Who's Hurting Who?

Monopolies and mergers policy is up for review.  The Commonwealth has given the job to former High Court judge Sir Daryl Dawson.  As always, the issues revolve around how to prevent a supplier being able to charge excessive prices.

The task in detecting such market power is difficult.  This is because nearly every firm has some degree of it.  If this were untrue, we would never see any price differences and there would be no point in shopping around.  Any firm that poked its prices slightly above the competition would lose every customer.

The battle lines in the review are set.  They are between those in the regulatory game who want increased powers, and businesses who are wary of the costs, inflexibilities and adverse publicity that goes with regulatory intrusion.  This last facet was highlighted in the shameful way that the ACCC stage managed "raids" on petrol companies showing TV footage of its officers emerging from a particular firm with bucketloads of phantom documents.

During the last review in 1986, the arm of the regulator was lengthened to reach firms with less power than that derived from "dominance" of a particular market.  A merger can now be prevented where it merely brings a "substantial lessening of competition".  This has led the ACCC to inappropriately review and require changes to mergers, like that between the Bank of Melbourne and Westpac, that made little difference to market power.

But the ACCC wants increased authority, including the ability to have executives jailed.  It also wants to weaken the test for monopolistic exploitation so that it can take action where the effect of one firm's market strategies damaged its competitors.

Whoa there!  Is it not the aim of every firm to wipe the floor with its opposition?  Is it not that sort of rivalry that leads to keen prices and the constant search for improved products and better service?  The ACCC would argue that they would judge where the particular strategies are legitimate, but business, chastened by some pretty low blows from Professor Fels, is in no mind to trust him.

Many businesses consider the ACCC has greater powers than Commonwealth Ministers whose real ability to act is disciplined by a hostile Senate.  Although the ACCC's decisions can be challenged in the courts, this is a lengthy process and embarking on it will generally defeat the purpose -- business firms, unlike bureaucracies, have to act fast to seize opportunities or watch them disappear.

Some business people welcome increased power for the ACCC, especially petrol retailers and pharmacies.  They see it as a bulwark against powerful suppliers.  Yet the petrol suppliers have had 45 different inquiries into their operations without these producing a scintilla of evidence of market power.  This is hardly surprising since they have been bleeding red ink for many years now, a feature that is rarely consistent with bloodsucking monopolies.

Those seeking regulatory assistance to gain a short term edge over their suppliers should bare in mind the longer term damage that such government control does to the efficient operations of a market.

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Writing on the Wall for Unions and Labor Party

The change in the structure of employment has led to a remarkable transformation in the relative importance of trade unions and "non-employees" within the workforce.  "Non-employees" include owner-managers, contractors, own account workers and so on.  They now considerably outnumber unionists within the workforce.  Nor are these people underpaid.  In general their income levels are above those of those of unionists.

Thirty years ago most employees belonged to unions and even in 1986 the figure was 46%.  On the latest data, unions can claim 24% of employed workers.  However, once contractors or worker-employers and other similar workers are included the unionised share of the workforce drops to about a fifth.

The Cole Royal Commission into the building industry is showing how unions use their muscle to rope-in reluctant workers.  Some labour hire firms have to pay their employee's union subscriptions as a condition of being able to operate.  Even so union membership as a share of the working population is in precipitous decline.

This is all the more so for private sector employees, who are far less unionised than their public sector counterparts.  48% of public sector employees but only 16% of private sector workers are in a union.

A traditionalist might argue that public servants continue to flock to the union banners because, in contrast to the private sector, the government sector ruthlessly exploits its human fodder!  More probably, unions continue to occupy the heights in the public sector because many government workers are ideologically disposed towards them.  Also, in some cases, the unions offer a valued service, for example in providing insurance to teachers.

But outsourcing, especially in the public sector, means a steady erosion in union coverage of the workforce.  Outsourcing of tasks previously undertaken by employees is in part a budgetary response to the excessive costs and inflexibilities brought by union conditions of employment.  It augments other trends that are reducing the importance of the traditional employer-employee model, trends which include an increased preference for part-time work, and a greater need for specialised services.

By contrast, to the mauling that union membership is receiving at the hands of workers with choice, the "non-employee" element of the workforce appears to be growing strongly.  Non-employee workers account for an estimated 23% of the total workforce and 28% of the private sector workforce.  By contrast union membership is down to 21% of total workers and only 16% of private sector workers.  And the union membership is artificially boosted because it includes reluctant contractors who are forced to join up.  This is certainly the case with those contractors working on building sites who have Troubleshooters as their agent.

The power of unions in some workplaces stems from the radical nature of their leadership and its determination to exercise control.  By contrast, most workers just want to get on with their lives.  For most workers work is only one of a great many important things in their lives;  for many it is simply a means of gaining income to do other things.  So the prominence a union might gain from militancy in a particular work environment tends to undermine its attraction in more general situations.

Union leadership czars increasingly resemble dinosaurs on the cusp of extinction.  Internecine disputes and the imperial way that union bosses without consultation move the membership to whom they are supposed to be responsible between ALP factions and sometimes to different political parties must surely be further detracting from their appeal.

The declining importance of unions goes to the heart of the reforms to the Australian Labor Party that Simon Crean is trying to bring about.  Unions are losing their relevance to the Australian workforce, yet continue to command 60% of the votes within the ALP.  Other centre left parties have managed to break the now damaging stranglehold that their union-creators had on their policies.  The ALP will join the unions at the margin of relevance unless they follow suit.

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The Future Belongs to Us

Oh what a time to be in business in Australia.  The economy is going gang-busters.  The Aussie dollars, despite its recent rise, is still one of the most undervalued currencies in the world.  Exports are growing strongly.  Capital investment is rising as is labour and capital productivity.  Unemployment is in the decline.  And the world economy appears to be improving with even the moribund giant -- Japan -- showing signs of life.

The challenge is to take advantage of these opportunities and consolidate Australia's future.

The biggest impediment to this lies in the area of workplace reform.  While advances have been made in some workplaces, much remains to be done.  The latest edition of the World Competitiveness Index shows that industrial relations remain the weak link in Australia's outlook.  Australian workplace regulations rate some twenty percentage points below US and the UK.

The improvement we have made in recent years has come about by firms and workers avoiding the regulatory net altogether rather than by better regulation.  Over the last two decades the great bulk of new jobs have come in the non-unionised services sector.  In addition manufacturers and miners have significantly, contracted-out work and where feasible adopted individual contract.  These trends have resulted in large productivity gains.  They have also contributed to a less regulated workforce, with private contractors now exceeding the unionised workforce.

The regulatory regimes however have not improved significantly and the states are now winding back past reforms and widen the net to entrap contractors and service workers.  While companies under federal jurisdiction do have the option of individual agreement via Australian Workplace Agreements, these have proven to be very costly and have been strongly resisted by unions.  Individual agreements have now been outlawed at the state level in all states.  Enterprise Agreements do offer scope for greater flexibility but this has seldom been exploited with most EB's simply mirroring industry awards.  They also characteristically impose bureaucratic decision making processes which greatly limits the ability of management and workers to make decisions and optimise their work places.

The unions also have their sights on fast growing service industries such as call centres, IT services and house construction.  Awards have been drafted and campaigns are underway to pull these non-unionised and high competitive activities into the IR net.

What is worse, sections of the union movement have in response to declining membership become more militant and destructive as witnessed by the recent strike at BHP's Western Port steel plant that threatens to shutdown the car industry.  While the number of days lost to strikes is not rising, the overall cost of union action is increasing.  The unions are picking their targets more carefully to maximise collateral damage and firms are more exposed than every to strategic attacks.

Thus while the times may be good, unless we make a concerted effort to reform our workplaces they will not last and opportunities will be lost.

PS On the 18 May I stated that Greenpeace broke into the Caltex refinery.  While they did break into a refinery it was the SPP refinery not Caltex's.

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Building a Case Against Unions

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

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

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

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

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

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

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

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

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

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

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

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

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

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Just How Many Are There?

Occasional Papers

Employees?  Independent Contractors?
Clarifying the Confusing Statistics

INTRODUCTION AND SUMMARY

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

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

The following is clear from the 1998 ABS data:

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

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

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

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

• over 28% in the private-sector workforce.

REASON FOR THIS PAPER

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

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

SHARE OF NON-EMPLOYEES IN THE WORKFORCE

THE ISSUES

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

The ABS collects data in three forms:

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

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

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

There are three major classes of interest in the matter.

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

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

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

Source:  Productivity Commission

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

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

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

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

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

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

BASE CASE DATA

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

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

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

GETTING A BETTER FIX ON THE STRUCTURE OF EMPLOYMENT

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

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

The breakdown of employment is shown in the figure below.

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

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

FURTHER REFINING THE DATA

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

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

1998 Decomposition of ABS Data on Casuals

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

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

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

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

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

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

NON-EMPLOYEES AS A SHARE OF THE PRIVATE SECTOR WORKFORCE

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

TRENDS IN CATEGORIES OF EMPLOYED PEOPLE

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

---

ENDNOTE

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

Power Without Reason

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

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

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

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

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

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

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

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

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

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

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

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Is the National Broadcaster Biased or Just Doing its Job?

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

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

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

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

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

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

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

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

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

Generator Market Power and Bidding Rules in Wholesale Markets

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

ELECTRICITY AND GAS AS COMMODITIES

The electricity and gas markets are fundamentally commodity markets.

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

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

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

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

THE ELECTRICITY CODE

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

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

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

These include:

Gazette Notices

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

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

Proposed Code changes forwarded to the ACCC

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

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

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

EVIDENCE OF GENERATOR MARKET POWER

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

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

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

The causes of the Californian meltdown were clearly a mixture of

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

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

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

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

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

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

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

Average Prices in Major National Electricity Markets ($)

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

COMBATING MARKET POWER

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

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

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

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

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

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

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

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

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

Following meetings and discussions these became:

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

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

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

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

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

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

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

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

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ENDNOTES

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

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

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

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

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

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

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