximising all potential benefits, but to ruthless and destructive exploitation of the environment, destroying rare and irreplaceable goods like unique scenery or endangered wildlife in the name of economic growth and employment.

Secondly, there are many more effective means of achieving full employment and growth.  Freeloading on the EIA process is inadvisable as it misdescribes the problems of unemployment.

Thirdly, direct government or political control over potentially private decisions is not necessarily an effective means of achieving full employment or growth.  If the political control acts, as it usually does, to protect or help one interested group at the cost of another, rather than from motives of economic rationality, it is likely that the outcome will be less, rather than more, employment and growth.

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CHAPTER 4
MODELS AND METHODS

The models discussed so far are basic.  They nonetheless illustrate extremely complex events and help identify the heart of the problem:  the absence of private property rights.

Conceptually, they provide a framework for finding the best allocation of environmental resources.  In application, however, there is the practical difficulty of measuring marginal benefits and marginal costs.  Marginal benefits are particularly hard to measure because a knowledge of the "damages" associated with a given externality is required to ascertain the benefits possible from its correction.  The estimation of such "damage" functions involves identifying and valuing the effects of externalities on a wide variety of uses.  It is also necessary to know the geographic dimension of the externality:  localised, national or international.  The spectrum of externalities including those with latent effects (such as asbestosis), and those with immediate and cumulative effects (such as noise pollution and salinisation of soil) complicate the task further.  There are also those externalities which do not become a problem until a certain threshold is reached after which damages build up rapidly.  Acid rain appears to be an example.

In spite of the difficulties inherent in the process, a decision-maker must ascertain the cost and benefits associated with specific actions in order to come to an efficient decision.  This process must entail:

• Describing the resource and the relevant physical impacts.
• Procuring peoples' valuation of these impacts, either in monetary terms or in some qualitative form.
• Comparing the effects of the actions which can transpire at different periods of time.
• Indicating the distribution of costs and benefits.
• Ascertaining the efficient or optimal level of use and abatement of all resources.  (Hufschmidt et al 1983).

In the EIA process any effort to measure the benefits and cost of a project is eschewed.  Instead, the EIS, whether it focuses on economic impact or environmental impact or both, attempts to identify and quantify physical impacts.  Impact analyses do not convert these consequences to a common denominator, such as money, to ensure comparability.  They merely describe the expected effects of the project on the environment and the remedies proposed by the proponent to the decision-maker.  The decision-maker must then use the data to form an opinion on the best use of the environment.

The EIS essentially furnishes data and facilitates the first stage of the decision-making process.  It does not provide any guide to conclusions on the more difficult issues.  As a result, decision-makers are left to act without any worthwhile indication of people's preferences on alternative courses of action, except what may be proffered through political channels.  The ensuing decision may be an imposition of the decision-maker's own values, or be a product of chance.  An overworked functionary with an ulcer may guide "the hand that signs the paper".

The EIA process assumes that a full and unbiased estimate of social values can only be obtained from the political process.  This wrongly ignores the fact that the market system provides substantial information on people's desires and values.  More importantly, these values are "objective" in the sense that they are not distorted by an individual or incorporated decision-maker.

Even where markets do not exist for the many uses with which the EIA is concerned, the values of these uses are reflected in the prices of other goods or in the expenditure patterns of consumers.  For example, no matter how distasteful we may find the action of placing a monetary value on human life or a unique shoreline, their values can be assessed indirectly in market transactions.  Insurance companies, hospitals and individuals make decisions on safety constantly, and develop and use monetary estimates of human life in a number of ways, each of which serves some need.  The high price of real estate along any picturesque shoreline represents in part the aesthetic value of its view.  (See Yang et al 1984 and Hufschmidt et al 1983).

A criticism levelled at cost-benefit analysis and used as an argument for impact analysis is that cost-benefit analysis, in condensing the decision to a single quantitative value, obscures value-judgements made in the estimation process.  This is not a valid criticism of the methodology itself, but as a criticism of the manner in which the task is undertaken it is frequently justified.  A cost-benefit study in which all costs are itemised and underlying assumptions specified is anyway at least no more obstructive than an impact statement.  Given the complexity of the environmental resource, and the paucity of knowledge about many parts of that resource, value-judgements are required in respect of choices of theories, hypotheses and data.  Ecology, the discipline essential to the EIA process, can hardly be said to have a richer theoretical information base than economics and is as subject to value-judgements.

A related criticism of cost-benefit analysis is that there is a high degree of uncertainty about the relevant relationships within the physical, biological and social aspects of the environment.  The argument suggests that because of this uncertainty the quantification required under cost-benefit analysis is not practical to undertake.  As a description of our understanding of the various facets of the environment this is often true, but it by no means provides a justification for the EIA process.  The uncertainty inherent in the relevant environmental relationships must be dealt with by whatever methodology is used.  Moreover, the economic techniques adopted to cope with risk and uncertainty may be especially appropriate.

As was pointed out earlier, there are a number of sources of market failure.  The most important as far as the environment is concerned is the inability to assign private property rights.  However, other sources of market failure, such as monopoly production, may also affect the use of the environment, and will accordingly need to be considered in the process of deciding the level and allocation of environmental goods.  These subsidiary concerns, however, are frequently glossed over by the EIA process if it addresses them at all.

The EIA process is extremely costly.  An environmental impact statement (EIS) often costs as much as $500,000, excluding the cost of the preliminary report (Notice of Intent) or the substantial cost incurred by the bureaucracy in supervising the study.  The complexity of environmental resources and the paucity of baseline information contribute to high costs, but indiscriminate collection of data is also often to blame.  The EIS has come to be a scrap-book of diverse data gathered with little apparent regard for relevance or worth.  For example the recent EIS of the Wagerup aluminium project ran to over 1,000 pages, costing more than $750,000 (Alcoa and Dames and Moore 1978).  The report collected and generated data on all possible aspects of the physical, technical and social aspects of the project, irrespective of the expected significance and value.  It is ironic that the excessive energy and paper expended in all this must ultimately be taken out of the environmental resource itself.

There are a number of reasons for a copious EIS.  Guidelines provided by the agencies controlling the process are general and brief.  They place minimal restrictions on the scope of the study, and indeed a proponent is encouraged to cover all possible angles or impacts.  Also issues are not ranked in importance.

In these circumstances the proponent can be expected to expend large sums of money generating data on all possible aspects of the project to safeguard as best he can against the loss of potential gains from the project.  Frequently the EIS includes data to try to satisfy every possible whim of the decision-makers.  This behaviour represents a loss to society to the extent that the data generated does not or is not likely to produce information of value to society equal to its cost.  Sometimes a mass of loosely assembled data is intended to overload, overwhelm or intimidate the decision-maker in the hope that more important effects will be obscured or forgotten.

All this does not deny the peripheral value of the data in, for example, providing information which may be of value to scientists.

Be that as it may, depending on the prospective profitability of the project the proponent will be willing to spend more or less on the generation of marginally relevant data.  It is not obvious that there is any incentive to check wasteful expenditure within the system.  In fact many of the participants in the EIA process might benefit from the generation of irrelevant or marginally irrelevant data, since their income is derived from this activity.  They may accordingly have a vested interest in encouraging that wasteful collection of data for its own sake which is now all too characteristic of the EIA process.

The cost of this is put into perspective when one remembers that impact statements -- the collection of data -- only attempt the first step of a 5-step decision-making process.

Instead of collecting data of dubious value, the proponent should be generating information on people's preferences.  The data collected under an EIA has a high opportunity cost and accordingly should be substituted with data and information on market and non-market measures of preferences.

There will be a reluctance on the part of many supporters of the existing EIA system to orientate the system more towards ascertaining economic value and away from description of the physical and social impacts.  Many have made a large investment of their own human capital (that is, they have relevant science training, know the present system and are well known to potential proponents) and this capital could depreciate if the EIA process is significantly changed.  Such concerns should not, however, be significant when set against the gains from re-orienting the system towards identifying what is of greatest value for all the individuals who make up the community.

Environmental Impact Statements are becoming more circumspect, with clearer indications of their proper scope and more uniform methodologies.  These evolving standards are slowly leading to shorter, more concise statements.  An excellent example is the Boddington Gold Project Environmental Study (Dames and Moore 1985).  But further reform will be needed before the generation of useless information ends.

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CHAPTER 5
REMEDIES

After the causes of environmental degradation have been analysed and their effects examined, corrective economic policy measures must be chosen.  The EIA process requires, or at least recommends, controls that directly regulate the uses of the environment.  The common feature of the controls or remedies is that they contain stipulations about production and investment.  These remedies include amongst other controls (Siebert and Antal 1979):

• Technical specifications for production processes or equipment which force a particular level of control.
• Restrictions on land use, building standards, and architecture.
• Limits on the type and amount of goods to be produced, or the prohibition of production of certain goods.
• Regulation on particular inputs.
• Standards which set limits to the external effects which the project may create.

The most serious problem with direct controls is that they presuppose the regulatory body can and will determine the most economically efficient level of abating external effects and of means of abating them.  Given the low levels of information available to government agencies, economic inefficiency is almost certain to result.  Additionally, it is by no means certain that even with perfect information the regulator would be willing to enforce an efficient pattern of use.  There may certainly be conditions in which the regulator will individually gain more by not being strict enough or by being too strict than by pursuing an optimal course of action.

For example, a regulator may wish to be lenient with a particular producer because it is a long-established local firm with political influence, while being overly restrictive to another firm because of a desire to control foreign and/or new investments.

A second problem with direct remedies is the difficulty of achieving an efficient allocation of environmental services.  For example, it may be more costly for steel mills to eliminate a unit of sulphur oxides than for a power plant.  It would thus be economically efficient to reduce the sulphur oxide put out by the power plant before the steel mill is required to do the same, as this would be the cheapest way to reduce pollution.  It is unlikely that a regulatory body could or would differentiate between uses in accordance with their costs.  It is unrealistic to suppose that a regulatory body could have detailed, up-to-date knowledge of the cost of every polluter, even if it tried to get such information (which has often not been compiled even by the polluting firms themselves).

The political process that guides the EIA process requires differentiation between projects in that some projects get special consideration.  Technical efficiency, however, is not a criterion, unlike distribution of the political or monetary benefits produced by projects.

A third problem, common to both direct and indirect remedies, is that once the controls are determined they must be enforced.  Direct controls however fail to provide the project manager with an incentive not to pollute.  The project is allowed to pollute up to the amount specified by the remedy, irrespective of the cost to society of that action.  Further, the project managers, through superior information about the project, may be able to convince the regulator to vary the remedy to the proponent's benefit.

Another problem of direct control is that it provides little incentive for the development of more effective abatement techniques.  A polluter has no incentive to adopt a new technique that costs the same but reduces the amount of pollution (although he does have an incentive to produce the same amount of pollution more cheaply).  Therefore he is unlikely to consider, when making investment and production decisions, the returns to society from lower pollution levels and abatement costs.  Furthermore, direct controls often specify the type of abatement technique, effectively preventing the user from developing or adopting different, and possibly more efficient, techniques.  Additionally it is by no means assured that the bureaucracy will be willing or able to allow a proponent to adopt more efficient techniques which conflict with precedents set by previous decisions, particularly if it is unable to ascertain whether the adoption is a bona fide improvement or simply an attempt to evade controls.

INDIRECT REMEDIES

The alternative indirect remedies take three basic forms, private negotiations, judicial determination and legislation.

Private Negotiation:

The simplest means of achieving efficiency is private resolution of conflict through negotiation between the affected parties.  Suppose the noise from the construction of a project shatters the tranquillity of the neighbourhood.  Unacceptable levels of noise are likely to result because the project's owner does not bear the whole cost of the noise.  The neighbourhood could through private efforts to resolution, say, bribe the project owner to reduce the noise level.  Diagrammatically represented in Figure 3, noise is the pollution and the pollution recepticle is the neighbourhood.  Without considering the neighbourhood's welfare, the contractor chooses q_m decibels, a choice derived solely from his own personal demand.  Meanwhile the efficient level of q* is the level which maximises the net benefit.  The neighbourhood could, however, afford to pay p* to the contractor for each decibel he reduced or did not emit.  The contractor should, in that case, be willing to reduce his noise level to q*.  This bribe fully internalises the externality.  The neighbours are better off.  Though they had to pay the bribe they now no longer bear the cost of the loud noise, which exceeds the bribe.

The successful use of private negotiation is in practice very limited.  Solutions are difficult to achieve when the number of people affected is large.  Such a remedy, if successful, effectively gives the property right to the person who first seizes the resource.  Also it is possible that noise production could become profitable where it yields a bribe in excess of the cost of producing the noise.  Another disadvantage with such an assignment is that the gain from the resource is given to the noise maker, an outcome which though efficient may not be deemed fair.  Private negotiations are further reduced in effectiveness by the existence of alternative remedy mechanisms.

FIGURE 3

Judicial Determination:

An adjunct to private negotiation is judicial determination of property rights or liability rules.  Property rules specify the initial allocation of the entitlements which in the above example are, on the one hand, the right to peace and quiet and, on the other, the right to produce noise.  In applying property rules, the court decides which right or mix of rights is to prevail.  If negotiation costs are low and the affected parties are allowed to negotiate freely, an efficient allocation will result no matter whom the court decides in favour of.  If the entitlement is found to be the neighbours', then the project owner bears the burden;  if the project owner has the entitlement the neighbours bear the burden.  The only effect of the court's decision is to shift the distribution of the costs and benefits amongst the affected parties.  This rather remarkable conclusion was first pointed out by Coase (1960).

The judicial remedy has the same basic weaknesses as private negotiation, for the ultimate efficiency of the remedy relies on negotiation.  The judicial process, in deciding and interpreting the property rules, entails cost such as court time and lawyers' fees.  When the number of parties involved in this dispute becomes large or the issue complex, the cost of administration becomes prohibitive.  Some other remedies will be necessary unless all concerned live with the inefficiency.

Indirect Legislative Controls:

Indirect legislative controls take several forms including taxes and transferable pollution quotas.  The central objective of these controls is to correct the market system by internalising the externality and otherwise allow the market to allocate the resource.

The most widely advocated indirect control is an emission tax.  Business or communities would be taxed for every unit of pollutant or externality they discharge into the environment.  This tax would induce the polluter to reduce pollution.  Such a system requires that the amount of pollution discharged into the environment be measurable.  In cases where such measurement is not practicable, pollution may be controlled by taxing inputs or outputs rather than directly on the external effect.  For example, a tax may be levied on automobiles not equipped with a pollution control device on a per mile basis.  This would induce the owners to reduce pollution either by installing such a device or by driving less.

The dimensions of an emission tax can be illustrated through Figure 1 and Figure 2.

In Figure 1, the steel producer will use the maximum amount of water in the production of steel, for he does not have to meet the cost of this use:  the swimmers suffer the cost.  The state or some other collective group could internalise this cost by imposing a tax on each unit of water used and polluted.

As shown in Figure 2, if the tax is set at p*, then the steel producer would produce the quantity of steel q*, which represents the most efficient allocation of the water body.  It would do so because the cost of steel now includes the lost value of the water it uses, the cost that was formerly ignored and gave rise to the environmental problem.  Figure 2 shows the internalising process more clearly.  Here, you remember, we have two different cost curves, S_p the private costs and S_s the social costs of water pollution in the production of steel.  The steel producer, in the absence of any sort of countervailing force, will respond only to these indirect costs.  It will therefore produce too much steel q_p and thereby pollute too much water.  As discussed above the price of steel will be too low, for all costs are not considered in its formulation.  If, however, a tax equal to the value of the polluted water is imposed on the steel producers, they will still act accordingly to their own costs, but now they will carry the full cost to society of their actions and will produce the optimum level of steel.

The essence of the tax as a control is vesting of the property rights over the water body with authority and allowing it to sell it to steel producers at a price that reflects the opportunity cost to society.

Another legislative control, proposed by Dales (1968), is a system of pollution rights.  Under this system, the government determines the overall permissible level of pollution, as is necessary under any control system, and then sells the rights.  Only right holders are allowed to emit pollutants and then only in the amount specified by their permit.

The pollution rights would be tradeable, and a market and a price would develop for these permits, which would facilitate the distribution of the rights to those polluters who were most willing and able to pay.  This would protect the environment by making it more costly to pollute it, by a process economically equivalent to raising its scarcity value.

Indirect control overcomes the major problem associated with direct control by relying on economic incentives and the market to allocate the environment, rather than controlling investments and production decisions.  Since under indirect control a user will bear the full cost of his action, he will have a strong incentive to abate or otherwise control his polluting activity up to the point at which the cost of abatement equals the cost of polluting.  Furthermore, he will have a strong incentive to ensure that the lowest-cost means of abatement is used.  Since the producer is in a superior position both in terms of incentive to minimise cost and to know, or at least seek out an advisor that knows, the most appropriate technology, indirect control will achieve a given level of abatement at lower costs than direct controls.  Moreover they will provide an incentive to seek improved ways of abating or avoiding pollution.

The overall cost of controlling pollution will also be lower under indirect control because it allows the abatement to be conducted by those firms with the lowest cost.  Each firm will face a different abatement cost function:  thus if they are all confronted with a specific charge for polluting each firm will wish to abate different amounts.  Because indirect control allows each firm to chose the level of pollution and abatement, it will tailor its decision in line with its specific costs.  Under direct controls, because they are set by bureaucratic decree, the level of use and control is not likely to vary in line with firm-specific costs.

The major advantage of indirect controls is that they significantly reduce the power of a regulator to use environmental policy to gain control over other resources.

Since the regulator will not control investment and production decisions, it will be less able to direct those activities toward goals other than environmental protection.  There remains some scope for the regulator to pursue goals other than efficiency or equity (for example allowing differential tax rates or otherwise giving special treatment to favour clients or to penalise political opponents), but overall control over private goods is significantly less.

Of course there are many arguments presented against indirect systems for regulating environmental services.  Often, however, these criticisms are based on misconception or apply equally to all other remedies.  (See Anderson 1977 for more complete discussion of the relative merits of indirect controls).

It is usually difficult to determine the benefits and costs to society of environment regulations.  Furthermore, once remedies are imposed, enforcement and monitoring are not easy or costless.  However, these problems apply to direct as well as indirect remedies, and it is by no means clear that indirect control is more costly.

Probably the most prevalent criticism of indirect controls, put forward by environmental users as well as regulators, is that they reduce the quantity of all final inputs used in the production process.  If the price of an input increases, part of this increase in cost will be borne by consumers in the form of higher prices, which in turn will reduce the demand for the product.  The reduction in output will cause a reduction in the use of environmental services as well as other inputs.  But these adjustments are just what is needed to reduce the stress on the environment:  production needs to shift towards less environmentally-damaging industries or processes.  The structural adjustment may be painful but so is pollution and other misuse of the environment.

Another argument against indirect control often heard in Australia is that the higher cost will disproportionately affect export industries and will make them less competitive on the world market.  This argument is dubious.  First, many major trading countries have already introduced significant environmental protection measures, so increases in cost are not always one-sided.

Second, there is no clear reason why the competitiveness of industries should be maintained at the cost of the uses of the environment.

Third, research has shown that pollution control costs do not critically affect the competitive capacity of industry, as unrelated changes in cost of other inputs in the short term can offset pollution control costs.  The major factor affecting the competitive capacity of industry is that regulators are slow to make decisions (Porter 1978).

One caveat, however, is that the political process may well enforce more stringent controls on export or foreign-controlled firms than are optimal, thus truly decreasing their competitiveness to the detriment of society.

An important case where direct controls may be superior to indirect ones is when an activity and its impacts cannot be separated, for example a hydro-electric scheme or (in an extreme case) a nuclear explosion.  Nonetheless even in these cases the economic approach has proven itself capable of reasonable application.

In the economic model presented earlier, it was explicitly assumed that the optimal level of pollution is achieved at a level which does not damage the assimilative capacity of the environment.  However, this may not always be the case.  If it is not the case, and particularly if the affect on the assimilative capacity of the environment is large or highly uncertain, then the direct controls may be at least as effective as their indirect counterparts.

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CHAPTER 6
DISTRIBUTION OF ECONOMIC IMPACT

As indicated earlier, distributional considerations are relevant to the decision-making process because policies are often, and under the EIA process primarily, chosen on distributional grounds.

What then are the distributional effects of the EIA process relative to alternatives?  There is little in Australia with which to compare the EIA, and little work has been done on the distributional impact of alternative processes.

Nonetheless, we can indicate a number of distributional characteristics of the EIA process.

• It is relatively inefficient, so that less environmental services are available to be distributed.
• It is directed by the political process.  As such, the level of pollution and the remedies will be chosen in line with the preferences of various interest groups, bureaucrats and politicians, which are unlikely to align with the preferences of society as a whole.
• It considers factors other than those strictly related to the use or misuse of the environment.  The bureaucracy and their political mentors use the EIA process to achieve other goals at the cost of environmental matters.  For example, the EIA process is often used by politicians to gain concessions from the proponent in the way of site selection, workforce, choice of suppliers, timing of activity, etc, which, though not related to environmental problems, provide gains to bureaucrats and/or politicians in exchange for more lenient environmental controls.
• It gives no consideration to the long-term effects of the regulatory process.  The EIA process usually gathers descriptive data on the groups to be affected by a specific project.  But the simplistic analysis conducted in these studies does not provide a firm basis for identifying the extent or distribution of the economic cost of the regulatory process.  The distributive analysis is generally designed to identify the initial recipients of the impact and to estimate in political terms the compensation required.  This is related more to the "victim's" ability to convince the decision-makers of a need for compensation than to the actual cost they bear.
• The case-by-case approach of the EIA process gives the project a property right to a part of the environmental resource, subject to adoption of special technical, locational or temporal controls.  This right is given on a first-come, first-served basis, with later projects using environmental services in higher demand being required to adopt more stringent standards than their predecessors.

Such rights provide existing projects with the use of the environment free or at significantly lower costs, as well as a portion of the gains accruing from the environment control process.  Studies have shown that firms have used environmental controls to restrict entry and competition in an industry and have thereby obtained some degree of monopoly power or prevented necessary restructuring.  (Walsh and Brennan 1978).

PUBLIC PARTICIPATION

The opportunity for public scrutiny or direct participation is an important feature of the EIA.  The publicness of the decision-making process varies significantly within Australia, although the trend is towards full public scrutiny of the EIS, with public comment and consideration in the final decision-making process.  The democratisation of the decision-making process is a positive move, in view of the political nature of the decision-making process.  The wider the range of opinions solicited the more fully will the diverse interests of society be considered and the more likely will the decision be efficient and equitable, if this public input is taken seriously by the decision-makers and is not merely political window-dressing.

Public participation can furnish information not otherwise available and diminishes the likelihood of pertinent information being withheld.  However, the value of such information will depend on the extent to which it needs to be sifted and filtered for accuracy and reliability.  But the fact of public participation alone allows for potentially powerful scrutiny of political and bureaucratic behaviour.  The efficiency of the public voice if organised and supported by an effective media campaign is well documented in the controversies over the Franklin Dam in Tasmania and the South-West Aluminium Smelter in Western Australia.

A major problem with public participation is that it acts as a conduit for enhancing the public's control over private goods.  It may also be noted that some people involved in a quasi-public role, many media and academic commentators for example, often tend to have a personal ideological hostility to private ownership, production and capitalism generally, which also implies a hostility to private property rights.  They may of course also have (conversely if more rarely) an ideological hostility the other way.  If the public is allowed to affect the decision as to the existence or form of a project, it can potentially receive gains over and beyond those emanating from the more efficient use of the environmental resource.  It will then effectively gain control over potentially private resources.  Public participation can thus augment the process of collectivisation of private goods inherent in the EIA process.  This problem is not inherent in public participation, but rather is derived from the scope and focus of the EIA process.  If the process and thus the focus of public interest was concentrated solely on the public good (the environmental resource), this problem would largely dissolve.  The ability of the public to use control over one resource as a medium to control private goods would also dissolve.

OPTIMAL JURISDICTION

There is a question whether the States and the Commonwealth represent the optimal jurisdication for controlling the environmental resource.  Economic theory indicates that public actions, such as environmental protection, should be provided and their cost shared in line with the preference of those individuals who are to be affected by such actions.  Some environmental uses are such that their effects are statewide, nationwide, or international, for example acid rain and the endangering of mobile wildlife.  Others, such as localised pollution and the aesthetics of open spaces are geographically limited.  Therefore, the only members of society who are affected by externalities may be the residents of a particular region.  Given the mobility of the public and of ecological activists however, the geographic horizons of concern or effect have been expanded in recent years:  the preservation or destruction of a local beauty-spot may touch many people beyond the immediate neighbourhood.  Nonetheless in a large number of small projects and actions the effect on the environment is limited to a small local area.  In such circumstances the control of the environment should be provided and paid for by residents of the community rather than by the wider State or national entities.

In Australia the revenue-raising system is very centralised, with local jurisdiction significantly restricted in the manner and source of taxation activity.  Most taxes are the domain of the Commonwealth and to a lesser degree the States.  Local governments would be hard-pressed to fund an EIA system from their small tax bases.  Another argument sometimes mooted for more centralised control of environmental protection is that there are significant economies of scale in the provision of any such protection and the initial investment, particularly in human expertise, is very high.  Given these characteristics, it is maintained by some that it is administratively more efficient to have a single State authority controlling all environment action, whether localised or more dispensed.  Another related argument for a single State-level environment agency is that only under centralised control will an uniform policy be applied throughout the State.

The argument for a single State authority does have substantial plausibility in Australia.  In terms of the EIA process, one would have to concede that institutional and financial factors militate against local control of the process.  However, in the context of a less centralised mechanism to be discussed below, the value of centralised control could be less (It may also be worth noting that political systems with even more centralised control do not have particularly good environmental records).

Under a decentralised system, particularly one in which the user-pays principle is applied, a local jurisdiction could cover the cost of environmental protection by levying charges for the use of the environmental resource i.e. by implementing emission taxes.  The environmental resource could thus be treated like any other set of goods provided by the local jurisdictions.  Given the ability directly to fund a decentralised control mechanism plus the improved efficiency of the decentralised process and the ability of local agencies more accurately to reflect the preference of individuals affected, local agency may well be the best jurisdiction for the control of localised environmental problems.  Local control would be more practical if the State or Federal agencies were to provide assistance to the local jurisdiction on a user-pays basis.

WHY THE E.I.A. PROCESS?

If, as argued here, the EIA process is an inferior mechanism for allocating environmental resources, why is it the dominant one?

One obvious reason for its widespread use, in spite of its relative inefficiency, is that efficiency is not a decision criterion employed by governments and the political process.

A requirement to consider economic efficiency would restrict politicians' options.  Further, it would need more recognition of the economic approach, which is disliked by many conservationists, developers, bureaucrats, consultants and politicians.

One could argue that gains from improved efficiency would over-ride the personal interest of these parties.  But the diffuse nature of the efficiency gain in comparison with the direct and concentrated nature of the distribution gains tells against placing a high weight on efficiency considerations.

Another reason for ignoring efficiency is that the control process serves purposes other than resource allocation.  The assessment process is not designed solely to determine the optimal pattern of resource use.  Another function is to calm the anxieties of the citizen and to project an image of governmental rationality, efficiency and accountability (Floden and Weiner 1978).  The EIA is particularly suitable for public relations, for its methodology is easily understood, its case-by-case approach provides government with many chances to illustrate its capabilities, and direct controls allow it to take apparently decisive actions.  Nonetheless, the public relation strengths of the EIA do have a cost in terms of efficiency.

Developers themselves often prefer the EIA process to the planning process.  First, as indicated earlier, direct controls are usually based on the user-pays principle while the direct control used in the EIA process allows free use of a portion of the environment.  Second, the EIA process provides proponents with a quasi-guarantee which largely inhibits subsequent government and/or private action to alter or stop the project on grounds of its effect on the environment.  Thirdly, the EIA process provides a venue for encouraging government assistance to favoured clients by exempting their projects from some environmental controls or by the provision of other assistance which has nothing to do with environmental considerations.

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SUMMARY AND CONCLUSION

In this paper I have tried to indicate a central and longstanding deficiency in the standard approach to the control of environmental resources.  Governments and other collective groups have relied on the powers of science and the meanderings of the political process to control the allocation of environmental resources among competing uses.  The political process and science in its many forms have most important roles in environmental control.  Science must provide technical understanding of the ecosystem and its response to the demands imposed on it by man, a complex and indispensable task.  The political process provides probably the most reliable mechanism for considering questions of equity.  Fundamentally, however, problems with the environment are not technical nor are they questions of distribution.  Problems of allocation and allocative mechanisms are the crucial cause of difficulties.

Hence the environmental problem is or should be primarily in the domain of economics.

However economics has been largely excluded from the development and conduct of environmental policy.  It is a central thesis of this paper that the aversion of policy-makers to economic theory and research has led to the institutions set up as a result of their policies generally failing.

It is not argued that economics is a panacea, but that it provides a perspective, largely ignored, for a clearer and more accurate assessment of the core issues.

The central problem with man's use of environmental resources is that it is inefficient:  they are not allocated to the uses which provide society with the highest benefit.

The resources are pervasive and non-exclusive, so traditional forms of co-ordination and control such as markets appear irrelevant.

The institutions set up to rectify this misallocation are largely inferior to others available.  The Environmental Impact Assessment process, which is relied upon most for allocating the environment among competing uses, is particularly inadequate.  Other processes provide a more equitable and efficient allocation of environmental resources at a lower cost.  What is called in this paper the Planning process will in most instances be better.  The deficiencies of the Environmental Impact Assessment Process are manifold:  it is myopic, costly and ad hoc;  methodologically it is incomplete and misdirected;  its remedies serve the purposes of regulators rather than society generally, and it is controlled largely by a less-than-optimal jurisdiction without adequate direct or indirect public participation.

These deficiencies come largely from the attempt to replace or ignore rather than use and rectify the existing allocative mechanism -- the market.

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