Review of Competition Policy

Submission to the Productivity Commission's Inquiry into
Legislation Review of Clause 6 of the Competition Principles
Agreement and Part IIIA of the Trade Practices Act 1974

1. INTRODUCTION

As long ago as 1945, Hayek showed why regulatory interventions inevitably beget further such measures and lead to the "road to serfdom", but his insights are often overlooked.  Regulatory bodies drawing from the logic of their remit and, perhaps their self interest in retaining responsibilities, will usually seek additional powers.  As the nature of markets shift, partly in response to the regulatory environment, some of these additional powers will be necessary for the regulatory authorities to undertake the tasks originally envisaged of them;  the additional powers are, however, likely to further reduce the scope for market operations.

The following addresses some of the areas in gas, electricity and rail where this is considered to be occurring and makes recommendations to reduce regulatory intrusion.

The effects of this intrusion can also be seen in telecommunications.  The ACCC in the parallel inquiry to this one, while claiming, "The predominant trend is now clearly to remove regulation by reviewing the continuing need to regulate some services", is seeking additional powers to:

• control the content of telecommunications, "If content were to become a new source of bottleneck power." and
• to require certain expenditures by dominant firms, expenditures that the ACCC considers would be made by a business that was facing competitive pressures.

Permitting such extensions of the power of the state and can lead to dangerous economic distortions and cause resources to be directed away from meeting the needs of consumers towards meeting those of the regulator.  Accordingly, we consider calls for the extension of powers should be firmly rejected.  Indeed, it is our view that the present powers of the ACCC and other bodies under the Competition Principles Agreement are a regulatory tourniquet.  These powers are a belt-and-braces approach, justifiable in a transition to a new regime but to be significantly moderated once the initial hurdle period has passed.  If this is not forthcoming the out-turn will be re-regulation and a further period of ossification.

2. COMPETITION AND PROPERTY RIGHTS:  THE BASIS OF ECONOMIC PROSPERITY

It is worth re-stating that individually owned, secure and transferable property rights combined with vigorous competition between sellers are the kernel from which our present prosperity has grown.  Free competition and secure property rights are the two arms of a pair of scissors, neither of which is useful without the other.

The earliest development of the modern economy took place in England and, albeit more slowly, other parts of western Europe because the sanctity of personal property rights that evolved encouraged the setting aside of income and leisure to allow improved future income levels.  Early economists like Adam Smith (in his Lectures on Jurisprudence, 1760, rather than The Wealth of Nations) considered "preventing members of society encroaching on each others' property, or seizing what is not their own" to be "the first and chief" aim of government.  Jean-Baptiste Say (1803) wrote, uncontroversially, that only with secure property rights can production achieve its highest output, a matter he regarded as "so completely self evident that demonstration is quite superfluous" ⁽¹⁾.

We make these points because in the terminology of competition reform, the property rights arm of the scissors can be overlooked.  Competition reform can no more bring prosperity without property rights secure from appropriation by others -- private or government -- than can a society in perpetual warfare with itself.

The competition authorities that have been expanded or created in the wake of the Hilmer Report have placed considerable emphasis on the promotion of rivalry as a means of enhancing output and living standards.  But they have often been less cogniscent of the importance of property secure from measures by government (including their own arm of government) that constitute expropriatory "takings" and reduce the value of that property.

We welcome this inquiry, which we see as an opportunity to re-seat property rights with competition at the head of the efficiency table.

3. ACCESS TO ESSENTIAL FACILITIES

The Commission has outlined the processes whereby Clause 6 of the Competition principles Agreement and Part IIIA of the Trade Practices Act operates.  Access to eligible services may be through the NCC declaration process ⁽²⁾ (after which the ACCC becomes the price regulator) or directly through the ACCC issuing a legally binding and non-appellable undertaking.

The major regulatory agency in Australia, the ACCC, now has powers that are arguably greater than those rescinded by governments under the National Competition Policy Agreements.  These derive from the ACCC's ability to grant immunity from court challenge where it makes a determination of the correctness of a particular course.  This and its corollary, an ability to prevent a development of which it disapproves, is tempered only by an appeal avenue to the Trade Practices Tribunal.

Such an appeal process is normally impracticable in the business world where deals must be struck quickly or not at all;  moreover, the Tribunal is composed of individuals who increasingly share a common philosophy with the ACCC.

That ACCC philosophy has a strong focus on the detrimental effects of monopoly which is seen to be able to charge excessive prices to customers.  In fact most such monopolies are short-lived since if they extract high prices this rapidly attracts competition.

In addressing the prices that firms it regards as monopolies may charge, possibly because of the frameworks set for the industries it regulates, the ACCC tends to adopt arithmetical and highly formulaic price-setting arrangements.  These centre on a form of profit control based on the Weighted Average Cost of Capital.

Any modern regulator's pricing decision can only work in one direction.  Since, unlike a monopolist, no regulator is in a position to restrict supply, its price decisions can never have the effect of raising prices above the market level.  The only effect can be to reduce prices.  Yet, forced price reductions also make it difficult for competitive rivals to enter the market.  Thus regulators' decisions tend to prevent competition, the very process they were created to enhance.  Forced price reductions have two other detrimental effects:

• they reduce the incentive of the owner to maintain the facility at its peak service levels, and,
• they deter new investment both by the owner and others in similar circumstances.

In short, a forced price reduction acts against the longer term interests of all consumers by discouraging investment in new facilities, preventing rivals contending the regulated facility and reducing the incentives of the regulated facility's owners to optimise service levels.  For these reasons the power of the state to require such price actions needs to be heavily constrained.

These matters were well recognised by the Hilmer Report which formed the basis of the matters under review.  The thrust of the Hilmer recommendations, taken up in the National Competition Policy Agreements, was that a "covered" facility should be of major significance to the economy, and in this respect the report made specific mention of electricity transmission grids, major gas pipelines, major rail-beds and ports.

Recommendation 1:  the notion of Essential Facilities should be more narrowly restricted than has been the practice and be confined to those "of major national significance".

4. PRIVATE PROPERTY RIGHTS' CONSIDERATIONS IN ADDRESSING ACCESS ISSUES

Ostensibly, the Hilmer Report itself did not differentiate between private and publicly provided essential facilities.  It was however aware of the harm that could be visited on private property rights generally by regulatory seizure of some of those rights.

Hence, although Hilmer discussed wide notions of property that constitutes "essential facilities", for example, private baseball stadiums, the report understood the deleterious investment implications of regulation.  Indeed, the authors said they were, "conscious of the need to carefully limit the circumstances in which one business is required by law to make its facilities available to another." (p.250).  The Hilmer Report returned many times to emphasise the need to avoid undermining property rights and, hence, investment incentives, (e.g. p.256, 258).  Hilmer added "While it is difficult to define precisely the nature of the facilities and industries likely to meet these requirements, a frequent feature is the traditional involvement of government in these industries, either as owner or extensive regulator".

In reality the impetus for the Hilmer report was to redress the competitive restraining effects of state government owned or controlled monopolies.  In Australia in the early 1990s the only "essential facilities" were those businesses which enjoyed government support or protection from competition The Hilmer report followed from earlier work by the Industry Commission, especially into electricity supply, which demonstrated that the enforced government utilities' monopolies were high cost and inefficient.

The Hilmer report and the succeeding legislation was put in place to ensure the regulated aspects of these services were confined to the core "essential facilities" comprising the sorts of capital -- electricity transmission grids, gas transmission pipelines major ports, major rail beds -- that were mentioned in the report.

This inquiry offers an opportunity to re-focus on to these matters.

5. COMPETITION POLICY AND THE REGULATORY FOUNDATIONS OF DIFFERENT INFRASTRUCTURE

5.1 INFRASTRUCTURE'S OWNERSHIP AND REGULATORY ENVIRONMENT

The National Competition Policy is now in place and all legislated monopolies, government and private are being reviewed against criteria to ensure they are justified.  The Commission's Issues Paper (p. 18) draws attention to the costs of access regulation.  Our own recommendations on the access dimension are couched within a taxonomy of features based on ownership and the original conditions under which the facility was developed.

Accordingly, in addition to the need to avoid regulating facilities that are not of "major significance to the economy" there are six important classifications of essential service or bottleneck infrastructure that may justify a difference in regulatory policy approach:

1. That which has been built without any market protection, especially that built since 1995 which is almost by definition "entrepreneurial" rather than regulated.
2. That which introduces new competition, albeit is not identical to existing facilities.
3. Privately built infrastructure built prior to 1995 that enjoyed no government protection.
4. That which is owned by the private sector but was built under a regime that offered protection from competition.
5. That which was owned by a government but has since been sold under contractual terms to the private sector.
6. That which was built by and remains owned by a government.

A major concern rightly addressed in the Commission's Issues Paper is the costs that regulation may bring.  These matters assume greater importance with private facilities.  Ensuring the appropriate incentives are in place is crucial.  In this respect, Australia has implemented an innovative approach with electricity transmission with "entrepreneurial interconnects".  These enable the lines' owners to bid the capacity of the lines linking two areas, thereby arbitraging the price.  One entrepreneurial line is currently operating in Australia and another is committed.

However, such market-driven measures can be undercut by government financed investments (or investments financed by compulsory charges on consumers).  Subsidised facilities undermine the level playing field and therefore the incentive structure that is now being relied upon to provide reliable, low cost electricity.  Similar considerations are present with gas and, at least in principle, with rail and ports.

5.2 NEW INFRASTRUCTURE BUILT WITHOUT MARKET PROTECTION

Where there are no regulatory restraints on competition, we see the most promising conditions under which entrepreneurs seek out new needs or seek the meeting of existing needs more cheaply.  The outcomes of new infrastructure built under such conditions epitomise the gains made by competitive processes.  For, although mistakes in competitive strategies are inevitable from time to time and excessive or wrongly sited infrastructure will be built, the outcome of the process of free market decision-making offers us the best use of resources and the widest scope for the application of human ingenuity.  If excessive building occurs, unless there is (illegal) collusion the mistakes cannot be retrieved from the consumer.  Indeed, in such circumstances the consumer obtains windfall gains as the rivals seek to cut their losses by expanding their market shares and in the process driving down the price.

Infrastructure built by private enterprise in the "post-Hilmer" era should not be required to grant access or be subjected to price restraints.  The builders of such infrastructure are responding to a profitable opportunity that they foresee, one that, by definition, also confers gains on the buyers of the service.  The two parties obtain a mutual gain.  The sharing of the gain is one for bargaining between the parties but the consumers of the goods that the facility supplies cannot be worse off since without it they would not have that particular access route and perhaps not the product that the access delivers.

For its part, the owner of the new facility in this "post-Hilmer" era, cannot obtain gain from it by virtue of some form of government granted privilege.  The owner will, moreover, usually be building a project that carries some economic risk.  Such risk may emanate from a failure of the market to develop in the predicted way, new competitors, or the "howling gales of creative destruction" stemming from a technology that renders existing approaches archaic.

Thus, in deciding to push ahead with the facility, the supplier had no lien on the idea and no lock on the supply itself.  Once built, the facility is not protected from imitators.  It may be that a successful facility becomes immensely profitable, like Microsoft Word.  But it can only do so if it provides value in excess of that which imitators and new approaches provide.

Such mutual gain is at the heart of the private enterprise system.  Attempts to "redistribute" it can only harm the process.  This can be illustrated in the case of a new pipeline.  The owner of the pipeline will usually have considered a spectrum of alternative market projections (and perhaps a spectrum of cost projections).  There is uncertainty and, implicitly or explicitly, the owner will weight each scenario in making his investment decision.  If his threshold is a rate of return of 15% and he is considering scenarios that might yield rates ranging from 25% to 5% but provide a weighted average rate of 15%, cutting off the potential to earn the higher rates will reduce the weighted average to something less than the threshold.  The regulatory action would then eliminate the commerciality of the project.  In such a case, the sponsor and the customers would both be losers.

Even if, in this case, a new developer were to arrive and build the pipeline, that developer would have done so in the light of the experience gained by the original developer.  The process would still result in an inferior outcome because the regulatory process would have demonstrated a cost in originating new ideas and will deter investment in searching out new opportunities.

We have seen an example of this with the Central West gas pipeline.  This was a marginal project which required a Commonwealth grant in order for its owner, AGL, to justify its go-ahead.  The ACCC required AGL to lower its prices based on a rate of return on capital of 7.5% compared to a rate it sought of 10%.

Although such an outcome brings lower costs to the customers in the area, the decision undermines entrepreneurship.  It has no place in a situation where there is no monopoly.  AGL had no franchise to supply gas to the area in question.  It has many rivals in Australia seeking opportunities to find new markets.  The outlet is from the Moomba to Sydney pipeline, largely owned by AGL but operated by EAPL as a totally independent entity.  Had an AGL rival approached EAPL they would have secured the same conditions as those gained by AGL.

AGL had determined that the customers for the pipeline would be willing to pay $2.78 per gigajoule in 2004 but the ACCC has determined they must pay no more than $2.32.  Intervention to reduce a price sought by an enterprise in this way is a sure route to economic stagnation.  At best it will lead to the entrepreneur engaging in wasteful deception to try to persuade the regulator that his costs are really higher or his market weaker than he has said they are.  Most likely, it also sends a message to all businesses looking at expanding networks under the ACCC's oversight that they must please more than the target customers.  Hence, the decision of the ACCC to cut the price of using the pipeline in this way will have a sobering effect on other worthwhile ventures.

Recommendation 2:  that there be no application of the access provisions to new facilities that are not built under government regulatory protection.

5.3 A DUPLICATED FACILITY

The declaration and undertaking provisions are designed to operate where there is a monopoly "essential service".  Clearly the conditions for deciding when this is the case often call for considerable judgement.  However in the case of gas pipelines we have seen the NCC develop a considerable extension of the concept of monopoly.

An additional pipeline brings new competition.  This means the basic premises on which the competition policy arrangements are set for infrastructure do not apply.  The regulatory arrangements are posited on natural monopoly, an oxymoron where new competition actually emerges.  Regulation in those cases contains all the inevitable downside costs but no upside benefits.

In principle, this is acknowledged by regulators.  Thus, the NCC said in one of its own publications ⁽³⁾, "Against these benefits (of increasing competition by giving a business a right to use another business's infrastructure), access regulation can also entail costs if it is applied inappropriately or too widely."  Although such wording leaves the agency with maximum scope not to interpret its own activities as "inappropriate" or "too wide" this is a useful acknowledgement.  The NCC notes that such regulatory actions would be detrimental for a number of reasons but most importantly by reducing incentives to invest in infrastructure.

We sought revocation of the coverage of the Moomba to Sydney EAPL gas transmission pipeline with the building of the rival Duke Energy line from Bass Strait.  We also sought that the Duke Energy line not be covered.  This provided a test about whether the NCC would "walk the talk".

We argued,

The Eastern Gas Pipeline means we have Coke versus Pepsi in pipelines to Sydney and the case for their regulation has disappeared.  With the construction of the Eastern Gas pipeline, the conditions that could warrant either an undertaking or any other form of regulated price and access conditions disappear.  The two pipelines themselves have considerable over-capacity and they will be engaged in a price war. ....... With two pipelines supplying an area, as long as there is no collusion, the case for regulation rests solely on the benefits to the regulators themselves.

The existence of two transmission pipelines serving NSW is the very definition of competition, the absence of which provided the initial rationale for regulation.

The NCC argued that they should regulate both pipelines since they did not traverse parallel routes and that, even if they did, regulation would still be necessary to prevent collusion!  It is clear such analytical reasoning by the NCC gives regulatory agencies the opportunity to control virtually every economic activity in the country.

This case also indicates the failure of the revocation provisions addressed in the Commission's Issues Paper (p. 30)

Recommendation 3:  that where two substantial pieces of infrastructure serve the same market, no regulation, aside from normal anti-monopoly provisions of Part IV, should be required.

Recommendation 4:  that the building of significant infrastructure serving a market or source alongside infrastructure that is "covered" should require automatic revocation of the former

5.4 PRE-1995 PRIVATE INFRASTRUCTURE BUILT WITHOUT GOVERNMENT PROTECTION

The regulations on "essential facilities" take an arbitrary definition of the targeted facility.  Thus, the notion of an essential facility can be stretched to include manufacturing plant.  For example, a car assembly line owned by Ford could be regarded as a bottleneck facility to an intending vehicle assembler, especially if there were only one such plant conveniently situated.  A rival supplier could require access on fair and reasonable terms.  The ACCC could eventually specify such terms.

Similarly, an oil refinery, say the BP plant in Western Australia, might be regarded as an essential facility by an explorer who has discovered a nearby small field.  The refinery owner would clearly seek to charge any business that wished to use that plant to toll-refine its own product a price that was close to the applicant's next best alternative.  In the eyes of many, such action might be regarded as extortionate.  Nonetheless, the law cannot and should not compel such access to be provided for the sorts of reasons that Hilmer emphasised.

Although in the case of a manufacturing facility there is a specific exclusion, the principle is no different for infrastructure facilities.  Hence, where private firms have constructed infrastructure with no assistance from government, they should be obliged to offer access, if at all, only in the most exceptional of circumstances.

The foregoing is all the more necessary because the Hilmer concerns about the damage done when property rights are not fully respected received less prominence in the succeeding legislation.  As the Commission points out ⁽⁴⁾, the arbitrated price under Clause 6(4)(i)(i) appears to rule out allowing the owner the full benefit of any losses he may incur out of such an obligation (the efficient components pricing rule).  But it would be no different for a private pipeline to seek to fully exploit market power than it would for a refinery, a hospital or any other facility.  We refrain from forcing the owners from providing access so that they earn no more than a specified return because experience demonstrates that attempts to exploit such power founder under an avalanche of new competitors they attract.

The treatment of private pre-1995 infrastructure was put to the test when, in 1999, the NCC joined with other parties to try to force Rio Tinto to open its railways in WA to a then competitive iron ore producer.  In that case a rather strangely based legal decision and the eventual merger of the two firms thwarted the attempt ⁽⁵⁾.  But is seeking to force the opening of a privately built railway to a rival firm the way to encourage new infrastructure?  Our own view is that the undermining of property rights in such action would invariably have a greater adverse effect than the extra costs the applicant would incur in paying the quasi-rents to the owner or seeking out alternative avenues.

Recommendation 5:  that privately owned infrastructure established without government protection prior to 1995 should not be required to be "covered" without the regulatory agency demonstrating exceptional need.

5.5 INFRASTRUCTURE OWNED BY PRIVATE ENTERPRISE AND BUILT UNDER GOVERNMENT PROTECTION

Where governments have allowed particular businesses a monopoly over some essential facilities, terminating that monopoly involves an attenuation of property rights, albeit rights that were inappropriately extended in the first place.

Options for moving forward include a sunsetting of the exclusion provisions and the recompensing of the private business concerned.  The latter may be more pertinent where the private owner won a franchise that involved payment to the government.  This is a situation similar to that involving taxi cabs, where the scarcity "rents" themselves are caused solely by government licences.  Strategies for removing the impediment will always involve some attenuation of the property right the owners consider themselves to have (a view shared, in the case of taxi licences by others like bankers who lend on the basis of the artificially created value).  Restricting and preferably eliminating the effects of shortage created by the government action is necessary but the property rights holders should not be expropriated without fair compensation.

Recommendation 6:  that access to privately owned infrastructure established under government franchise or protection be opened under conditions that provide adequate recompense for the government undertakings their development involved.

5.6 PRIVATISED FACILITIES

Where governments have sold facilities that were (and remain) monopolies, the terms of that sale cannot be overturned without giving rise to "sovereign risk" issues, which would undermine the property right certainty that we have shown to be so essential to prosperity.

These matters have become issues with the Victorian price re-set where the Office of the Regulator-General is being challenged by the regulated distributors.  Similar issues will arise with the ACCC with the re-sets under Part IIIA for SPI Powernet.

Recommendation 7:  that provisions be put in place requiring regulatory agencies to fully abide by any undertakings given by governments to the new owners of privatised industries.

5.7 INFRASTRUCTURE OWNED BY GOVERNMENTS AND DEVELOPED PRE-PART IIIA

Where the infrastructure, for example a pipeline, was built by a government agency and no other competitive provider was permitted to offer the service in the same manner, some means of ensuring access is required.  In such cases an access regime is the most efficient means of ensuring that competition whittles away any rents or excess charges the benefit of consumers and other downstream users.

The alternative would be to rent out the facility's services to maximise profits.  It makes sense to use price to ration a scarce resource (but pricing merely to cover marginal costs seldom makes sense, except temporarily of if the demand for the facilities is in terminal decline).  Nonetheless, it is not in the interests of the community for governments to price their own facilities to gain monopoly profits.

Government owned and operated infrastructure provides the purest case for the operations of the Hilmer principles.

Recommendation 8:  that the Provisions of Part Clause 6 of the Competition Principles Agreement and Part IIIA of the Trade Practices Act 1974 be left unchanged with regard to government infrastructure.

Recommendation 9:  to avoid any misunderstandings like that which may be the cause of disputation between the Victorian ORG and electricity distributors, any future sale of such infrastructure be undertaken on the understanding that these provisions will apply in full.

6. PRICING ISSUES

6.1 REGULATORY APPROACHES

We have already commented upon the apparent inability of the regulator, under Clause 6(4)(i)(i) to apply the efficient components price regime.  In this respect, it is highly unlikely however that any Australian regulator would do so.  Unlike the situation of "regulatory capture" traditionally referred to in the literature ⁽⁶⁾ the capture of Australian regulators is one by consumer interests in having low prices in the immediate future.  Indeed, it is difficult to envisage how prices could be set by regulators in excess of the levels that customers would pay.

In any event, to our knowledge, aside from prices set by competitive tender, other than auction determinations, there has been no price determination by Australia's regulators in the post-Hilmer era that privately owned suppliers have found acceptable.

The original intentions of "light handed" regulation have clearly not eventuated in any Australian jurisdiction.  The notion of CPI-X has been perverted from its original intent as expressed by Littlechild.  Littlechild's proposal was to set an external basis for a price cap and require the natural monopoly (which he envisaged would gradually cease to be a monopoly) to keep its average real prices below this and an allowance for productivity improvements.  As applied it has come to be based on a firm specific forecast of future costs, adjusted by the regulator to exclude costs that he regards to be excessive and unnecessary.

In terms of paperburden, the simplicity envisaged is totally lost ⁽⁷⁾.

Recommendation 10:  the Commission should seek out ways that allow greater automaticity in price determination, thereby reducing the need for regulators to undertake the sort of detailed price determination that invariably prevails at the present time.

6.2 REGULATORS' HISTORICAL PRICE DETERMINATIONS AND SUGGESTED FUTURE APPROACHES

In terms of regulators' decisions, the recent re-set in Victoria applied an after-tax WACC (Real) of 6.8% compared to the levels sought of between 7.3% and 8.4%.  The following table outlines other decisions in of which the original application price has been pared back, sometimes considerably.

The regulators will claim that the sort of returns offered for the investments concerned are handsome in view of certainty of the returns given the sunk nature of the assets.  However the real issue is the replacement costs.  As is demonstrated by the ACCC's proposal to require Telstra to undertake investment that the company may not favour but which the ACCC considers necessary, a price set too low may offer inadequate incentive to replace capital.

Whatever the "just price" it is clear that a complex system like the Victorian gas network would not have been built in the first place if the sponsors had been told that their profit levels would be capped at a real rate of 7.75%.

The Commission raises the question of whether a system, first suggested by King ⁽⁸⁾, of a regulatory holiday akin to a patent could be offered for an initial period of a new project.  We consider this has merit in those cases where it is considered that the infrastructure will constitute an "essential facility" and it faces no realistic competition.  In our view such a scheme is, however, inferior to no regulation since it requires some reduction of the proposal's returns from the infrastructure investment and, hence its net present value.  In essence, it is therefore likely to deter some marginal projects.  Nonetheless such an approach is preferable to the alternative current highly investment-deterring regime.

The application of regulatory holidays might have particular attraction where a business wishes to reduce risks of early competition in a market it is considering serving.

Thus, a gas producer will have good information that the size of his reserves is adequate to provide the necessary product stream.  However, he cannot be sure of the extent to which his product will influence the price in the target markets.  As a producer and owner, he will certainly wish to restrict competitive fields' access to his target markets.  If he were to carry that competitive product he would insist on a price marginally below the competitor's next best alternative unless other competitors looked able to obtain access to his market at a lower price.

Government may require that the transmission facility be a designated "essential facility".  (Such a designation would of course draw attention to the logical inconsistency that the pipeline could hardly be essential since a prosperous life went on prior to its construction.)  If so designated and the owner were to be obliged to carry competitors' gas, the value the gas producer obtained for his gas at the target market would be likely to be reduced.  The incentive to construct the pipeline would thereby be reduced.

If required to allocate "spare capacity" to competitors the producer has every incentive to minimise the extent of that capacity and the facility is also likely to be constructed with a sub-optimal capacity.

This will be all the more so to the degree that the producer-builder is required to offer capacity to a competitor at a price that he regards as likely to offer inadequate recompense.  And the deterrence factor in building a new pipeline would be further increased if a regulatory regime were introduced obliging him to displace his own product in order to carry that of his competitor.

Recommendation 11:  where a regulator sets the price based on the value of a facility, that value should reflect replacement costs.

Recommendation 12:  the Commission support the development of a regime that allows a limited regulatory access holiday.

Table 1:  Regulators' Price Decisions

ISSUE	REGULATOR	APPLICANT CHARGE	DETERMINED CHARGE	DATE
AGL gas contract market	IPART	Annual revenue reduction from $140m to $128m	Annual revenue reduction to $99m	May 1997
Vic gas	ACCC/ORG	9.7-10.2 return post tax	7.75% return post tax	Oct 1998
Wagga gas (GSN)	IPART	Original 11.1% later offer 9.0%	7.75%	March 1999
Telstra Interconnect	ACCC	4.7c/minute	2.0c/min. with 1.6c suggested Sept 1999	June 1999
Adelaide Airport	ACCC	8.89% pre-tax or $3.66/ passenger	8.25% pre-tax or $3.45/ passenger	June 1999
Mildura gas	ORG	Tender at 9% real pre-tax	9% real pre-tax	June 1999
Albury gas	IPART	9.6%	7.75%	July 1999
NSW vesting contracts	ACCC	43.64 cents	no more than 40 cents	Sept 1999
NSW distribution prices	IPART		16% real price reduction 1999- 2004 7.5% (7.75% AIE, AE) 15% O&M reductions (10% AE, 5% AIE)	Sept 1999 Draft Determination
AGL Pipelines for the Central West Pipeline	ACCC	Real pre-tax WACC of 10% tariff increasing after 2001 at CPI+1.36%	Real pre-tax WACC at 7.5% meaning prices are frozen in real terms post 2001	Sept 1999 Draft Decision
AGL Pipelines for the Central West Pipeline	ACCC	Real pre-tax WACC of 9- 9.5% tariff increasing after 2001 at CPI+1.36%	Real pre-tax WACC at 7.8% (5.4% post-tax nominal) tariffs as proposed for 2 yrs then to fall by real 0.06% p.a	Sept 1999 Final Decision

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ENDNOTES

1.  Bethall, Tom The Noblest Triumph, St Martin's Press, New York, 1998 (p.98).

2.  or its related State certification process.

3.  The National Access Regime:  A Draft Guide to Part IIIA of the Trade Practices Act, NCC August 1996 p.7

4.  Issues Paper p33.

5.  In that case there may also have been some contractual requirements on Rio to open its line to others but these were not tested in the case itself.

6.  See Stigler, G.L. The Theory of Economic Regulation, Bell Journal of Economics and Management Science 2(1), 3-21, (1971)

7.  And as a regulator, Littlechild himself found it politically impracticable to apply his own theory.

8.  King S. 2000, "Access:  What, Where and How?", Paper presented at the Productivity Commission and Australian National University (Joint Conference) on Achieving Better Regulation of Services, Australian National University, Canberra, 26-27 June.

Electricity Privatisation: the Deal of the Century

Last week's sale of the giant Yallourn generator underlines how great a deal the Kennett/ Stockdale Government got for Victorian taxpayer.

In March 1996, the Government sold the Yallourn powerplant to a consortium led by Powergen of the UK for $2.45 billion.  Last week the Powergen consortium sold the plant to a Hong Kong based group for $1.84 billion or loss of around 25 per cent.

Both the other main generators, Hazelwood and Loy Yang have also seen post privatisation ownership activity.  CMS, the major owner of Loy Yang A, is seeking to bail out and Scottish Power sold out its 20% share of Hazelwood at a reported price that was a steep discount on the initial purchase price.

Earlier this year Scottish Power also sold Powercor for a price that was barely above its 1995 price, in spite of the firm having been highly successful, and GPU booked a $450 million loss when it sold its electricity transmission business, PowerNet, to Singapore Power.

The reasons for the reduced valuations are several.  Yallorn suffered particularly badly from union disputation.  While the generation sector as a whole suffered from viscous competition between the privatised Victorian generators and their government owned counterparts in NSW which put prices in a downward spiral.  Those consumers free to choose their power supply, including virtually all Victorian businesses, have seen the benefit in lower bills.  In the case of distribution and transmission sectors, the regulatory authorities have required price reductions for the charges levied on the use of power lines.

The price war for generation may be drawing to a close as demand catches up to the over-capacity.  Even so, as last week's Yallourn sale demonstrates, the assets are still fetching a steep discount from their original sale price.  As for the lines businesses, they are subject to tight regulatory oversight of Victoria's Regulator-General and the ACCC and can expect not substantial increase in levies.

In the interim, the Victorian taxpayer is revelling in the windfall the privatisations have brought.  Not only did the power privatisations allow over $28 billion to be wiped from the State's debt, but the price was ramped up by the government's exquisite timing (and, many would argue, astute salesmanship).  It is clear that the generators and transmission businesses are today worth at least $3 billion less than the $14 billion realised by the privatisation.  In the case of the electricity and gas distributors, while the current value is uncertain, the assets themselves sold for almost $5 billion more than their book value.

The process also gave Victoria a huge advantage over the other states.  Although South Australia's has privatised its electricity industry, the process was badly delayed and destorted by political opposition and as result it reaped no price premium.  The NSW Government's plan to privatise it electricity industry have been thwarted by the power union.

As with most things timing was vital During the mid-1990s there were a large number of cashed-up utilities of shore looking to expand in the electricity industry in the Asian regional and Victoria fit the bill perfectly.  Nonetheless, leadership was in the end vital -- as per usual leaders get the best price.

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Looking for a new way

Does social democracy require multiculturalism?

If one were to cite the most successful social democracies, it is a fair bet that the states of Northern Europe -- the Netherlands, Denmark, Norway and Sweden -- would be high on the list.  These societies are all monocultural:  their nationhood entails a clear, and single, ethnic identity with a single dominant religion (with their more divergent citizens having tended to emigrate, typically to North America).

Is there a link between social democracy and monoculturalism?

Social democracy is the extensive delivery of income, goods and services by the state.  It obviously requires high taxation levels.  But it also presumes a high degree of efficacy in centralised delivery and direction.

This is clearly much easier to do in dealing with a culturally homogeneous population.  If people have a fairly similar range of assumptions about how to live, how to act, right and wrong, patterns of life and so on, clearly it is much easier to design rules and centrally deliver services without too much ill-will and suited to the patterns of community life than it is if one is dealing with highly varied outlooks and patterns of life.

What's more, given the obvious potential for waste and idleness from government delivery and government income, it is much easier for social pressure to minimise shirking if people speak the same language and share a common outlook.  People are also more likely to be comfortable with a "one size fits all" approach, to feel that the officials do actually think like them and will see things in a way they also share.  So, a social democratic approach will be much easier to introduce, and to keep going, in a monocultural society.

Once one is dealing with a culturally diverse population, on the other hand, things become much more problematic.  People are much more likely to feel that the officials will have a different outlook to their own.  There is much more danger of services being seriously out of step with one group or another.  There is much more potential for resistance to paying for people more clearly "other" and for arguments about which group is getting what out of the system to become bitter and divisive.  Social democracy will be harder to introduce, comfort with what government provides is likely to be lower and problems with what government delivers likely to be greater.

It is noticeable that the Anglomorph countries -- which have always been culturally diverse, starting with the English, Welsh, Scottish and Irish of the United Kingdom -- have generally tended to have smaller governments and more liberal economic structures than more culturally homogeneous developed countries.  (The immediate postwar UK provides something of an exception:  it also produced, in Margaret Thatcher, the first substantive roll-back of "commanding heights" social democracy).  The most culturally diverse of the pre-World War One European Great Powers -- Austria-Hungary -- was also notably liberal in its economic policy.

It is very easy to mount an argument than a major reason why socialism, as a sizeable political movement, never took hold in the United States -- the most culturally and religiously diverse of Western societies -- is because it could never break out of particular ethnic associations.  Appealing to one group more or less guaranteed a failure to appeal to another.

It also seemed to make less sense.  Cultural diversity meant it was more socially harmonious to have a relatively simple set of rules and let people get on with it.  Conversely, it was harder to build an enduring consensus around intrusive intervention -- indeed, as the US Federal Government's role has expanded, Americans' confidence in it has fallen.

The US dealt with the social coherence problems of cultural diversity by fostering an American identity of a lowest common denominator variety rooted in a history conceived as a triumph of certain institutions and principles.  This left a stronger sense that the pursuit of happiness is a personal responsibility.  It also took it as obvious that one person's meat could be another person's poison.

Australia provides an interesting case.  The division between Catholic Irish and Anglo-Protestants certainly provided some difficulties in creating an extensive state (that Australia has one of the strongest private school systems in the developed world was a major consequence of that division).  It also showed how religion can be an important part of cultural diversity.

Yet Australia did develop its own version of social democracy.  This was the Deakin system of White Australia, trade protection, wage arbitration, state paternalism (what Sir Keith Hancock labelled government as a vast utility) and imperial benevolence (Menzies' "great and powerful friends").

Of the various elements, it is safe to say that White Australia was the most strongly based in popular feeling and the least politically contentious -- the Australian Labor Party's original statement of principles, for example, put the preservation of Australia for the British race as a fundamental aim.

We may have been of Irish, Scottish, English, Welsh, or some mixture of same, descent, but we were all White (except, of course, for indigenous Australians):  a principle which could be, and was, extended to Europeans of all varieties after the Second World War.

Despite White Australia's popularity, it was the first of the Deakin system's various elements to go.

Once substantial numbers of non-British migrants had been successfully accepted, opening up further became easier -- White Australia was breached by the Holt Government and its lingering elements were abolished by the Whitlam Government.

The referendum of 1967 abolishing the constitutional exclusion of aborigines from the Census and the Commonwealth's race power, the most consensual political act in our history, also showed that domestic exclusion was no longer acceptable.

The subsequent decay of the Deakin system is generally put down to economic and fiscal causes -- I have written of the fiscal pressure from the expanding welfare state as a fundamental driver of reform -- while the consequences of abolishing White Australia have not been much thought through;  presumably because it is so widely seen as a good thing.

It is notable that popular support for high immigration collapsed during the period of the abolition of White Australia, though the entrenchment of unemployment and the shifting of the justification for migration from national interest ("populate or perish") to moral vanity (proof of anti-racist credentials) are also plausible explanatory factors.

Gerard Henderson, in writing about what he calls the "Federation trifecta" of White Australia, trade protection and wage arbitration, has argued that once one of the legs of the trifecta fell, the others were bound to follow.  The link between trade protection and wage arbitration is clear enough -- the rigidities of the arbitration system tend to be undermined by the pressures of free trade.

The link with White Australia is more tenuous, even though it was a measure to stop labour competition being imported.

Nevertheless, once people with notably different outlooks began to come in, preserving agreement that intrusive controls, and inflating the cost of manufactured goods, were in the general interest became harder.  Less tolerance of low quality -- most obvious in the case of food -- may have also had an effect.

The influx of non-Europeans has been too slow to have had such effects on its own, however:  at best, it would have marginally increased any such pressures already operating from the expansion of non-British migrants.

Nevertheless, cultural diversity (nowadays usually lauded under the highly ambiguous term "multiculturalism") and liberal economics may be far more intimately connected than people have realised.

Few socialist theorists have been much inclined to pay attention to the implications of cultural diversity.  There has been a tendency to believe such things were unimportant, would fade away or that nationhood meant monoculturalism.

In that sense, all socialism has tended to be nationalistic (whether reflexively or avidly) in practice.

There has also been an very strong confidence in the effectiveness of political mechanisms and state delivery and "one right way":  attention to cultural diversity is not helpful for such confidence, nor has it been encouraged by it.

That ethnic identity has tended to trump class identity has been something of a standing embarrassment, though hardly surprising, since ethnic identity is so much more broadly grounded in life-as-lived.

The tribalism of the ALP, and that the first Asian-Australian, first woman and first indigenous Australian elected to Parliament all did so under non-Labor banners, fit a monoculturalist tendency within social democracy.

One area where the tension between cultural diversity and social democracy has been clearly disastrous is indigenous policy.

The concept of how to advance indigenous Australia has been overwhelmingly a social democratic one -- delivery of goods, services and income by the state through centrally devised and structured programs.

Yet indigenous Australians do not form a single culture, and the cultural distance between Anglo-Australia and indigenous Australia has been the widest such divide in the western world.

The result has been programs which, by and large, have been wasteful and miserable failures, as Noel Pearson has set out very clearly.  They have not been grounded in the life of the people they have been trying to help.  Regard for incentives, the operation of effective information feedback and attention to consequences have all been woeful.

The violation of "one rule for all" by indigenous-specific programs, and that indigenous Australians are "other", has also made popular support for such programs more problematic.

Commitment to multiculturalism is central to contemporary progressivism.

Indigenous advancement is, quite reasonably, regarded as the most urgent moral problem facing the nation.  Yet, social justice continues to be conceived first and foremost in social democratic terms.  There is a fundamental tension here.

Of course, the tension only matters if you believe that consequences matter:  if it is just a matter of being seen to be virtuous, and bugger the consequences, then you have no problem.

But the wider society does.

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Operating Regulatory Frameworks -- Government Agency Perspective

Address to APEC Infrastructure Symposium
13 December 2000

Standing here in front of so many distinguished people from many countries on the day the new leader of the world is decided is humbling.  So much so that when I thought of ways of dignifying this lunch with some deep aphorism, I reached for a quote from George W Bush.  One that fits the future that this conference is looking towards was made two years ago when the president said,

"I believe we are on an inevitable trend towards more freedom and democracy -- but that could change".  The trend is, after all, evitable.

There are a great many issues regarding infrastructure that are being aired today and tomorrow.  By its nature, infrastructure is the building block on which prosperous modern societies rest.  I want to address two prime matters in that provision.

The first of these is whether provision should be by the public sector or by private enterprise, and I know there is far from a clear dichotomy between the two.

Secondly, I want to talk about governance of the "essential facilities" or natural monopolies that infrastructure very often means.

PRIVATISATION

Australian competition reform commenced under a Commonwealth Labor Government.  Although it may have been senescent in its ability to handle the budget that government proved remarkably inventive in obliterating the sanctuaries from competition that had shielded government monopolies.  For ideological reasons the Labor Party prefers to pretend that ownership is not important, that properly focussed government owned firms can perform just as well as private firms.

In fact, the theory and outcome proves just the opposite.

Private firms operate more effectively because they need to do so.  Their management is under constant surveillance either by the stock market and ratings agencies or by an equally focussed parent company.

Public sector firms, by contrast, are often responsible to nobody in particular.  Governments of both political persuasions often use them as resting places for political allies.  NSW has tried to ensure its corporatised businesses are responsibly managed but even so has installed a variety of ex Labor politicians and even an ex-Communist wannabe federal politician on their boards.

Sometimes such appointees have considerable influence.  Thus, the management of the largest NSW electricity distribution business, conscious of a need to keep cost competitive with the nimble privatised Victorian competitors, recommended a strategy that would have halved the workforce.  The public sector-oriented board had a better idea -- save money by getting rid of a management that would prune so many union members.  On an even grander scale, public corporations acting with undue lack of restraint resulted in the debacles in the early 1990s when State corporatised businesses in Victoria, South Australia and Western Australia racked up such losses that they brought down the Labor Governments.

At other times there is a lack of commercialism on the part of the management.  Some see evidence of this in the disastrous contracting that one of the NSW generators engaged in with a Victorian private retailer, losing somewhere between $300 and $500 million.  State politicians are also liable to interfere to the detriment of the businesses.  For example, one of the NSW generators was seeking to buy its own coal supply but the government vetoed this when it realised that the intention was to make some economies that would involve reducing the labour force.

But profligacy is not necessarily the hallmark of government owned businesses.  Indeed, the normal behaviour is excessive caution due to the vast number of restraints the businesses have imposed on them by governments constantly worried about the political fall-out if one of their businesses goes bad.  This adds a domain that is not present to anywhere like the same degree with privately owned businesses.

What we have seen with the infrastructure that has been privatised in Australia is a vast carving out of excessive costs and innovations that were not considered possible.  In the case of electricity, we have seen generation businesses increase their availability to operate from 70% when they were run as an arm of government to the dizzy heights of 85% as corporatised entities and up to 95% since privatisation.  We have seen distribution businesses branch out into telecommunications, activities that would have surely not been allowed of a state controlled enterprise.  We have seen with Melbourne's City Link one of the most innovative road projects anywhere in the world.

It has been argued that the private prisons in Victoria have not performed well.  This would need to be tested.  But it is clear that private prisons in North America have proved so cost effective that few states are building any public ones now.

In short, however infrastructure is defined, the case for it being privately owned is unassailable.  Private ownership means:

• reduced susceptibility to political arm twisting inhibiting flexibility and adding costs
• management responsible to the sea of shareholder, predators debt holders and others all seeking to ensure their money is safe and getting the best possible return;  important in this respect is the market for corporate control -- a below par firm will see its share price deflated to such a level that it becomes vulnerable to take-over or its parent, fearing for its own on-going existence will divest.
• the possibility of having diversity and limited experimentation;  in electricity privatisation, some of the buyers have put, more management effort into retailing, others into lowering costs, others into diversification and others into seeking synergies with similar industries.
• privatisation with overseas ownership, offers the possibility of leveraging off experiences to make innovations without suffering from the hard knocks that often accompanies such activity.

Corporatisation, the preferred approach in Australia for shifting businesses away from government oversight, barely makes a dint in the deficiencies of government ownership.  Even though corporatisation means a board of directors operating under company law and making decisions accordingly, it is a bold Board that will take an issue at variance with the government's wishes.  Thus, if a shareholder minister writes to the board drawing attention to the government's support of centralised wage bargaining rather than individual contracts, as the government of Queensland -- and probably NSW -- has done, I doubt the Board would give licence to the CEO to move ahead with individual contracts even though they may save 10% plus in labour costs.

Corporatisation can be a useful half-way house to privatisation where a previous state monopoly is being split into several entities which are placed in competition with each other with the objective of injecting some competitive tensions into the market.  This is the approach used in those Labor controlled state governments with either an ideological aversion to privatisation or an inability unable to move because of their union support base.

But this still suffers from many of the disadvantages of public ownership.  In addition, it places Minister-shareholders in impossible conflicts of interest.  Rob Lucas, the South Australian Treasurer, tells of these when he was the shareholding minister of the five entities formed out of the previous electricity business.  He relates that briefings at each of the businesses would often outline their capital investment plans to overcome a supply problem.  Each business would have similar plans and if all were set in motion their goals would not be reached.  But as a shareholder minister he faced a dilemma.  On the one hand he was obliged not to divulge confidential information to competitors.  And on the other hand he could see the potential for wasteful expenditure by concerns for which he was responsible.  And a further more fundamental problem was that he was never quite sure whether the proposals he was hearing were those he had heard before from the business briefing him or whether it was from one that was ostensibly a competitor.

REGULATORY EXCESS

I have expressed concern at the imperialistic behaviour of Australian regulatory bodies.  Those bodies, with the ACCC at the pinnacle, include the National Competition Council (NCC), State regulatory bodies like the Victorian ORG and some quasi regulatory bodies like the National Competition Code Administrator, NECA, with which I have an association.

While the two most important bodies, the ACCC and the NCC -- and particularly the latter -- have undertaken very useful work in promoting competition their zeal is undermining some of the very drivers that efficiently bring new infrastructure.  Promoting competition can have adverse effects on efficient infrastructure development if the regulatory authorities insist upon conditions of access that the developer finds onerous.  It is all very well to argue that extant facilities are best opened to all at prices that simply cover their marginal costs.  However such approaches, even in a diluted form, will assure the goodies are not there to be shared in the first place.  There is inadequate recognition of this by Australian regulatory bodies.  Perhaps this is because they are loath to relinquish regulatory control.  Indeed, they have sought to expand such control into new areas.

This is amply illustrated by Duke Energy's Eastern Gas Pipeline, which is now carrying gas between the Bass Strait and Sydney.

Under the national Gas Code, pipelines are generally envisaged to be natural monopolies.  Their prices are regulated and they are not allowed to discriminate between potential users.

Two alternative regulatory routes are in place.

The first is through the National Competition Council (NCC).  This establishes the need for regulation, then passes the baton to the Australian Competition and Consumer Commission (ACCC) to determine prices.

The alternative is for the ACCC to accept an "undertaking" by the pipeline owner on price and other conditions.  At least according to the ACCC, this pre-empts the need for NCC involvement.

A fundamental issue with this important pipeline is why should there be any regulation at all?  Its construction means there are two transmission pipelines serving the Sydney region, one from Bass Strait and one from the Central Australian Moomba field.  Such rivalry is the very definition of competition, the absence of which provided the initial rationale for regulation.

The NCC however claims that the two pipelines both need to be controlled because they traverse different paths.  But it is rarely the case that two competitive products are identical and if we were to use their differences to justify regulation, almost everything would be covered.  Two robust competitors, as long as they do not collude, are usually sufficient to bring the required efficiency driving customer focus.  With the Eastern Gas Pipeline and Moomba line, we have Coke versus Pepsi, Ansett versus Qantas.  In such cases, as few as two rivals prevents price-gouging and promotes cost savings far more effectively than regulation.  And it does so without the price distortions and paperburden costs that are inevitable with regulation.

The NCC further argues that even if the lines were parallel regulation would be necessary because each of the lines would have "market power"!

The distressing aspect of all this is the negative value the regulatory authorities add.  If each new pipeline needs to pass an exhaustive regulatory review before it can seek customers, there will be far fewer pipelines built.  Companies will be unwilling to leave their money hostage to an unnecessary regulatory regime and consumers will lose fuel choice options.  Ironically, not only will this mean fewer opportunities for increased income but it will mean fewer competitive pressures.

The regulators' gas decisions are based on a misplaced assumption that pipelines are natural monopolies that can charge any price they choose.  For a start, they are subject to competition from electricity and other fuels.  Moreover, although the pipes are difficult to duplicate in full, they can be partially by-passed, thereby limiting their owners' pricing latitude.  Curiously, the regulators cite possible "uneconomic by-pass" as a major reason to keep the price low.  Yet the price cap they imposed does not prevent gas pipeline owners from reducing prices to meet competition.  Regulators' suggestions that the avoidance of uneconomic by-pass is a reason for them to impose low prices implies a pompous self-deceit on their part.  They are saying that the owners would be too stupid to determine for themselves when to meet a competitive threat with price action.

The ability of rival firms to by-pass existing lines and of rival fuels to win market shares provides strong disciplines on price gouging.  It should be left to the competitive process as much as possible to drive down prices.  Where a regulator attempts to do so, we run the risk of prices being set too low with inadequate incentive to upgrade and maintain the facilities.

Gas is not the only case where the NCC has sought to impose price reductions on private businesses where capital is sunk.  It had previously tried to force Rio to open its railways in WA to a then competitive iron ore producer.  In that case a rather strangely based legal decision and the eventual merger of the two firms thwarted it.  But is seeking to force the opening of a privately built railway to a rival firm the way to encourage new infrastructure?

The NCC is dwarfed in importance by the ACCC as an Australian regulator.  And the ACCC has its own ambitions to exercise control.  This is illustrated in the spat it has with Telstra who hired Professor Ordover to examine the extent of the control.  This was found to have increased from 38% to 76% of the firms' business.

Even if Professor Fels is correct in his retort that this increase is misleading as it occurred simply because of the commencement of regulatory control where none was needed previously, 76% of the telecommunications business is an awful large slice of a pie that has legions of new competitors entering the market.

Jim Hoggett has argued persuasively for a considerable trimming of the ACCC's regulatory powers in telecommunications.  He points out it is an industry with no lack of new entrants and some of these are of a comparable or greater scale and technological sophistication as Telstra

He goes on to say "If there was a need five years ago for the current highly intrusive level of regulation then the operation of the regulation should have led by now to a point where some of it could be dismantled."

Contrary to this, the ACCC calls for further powers.  Such calls suggest that the existing structure may be, perversely, generating its own amplification.  The ACCC seeks the power to direct persons to do what it thinks would conform to competitive behaviour.  An example might be a direction to enhance or replace technology.  This is an astonishing expansion of government control and one that would considerably augment the ACCC's powers and bring unfortunate increases in bureaucratic controls.

These access matters, the general Part IIIA controls and the specific Telecom Part XI are presently before the Productivity Commission.  In the interest of enterprise rather than the central planners seeking to assume control of infrastructure development and access, it is to be hoped that the outcome is a considerable diminution of the regulators' powers.

On that note let me finish with another quote from our new President.  Governor Bush said

"We are ready for any unforeseen event that may or may not occur."

Well, there are so many unforeseen events that have occurred in American politics in recent weeks it is just as well some did not occur.

All I can add is my satisfaction at having a man in the White House who got there notwithstanding some human fallibilities rather than a man whose febrile imagination claimed credit for more inventions and insights since Gallileo and rivals the late President Ceausescu for claimed innovations.

Our regulators are no more infallible and for the most part have no business experience.  We must ensure they do not prevent the beneficial operations of robust competition in the name of moulding the outcomes of that competition in their own image.

Private Conservation: Markets, Politics and Voluntary Action

The Hal Clough Lecture for 1999

INTRODUCTION

Despite what one tends to read or hear, the gains in environmental quality around the world in the last few decades have been astounding.  People are living longer, the air is getting cleaner, and agriculture is getting more productive, freeing up more land for wildlife and forest growth. ⁽¹⁾  Yet, strangely enough, the general view of the environment seems to be a dim one, and the issues of environmental protection and conservation seem to be growing in importance all the time.  Why?

For exactly the reason that people are getting healthier and wealthier, they now have the luxury of being able to worry about these problems (no-one who is starving or just trying to feed their family cares about carcinogens that might cause cancer in octogenarians).  We also have a system of governmental grantmaking and environmental fundraising that rewards the doomsayers and alarmists (imagine a grant proposal or fundraising campaign based on the slogan "There is nothing to worry about").

Of course, there are some very real environmental problems -- fisheries have collapsed, conservation estates have been mismanaged, pollution is common and some species are in real danger of extinction.  But this lecture is not about which environmental problems are perceived and which are real, it is about the cause of both kinds of problems -- political institutions which create more conflicts than they resolve -- and one solution -- private conservation.

When Garret Hardin coined the phrase "the tragedy of the commons" he used it to describe a situation where resources were depleted because they were free for the taking. ⁽²⁾  In Hardin's words, when the individual captures the rewards but the costs are borne by the group, "ruin is the destination toward which all men rush".  Hardin used the examples of a pasture and an ocean fishery, but the tragedy also applies perfectly well to the political distribution of environmental amenities, whether they are timber, wilderness areas or hiking trails.

Unlike the marketplace, where by definition voluntary trade makes everyone involved better off, politics is a zero sum game, where gains to one group are made at the expense of another.  Turning public lands into wilderness areas, for example, can only be done by taking land away from those who might want to use it as pasture or timber land, and vice versa.  In Western Australia, the acrimony and bitterness that accompanied the adoption of the Regional Forestry Agreement (RFA) in 1999 is a case in point.

The RFA in Western Australia was a pain-staking effort that tried desperately to accommodate everyone.  And everyone seemed to be interested -- the process garnered 30,000 public submissions.  Even though years were spent sorting out the agreement, not surprisingly, it pleased no-one, except possibly for some politicians.  Prime Minister John Howard called the agreement "fair and balanced".  The Wilderness Society, however, described the RFA as having "everything to do with forest clear felling and woodchipping, and nothing to do with science or community aspirations".  The Australian Workers' Union, on the other hand, called the agreement a "significant victory for the greenies".  And for those who worry about where their taxes go, the agreement included a $41.5 million industry development package and $38.5 million for "structural adjustment" in the timber industry.

And after all that, it seems, the RFA may not even last more than a year or two before it has to be renegotiated.  It is a process that goes on around the world, wherever environmental protection and resource use get tangled up in politics.  Solutions tend to be short-term and fair game for renegotiation whenever there are political gains to doing so.  Small wonder that most people take a dim view of finding solutions to environmental problems.

PRIVATE VERSUS PUBLIC CONSERVATION

There is, however, an alternative -- private conservation.  Private ownership radically changes the incentives that people face -- it encourages them to produce results rather than rhetoric, to look at tradeoffs, and to figure out ways to make the provision of environmental amenities a positive sum game.  It includes everyone from profit-seekers to those motivated simply by a love of nature.

When the Eoin Cameron radio show in Perth recently turned to the topic of private conservation, one caller remarked that it must be "a relatively new thing".  In the United States at least, it predates Independence.  Thomas Jefferson understood that private ownership was the best way to protect something, and to ensure that it would remain protected for future generations.  And so when Jefferson saw the Natural Bridge of Virginia, a remarkable natural limestone formation, it so inspired him that he bought it from King George of England in 1774.  It is still privately owned today and open to the public, yet its natural setting remains unspoiled.

Some of the best examples of private conservation arose in direct opposition to government programmes of their day.  Hawk Mountain in Pennsylvania has been a privately owned sanctuary since it was purchased in 1934 by the early suffragette Rosalie Edge.  Hawk Mountain was so named because of the vast numbers of raptors that would glide by on their south-bound autumn migrations, where an army of shooters would fell them and collect the government bounty on raptors.  Ms Edge and other early conservationists lobbied to stop the slaughter, but their pleas fell on deaf ears.  So Ms Edge turned to private action, raised some money and simply bought the mountaintop in 1934.  Then she created the world's first hawk sanctuary, posted it, and hired a warden to patrol and protect both the property and the birds.  Today, over 80,000 people visit the site annually, and it is one of the premier hawk-watching sites in the world.

Of course, the United States no longer puts bounties on raptors.  Instead it has swung to the other extreme.  In 1972, the US passed the Endangered Species Act (ESA), which not only forbids harm to any species listed as endangered but also restricts activity in the vicinity of those species.  This means that, at least on private land, having a rare or endangered species can mean the loss of property rights.

While the history of private conservation around the world has been long and varied, it has also typically been all but forgotten in the face of larger, governmental environmental programmes.  One of the great, early private conservation success stories was the recovery of the wood duck in the United States.  Due to hunting and government incentives to fill in wetland habitat around the end of the nineteenth century, the wood duck population was dwindling.  But conservationists found that it was easy to create artificial nesting habitat for this species, and soon these duck boxes were being placed all around the country.  Everyone from boy scouts to wildlife biologists helped put up the boxes, often on private land.  Today, the wood duck is one of the most common species of waterfowl in the United States.

Fast forward to the recent controversy that surrounded the spotted owl in the Pacific Northwest of the United States.  The spotted owl was listed under the ESA, and so it could potentially shut down any logging in the area.  Thus, anyone who owned forestland was scared to death of finding one of these owls on their property.  Not surprisingly, no-one tried to figure out ways to attract and propagate the owls on their land.  Helping rare and endangered species had gone from being an attractive proposition to a liability.

Forests themselves offer another stark contrast between public and private management.  Especially in Northern California, if you can tell the difference between a brown tree and a green tree, then it's easy to pick out where the property lines are between private and public forestlands.  The National Forests were set up initially for logging, but over the past 30 years that focus has changed to preserving wilderness -- that is, doing nothing.  The worst part of this "doing nothing" has been to allow the buildup of wood fuels in forest that would normally burn off in small fires.  In California, for example, instead of large, beautiful forests with big trees and green, open areas underneath, fire suppression has created a dense underbrush, so that now when there is a fire, it burns hot enough to reach the crowns of the bigger trees, killing them.  They are also more susceptible to disease and pests such as bark beetles.  On private lands, however, there has been salvage harvest, work to limit noxious pests and control of the undergrowth.  Many private forest owners in the United States are also moving away from logging as the sole revenue generator, toward such activities as camping, hiking and fee-hunting (paying to hunt on private land).  They are also managing their land more actively.

National Parks in both the United States and Australia have also suffered from political mis-management.  In the United States, reports from the federal government's General Accounting Office continue to document the mismanagement of our National Parks.  Much of this has to do with the incentives that Park managers face -- where the bottom line is not environmental health but political savvy.  For example, it may be more important to escape the blame for mis-management (and keep one's job) than to try to find innovative ways to improve either the environment in the park or its accommodation of visitors (and become a lightning rod for criticism).  For this reason, US National Parks, much like the aforementioned National Forests, have suffered especially from the trend toward "natural regulation", which means, once again, doing nothing. ⁽³⁾  Environmental economist Randal O'Toole has pointed out that under this regime of "natural regulation", if 10,000 elk starve to death after eating all of the available forage, park managers can simply say, "It's not us -- it's nature".

However one looks at the natural world, virtually everything is in some sense "disturbed" (touched or at least affected by human contact).  So nature must be managed, in some sense, like a garden.  The question that remains is not whether to build a wall around nature, but who should be the gardener?  And a landlord with the environmental record of most governments would be widely condemned, not extolled or encouraged to expand.

It is widely believed that government is really the only entity capable of conserving huge tracts of land, but that is simply not the case.  In Zimbabwe, for example, a remarkable transformation has taken place in recent years with the formation of private wildlife conservancies.  The conservancies were formed by adjoining property owners, mostly cattle ranchers, who contracted with each other to manage all of their properties as a single unit.  All of the internal fences have been torn down and all of the cattle are being replaced by wildlife.  The largest, the Savé Valley Conservancy in the south-eastern lowveld of Zimbabwe, is an amalgamation of over twenty properties that covers almost one million acres.

One impetus for creating the conservancies was to put the last remaining black rhino in Zimbabwe onto private lands.  The black rhino population in Zimbabwe had dwindled to just a few hundred.  Much of the eco-tourism revenues of the conservancies depend on the black rhino, and so they are vigilantly protected.  A scout tracks each rhino all day, and not a single rhino has been poached on the Savé since its formation.  In addition, for the first time in decades, the black rhino population in Zimbabwe is increasing (at its biological maximum, no less).

EARTH SANCTUARIES LTD

Earth Sanctuaries Ltd (ESL), an Australian company, is one of the best demonstrations in the world of how incentives and private ownership facilitate conservation.  ESL was founded in 1969 by Dr John Wamsley, who had the insight that the way to save Australia's endangered species was to protect them from feral predators (mostly cats and foxes).  More importantly, he also had the wherewithal to actually do something about it.

Which is a good thing, because more mammals have become extinct in Australia in the last 200 years than anywhere else in the world.  Since ESL started buying land, building feral-proof fences and reintroducing native species, the results have been remarkable.  Endangered Australian species like woylies, rufous bettongs, long-nosed potoroos and southern brown bandicoots have thrived inside the feral-proof fences.  Some species, like the eastern quoll, can only be seen on mainland Australia in an Earth Sanctuary.  ESL is well into a 40-year business plan that includes target numbers for specific species and the goal of turning one per cent of Australia into private wildlife reserves by 2025.  Revenues come from eco-tourism, consulting and wildlife sales, but ESL's biggest bottom line is saving Australia's endangered species.  And it is producing results and attracting investors. ⁽⁴⁾

The US Government's strategy for saving endangered species, on the other hand, consists largely of declaring them endangered and then imposing restrictions on any activities surrounding them.  Not surprisingly, hardly any species have been taken off the endangered list since 1972 (and of those 20-odd that have been taken off the list, most were either due to extinction or data error).  Fortunately, there is no Endangered Species Act equivalent in Australia.

No wonder Dr Wamsley has no faith in government and believes the only way to save Australia's native wildlife is through private enterprise.  (Although it should also be noted that some State conservation departments, especially Western Australia, Queensland and New South Wales, have made many of ESL's relocations and reintroductions possible.)

THE CASE OF THE FISHERIES

The power of human ingenuity to solve problems and overcome obstacles should never be underestimated.  Rosalie Edge and John Wamsley are prime examples.  Human resourcefulness is also one reason why private conservation has succeeded where other efforts have failed -- because the incentives and the institutions that direct those efforts are crucial.

One of the best examples comes from the fisheries.  Garret Hardin, and a number of economists before him, explained the problem -- no-one will cut back their harvests if whatever they leave behind may simply be caught by someone else.  Left to their own devices, however, people have been remarkably successful at devising ways of monitoring and enforcing rules among themselves to try to overcome this tragedy. ⁽⁵⁾  These agreements, however, are often tenuous and open to expropriation, and so government intervention in fisheries management has been the norm.

Regulatory approaches to fisheries management have had few successes.  One of those few is the remarkable recovery of the striped bass along the Eastern seaboard of the United States.  The method used, however, was an absolute moratorium on all harvest of striped bass.  And one official with the National Marine Fisheries Service described this as the only success story he'd been involved with in 40 years.

Apart from moratoria, external rules and restrictions on fishing direct human ingenuity into finding ways to beat the system, rather than ways to protect and enhance resources.  One of the most extreme examples was the Alaskan halibut and sablefish fishery, where regulators tried to reduce harvests by shortening the fishing season.  Before long, what was once a nearly nine-month season had been reduced to 48 hours -- with no reduction in the catch!  People respond to the incentives they are given, and they are very resourceful, and so they figured out how to catch more fish in less time.

Today that fishery is one of the better managed fisheries in the United States.  The fishery is now managed by an Individual Transferable Quota (ITQ) system that allots a certain percentage of the total catch to fishermen.  No more race to fish and no more huge investments in the capacity necessary to catch a year's worth of fish in two days.

This system is common in Australia for some species like abalone, but it has been taken furthest in New Zealand.  As ownership rights to the fisheries have grown stronger, New Zealand quota owners have formed management companies that are effectively managing the fisheries, investing heavily in research, enhancement and other measures to protect the health of the fisheries.  After all, the value of their ITQs is directly tied to the future health of the fishery.  New Zealand is one of the few places in the world where fishermen have balked at catching their allotment of fish because they thought it had been set too high.

The secret is not ITQs, but a sense of ownership.  The South Australian rock lobster fishery, for example, is managed by two different management regimes -- ITQs in one zone and simple trap limits in another.  Both systems work well because the industry was able to drive the rules and restrictions that were set, and so it devised systems to suit the situation (the trap limit zone, for example is more spread out and difficult to monitor).  Unfortunately, this success is now threatened by other interests who would like their own control over the waters -- recreational anglers and those who would like to see the creation of marine parks and reserves that would be off limits to fishing.

Just like the RFA, the lack of any sort of clear ownership has led to conflict, and will continue to do so in the future.  Conflict is common in the United States as well, where fishermen in the Florida Keys have vehemently opposed the creation of a marine sanctuary, and in numerous States that have seen voters move to ban certain commercial fishing gear to free up more fish for the recreationals.

There is at least one recreational/commercial success story, and it involves the Icelander Orri Vigfusson and his efforts with the North Atlantic Salmon Fund (NASF).  The NASF represents anglers who would like to see less offshore salmon fishing.  But instead of trying to exert political pressure, the NASF has raised enough money in recent years to completely buy out the Greenland commercial salmon fishery, allowing many more salmon to return home to their native rivers and streams.  The Greenlanders do not have any individual fishing rights, but they do know who has the right to fish and who does not -- and so there is a group of "owners" to bargain with.  The NASF is one more example of an ingenious solution to an environmental conflict, made possible by at least some form and definition of property rights.

Another good example of how private ownership leads to tradeoffs rather than conflicts comes from a private sanctuary in Louisiana owned by the Audubon Society.  Audubon has vehemently opposed drilling for oil on public lands in any number of cases, but they actually have some wells on their Rainey wildlife sanctuary.  Rainey is such an important bird sanctuary that even the public is not allowed to visit, but because they own the land, Audubon was able to weigh the benefits of drilling against the environmental hazards -- and to take whatever precautions they thought necessary to protect the birds.

THE PROBLEM OF UNOWNED RESOURCES

But what about those companies that aren't good stewards of the environment?  Once again, it is a question of ownership.  The resources that are being degraded, whether a river, a forest or an airshed, are generally unowned.  They are more examples of the tragedy of the commons, just a little less obvious than the fisheries.

Timber leases in the United States are a good example.  Timber companies tend to behave very differently when they are harvesting trees from their own land or from public lands.  Private timberland owners tend not only to invest in the future health of the land, but also to consider alternatives to logging such as fee-hunting or hiking, which they cannot with a short-term lease on public forest lands.  The problem is not with the timber company but with the incentives created by a system of public ownership.

Another caller to the Eoin Cameron radio show was convinced that shareholders demanding "short-term profits" would drive corporations to destroy even the environmental amenities that they owned.  They might desire short-term profits, but it would make more sense to sell out completely than to destroy the value of the resource.  A fishing company desperate for cash, for example, would simply sell its right to the fishery rather than starting to fish with dynamite to kill everything.  If resources are unowned, however, then there is no real asset to capitalise on, and resources are much more likely to be polluted, depleted or degraded.

The good news is that even partial rights can have a dramatic effect on environmental quality.  In the United Kingdom, private, heritable rights to fish for salmon in rivers and streams are common.  And under English common law, these owners have a recourse to stop activities, such as pollution, that damage their rights. ⁽⁶⁾

Even in Washington State, where there is no right to clean water, the fact that oyster beds can be privately owned has led to cleaner water.  Because oysters are filter feeders, they depend on clean water, and so the oyster growers have fought for clean water -- and obtained it.

MOVING TOWARD PRIVATE CONSERVATION

If one accepts private conservation as a viable alternative, the next question is how to create more opportunities for private conservators.  There are no simple answers to this question, but one of the most successful first steps has been to remove legal impediments.  In Zimbabwe, for example, a change in the law that allowed landowners to manage and utilise the wildlife on their property (where before wildlife had been the sole province of the state) spurred huge investments in protecting and enhancing wildlife habitat.  Zimbabwe has ceded a great deal of control over wildlife to poor, rural communities and villages through a programme called CAMPFIRE, which has served to benefit both the people and the wildlife that surrounds them.  This change in the law was also a key element in the formation of the private conservancies mentioned earlier.  Other southern African countries such as Zambia and Namibia have created very successful communal conservation efforts that rely on the right to manage and benefit from wildlife.

In places like Texas, however, the native game remains "the king's game".  As a result, many ranchers in Texas have turned their attention to exotic species, which they can actually own.  And they take care of what they own.  In some cases, for species like the scimitar-horned onyx, there are bigger populations in Texas than in their native environment.

Legal restrictions on how rights may be exercised can also impede private conservation.  Until recently, water rights in Oregon were based on a "use-it-or-lose-it" regime in which leaving water instream for salmon was not considered a "use".  This created conflict between farmers and the environmental community.  Once the law was changed to include instream flows in the definition of "use", however, a group called the Oregon Water Trust was formed to start buying water rights to leave them instream.

In Australia, the Australian Conservation Foundation laments that only twenty per cent of the Murray River's natural flow reaches the ocean, but without water markets, there is very little direct action they can take to improve instream flows.  Their only recourse is to wade into the political morass.  The same problems exist when conflicts arise over dams, which have become controversial in some areas for their effects on wildlife and riverine ecosystems.  Without a system of water rights, however, there can be no private solution, only public conflict.

HUMAN INGENUITY OVERLOOKED

Human ingenuity underlies just about every private conservation success story.  When private property rights institutions prevail, problem-solvers become remarkably resourceful at protecting and enhancing the value of what they own, for reasons as broad as profit and aesthetics, and covering everything from fisheries and forests to backyard gardens.  Unfortunately, that is rarely the environmental message that is heard.

A recent visit to the Australian Museum in Sydney, for example, turned up a rather remarkable display entitled "Populate and Perish". ⁽⁷⁾  The display focused on how people, and an expanding human population, are at the core of all of our environmental problems.  It stated, for example, that:

• "We change habitat through agricultural, urban and industrial development, and the exploitation of natural resources";
• "We pollute soil, water and air";
• "We overharvest resources which reduces both population sizes and genetic diversity of commercial species such as fish".

Certainly, more people living in a certain area will affect the landscape, but the presentation was determined to portray people only as a problem, never as a solution, which is an egregious error.  Human ingenuity is exactly why Malthus was wrong when he predicted mass starvation as population grew faster than food supplies.  Instead, innovation allowed agricultural productivity to far outstrip population growth.

The view that insists on portraying people as the problem must be addressed before any broad reform will really take place.  People like John Wamsley continue to build on the stack of evidence that demonstrates that, to the contrary, people are the solution.  Is there really any doubt that people take better care of what they own than what they do not?  The heart of the problem lies in the political management of natural resources.

What Thomas Jefferson understood so well in the eighteenth century -- that private ownership is the surest way to protect something -- has faded in recent years.  But it has hardly gone away.  And in some form or another, a return to this approach is inexorable.  For if one looks at the conservation success stories that exist today and acknowledges why some resources are conserved and others depleted, there is no denying the vital role that private institutions and human ingenuity play in overcoming the environmental problems we face.

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ENDNOTES

1.  See Ronald Bailey (ed.), Earth Report 2000, New York:  MacGraw-Hill, 1999.

2.  Garret Hardin, "The Tragedy of the Commons", Science, Volume 162, 1968, pages 1,243-48.  Unfortunately, Hardin's choice of terminology was not ideal.  The word "commons" is also frequently used to describe resources governed by private, communal ownership, which may be well-defined and managed.

3.  For an in-depth discussion of the deterioration of National Park management, see Alston Chase, Playing God in Yellowstone:  The Destruction of America's First National Park, New York:  Harcourt Brace Jovanovich, 1987.

4.  In May 2000, Earth Sanctuaries Ltd was listed on the Australian Stock Exchange (ASX code:  ESL), earning the distinction of being the world's first listed company whose "core business is conservation".  See http://www.esl.com.au for more information.

5.  Many of these examples come from the common property literature of anthropologists.  See, for example, Elinor Ostrom, Governing the Commons:  The Evolution of Institutions for Collective Action, Melbourne:  Cambridge University Press, 1990.

6.  For a more in-depth analysis of common law approaches to pollution prevention, see Elizabeth Brubabker, Property Rights in the Defence of Nature, Toronto:  Earthscan Publications Ltd, 1995.

7.  From notes taken on a personal visit to the Australian National Museum in Sydney, November 1999.