Petroleum Refining: Rationalisation or Atrophy?

Backgrounder

Summary

The Australian petroleum refining industry provides the fuel without which our economy and society could not function.  It is an industry in trouble.  It is fragmented and badly structured.  It makes a totally inadequate return for its investors.  In this weak state it operates in a completely open Australian market, competing with the best of the overseas refineries.  These are often several times the size of the biggest Australian refineries.  In addition they often enjoy more favourable tax regimes, have a growing excess capacity and generate surplus gasoline for sale in our region, including Australia.

This is a challenge we have to meet.  There is no possibility that substitute fuels will make a dent in the demand for petroleum, let alone supplant it, at any time in the foreseeable future.  The challenge is to create the conditions in which the industry can restructure so as to respond to the fierce and growing foreign competition.  In this endeavour the main task is for the industry to optimise the use of existing and new investment.  To do this requires the cooperation of government in Australia mainly by ceasing to obstruct its efficient operation.  State governments have a plethora of inconsistent regulation on fuel standards, additives and pricing, which breaks down the small Australian market into even smaller units, the size of tiny overseas countries.

Competition law retards or prevents potential rationalisation which would allow the industry to reform into more competitive units.  A sensible and cooperative effort by Commonwealth and State governments could clear away the regulatory mess.  At the same time it could provide the competition authorities with clear guidance as to the public benefits to be derived from reform.  The alternative is continued poor returns and functioning of the industry and slow inevitable decline.

INTRODUCTION

If we were to set the rules of boxing so that Australian lightweights competed against heavyweights from overseas, we would think it irresponsible.  But this is a reasonable metaphor for the current public policy applied to the Australian petroleum refining industry.

We have a fragmented and stunted petroleum-refining sector.  It survives by abjuring profit and mortgaging its future.  The question we face is how to change the rules to concentrate this lightweight team, which is taking a battering, into a few refinery heavyweights that will match the international competition in the years ahead.

THE INDUSTRY NOW

AUSTRALIA IS A SMALL PLAYER

Australian output of refined petroleum products roughly matches domestic demand.  Both are very small in world terms.

The most recent international figures show that our total production in the third quarter of 2002 was 8.9 million tonnes, compared with OECD production of 486 million tonnes, including US production of 202 million tonnes.  The relatively small size of our industry reflects our small local market and our inability to develop major export markets.

As for our region, Australia has about 4 per cent of current Asia-Pacific refinery capacity and accounts for less than 5 per cent of regional production.

Total Australian refinery capacity is shown in Table 1.  Capacity has been virtually unchanged for the last five years.  Our total capacity of 870,000 barrels per day (bpd) compares with the figures for China (5.3 million), Japan (4.7 million), South Korea (2.6 million), India (2.4 million) and Singapore (1.1 million).

Table 1:  Australian Refinery Capacity

	Barrels per day
Caltex Lytton (QLD)	105,000
Caltex Kurnell (NSW)	120,000
BP Kwinana (WA)	138,000
BP Bulwer Island (Qld)	83,000
Mobil Altona (Vic)	135,000
Mobil Port Stanvac (SA)	78,000
Shell Geelong (Vic)	125,000
Shell Clyde (NSW)	86,000
Total	870,000

Source:  Industry estimate.

Total Australian refinery inputs and production are as shown in Table 2.

Table 2:  Refinery Input and Production (Megalitres)

	Input		Production
Year	Total	Percentage Indigenous	LPG	Gasoline	Aviation Fuel	Diesel	Fuel Oil	Other	Total
1999-00	44,500	39.8	1,674	18,652	5,689	12,736	1,838	2,900	43,499
2000-01	44,708	38.3	1,794	17,886	5,963	13,212	1,951	2,672	43,490
2001-02	42,910	34.4	1,718	17,999	5,536	13,064	1,684	2,425	42,427

Source:  Department of Industry, Tourism and Resources.

Some important facts emerge.  First, there is a sharp decline in the indigenous contribution to refinery inputs.  This is a trend that is likely to continue with the peaking of local crude production in the fields close to the refineries in the South East of Australia.  Second, total output of products levelled off.  Third, reduced gasoline production accounted for a large part of this shift.  It is too early to say that we have reached a plateau, but the recent production trend looks more than a blip and possibly represents the beginning of a slower growth era.

Total regional refining capacity and production continues to grow despite declines in some countries.  In the five years to 2000, regional output grew by 22 per cent.  In the next few years, Chinese capacity is forecast to increase by more than the total existing Australian capacity and there will be large increments in Taiwan.  Middle East refinery capacity is also forecast to grow strongly.

Any decisions we make on the future of the industry will not influence our international environment.  Decisions will be made for and by ourselves.

The Structure of Our Refining Sector Is Out of Date The dispersed geographical distribution of our refining sector reflects its historical development, with each State capital city supporting one or more refineries.  The location of Australian refineries is as shown on Figure 1.

Figure 1:  Location of Refineries in Australia

The industry has restructured radically in one sense by expanding production to accommodate steadily growing domestic demand for fuel as the total population and vehicle ownership have increased.  Motor vehicle numbers were just over five million in 1971 and close to 13 million in 2002.

Despite this growth, over the last two decades the number of major oil companies operating in Australia has shrunk from nine to four.  Esso, Amoco, Ampol, Total and HC Sleigh have all left the field.  In each case, low returns and the potential for rationalisation of production were factors.  Although the number of players has more than halved, the number of refineries has reduced by only two, from ten to eight.

We suffer disadvantages of scale.  The average capacity of Australian refineries is around 100,000 bpd and none is much larger than the average.  New refineries in the region, particularly those engaged in export, are generally significantly larger.  Singapore's largest has 375,000 bpd, South Korea, 819,000, Taiwan 524,000 and Thailand 277,000.

The refinery capacity utilisation figure for Australia is generally estimated to be around 85 per cent.  This does not necessarily suggest very substantial overcapacity, even allowing for slower growth in demand.  The pattern of relatively small scattered refineries, however, is no longer optimal in a free market with large overseas players and continuing pressure to invest in cleaner fuels.

REFINING COSTS ARE RELATIVELY LOW

Despite its sub-optimal structure and odious comparisons with overseas operations, the Australian refining industry is not grossly inefficient, rather the reverse.  Nor did it sit on its hands as the competition became more intense.

Production efficiency has improved.  One indicator is the 9 per cent reduction in employee numbers over the four years to 2001.  Another is the value added per employee, which stood at $293,000 per employee in 2000-01.  This places the industry in the top five performers in the Australian manufacturing sector.

There has been $2.4 billion of new investment over the five years to 2001.  The new investment, however, would not all have added to productivity.  Much of it would be to satisfy new fuel standards.  The industry estimates that 28 per cent of its new investment in the five years to 2001 could be classified as environmental.

The cost competitiveness of Australian products is indicated by relative retail prices (see Chart 1).  This Chart shows that we have the cheapest ex-tax price of petrol in the OECD.

Chart 1:  Petrol Prices and Taxes in OECD Countries June Quarter 2002Source:  International Energy Agency

The cost/price performance is not all due to production efficiency, although this is undoubtedly a factor in the ability of the industry to maintain its position.

More detailed performance comparisons with the rest of the Asia-Pacific, where our main competition is found, are more relevant.  These suggest that while Australian refineries do not have the extremes of performance that occur across the region, nevertheless, we lag the average efficiency.  This includes factors such as capacity utilisation, energy intensity of production, labour productivity and operational availability.  Perhaps, more importantly, the best performers in the region are superior to our best.

Given the open Australian market, ex-refinery prices are virtually set by the major exporters in the Asia-Pacific region who are also operating on very narrow margins.  The proportionately heavy demand for diesel in South-East Asia tends to generate a persistent surplus of gasoline.  This surplus is available for export to Australia at discounted prices.  It is virtually a by-product.  The high public profile of retail petrol prices also exerts restraint.

All these factors have been instrumental in keeping pressure on costs.  The sum of them has not been sufficient to yield a satisfactory profit margin.

BUT ITS FINANCIAL PERFORMANCE IS POOR

Gross annual revenues for the whole industry, including marketing, were $32 billion in calendar year 2001, little changed on the previous year.  Marketing and production costs for the industry, excluding one-off factors, however, increased by 11 per cent -- well above current inflation rates.  Over the four years to 2001, the fixed asset base of the industry declined by almost 6 per cent to $12 billion, even after $2.4 billion of new investment in the period.

For the five years to 2001, the return on assets for refining and marketing averaged 3.8 per cent and was negative in the last two years.  The return on shareholders' funds was little better.

In the calendar year 2001, the refining sector lost $472 million -- a significant turnaround from the previous year.  Even allowing for stock gains, the sector just broke even.  The indications are that 2002 may have been a better year for the industry, but that the return on assets remains well below the cost of capital.

Shell has asserted that the refining and marketing margins that it achieves in Australia are lower than in any other country in which it operates.  Comparisons of profitability within the Asia-Pacific region support this statement for the industry as a whole.

ALTHOUGH NO-ONE IS LEAVING THE GAME

If there has been such sustained under-performance, why has no-one pulled out of the industry?  There are perhaps four main reasons.

First, the industry has engaged in continual productivity improvement.  Successive company programmes kept pressure on costs and operational efficiency, allowing them to keep within range of prices.

Second, everyone hopes that someone else will blink first.  The existence of huge sunk costs and significant possible gains may mean that the waiting could pay off.  This is not the same as the gambler who faces zero-sum or certain long-term loss -- there is the potential to hit a sustained winning streak if one or more players leave the table.

Third, the costs of leaving the table, the exit costs, are very high because of the nature of the product and the long occupancy of most sites.  The player doesn't just lose his stake, but pays a substantial penalty to leave.

Fourth, even while profitability is low, the industry has generally been marginally cash-positive.  So, each player can sit it out without going into death throes, even though they are all making a very poor return on capital.

These add up to a big "first mover disadvantage".  There is some incentive to stay and a powerful disincentive to leave.  The ongoing situation is not in the public interest but it is internally self-sustaining.

To conclude, we observe an industry that is making the best of the conditions in which it operates.  Its structure is historically determined and inappropriate but rigid.  It is ill-adapted to the future it faces.

THE FUTURE OPERATING ENVIRONMENT

The future the industry faces will be different from what now exists but probably less changed than some would expect or prefer.

PETROLEUM IS AND WILL REMAIN OUR MOST IMPORTANT ENERGY SOURCE

Petroleum products are 52 per cent of Australia's final consumption of energy (see Chart 2).  Nor is this likely to change in the next decade or so.

Chart 2:  Final Energy Consumption Market Shares 1998-99Source:  Australian Institute of Petroleum.

In 2019-20, the projection is for it to supply 50 per cent (see Chart 3).  Projections that far out in time are unreliable, but they indicate the absence of any major, foreseeable influences that will change the existing pattern dramatically.

Chart 3:  Final Energy Consumption in Australia 1998-99 and 2019-20Source:  Australian Institute of Petroleum.

Liquid petroleum fuels provide more than 95 per cent of Australia's transport needs and there are no forecasts of dramatic change here.  Industry forecasts indicate a slow growth in demand -- perhaps 1 to 2 per cent annually in volume, mainly driven by gasoline and diesel.

Are these reasonable scenarios?  Are there factors external to the industry that could dramatically change the outlook?  Can we reduce our demands for energy and/or for petroleum?

The three answers are "yes", "maybe" and "no" for the foreseeable future.

It is possible for us to be more fuel-efficient.  There have been major advances in fuel economy and these will no doubt continue, although possibly at a slower rate.  But more than counterbalancing this are two great socioeconomic developments of the post-war period -- the inexorable growth in demand for personal mobility and a parallel desire for traded goods from distant parts.

The causes of this are sufficiently powerful and enduring for us to conclude that, although growth in energy consumption may slow in Australia, we will not be reducing our consumption to any significant degree in the foreseeable future.

The significance of this is that there will be a permanent role for a substantial Australian refining sector.

SUBSTITUTES WILL MAKE LITTLE DIFFERENCE

Alternative energy sources, whether domestic or overseas-produced, will not be credible substitutes for petroleum.

First, there will be no shortage of cheap oil.  The spectre of declining world oil reserves has been comprehensively exorcised.  OPEC production capacity grew by 1 million bpd in 2001 alone and world crude production capacity is forecast to grow by as much as 1.5 million bpd pa for the next five years.  There is also potential for a massive further increase in world production if the price warrants it.  Furthermore, any significant sustained rise in the price of oil could bring in huge reserves of lower grade deposits, a burst of new exploration and, with a lag, a strong fuel-economy response.  This indicates a continuing downward pressure on the price of both crude oil and refined products and the relative unattractiveness of alternatives.

Second, the substitutes for petroleum are not promising.  Gas looks the most promising of the substitutes.  It offers an opportunity for some transport fuel substitution.  But very substantial new investment is needed just to avoid looming shortages, let alone allow for large-scale substitution.

Gas-to-liquids is another of the more promising of the technologies.  Its commercial prospects are clouded by gas/oil price relativities and the premium that consumers are prepared to pay for this alternative (which is generally not much).

Most other substitutes are much more expensive (and hence require substantial subsidies), are more adapted to stationary than transport uses or need significant further technology breakthroughs and development to become viable.  The solar car is still a long way off.  Electric vehicles have a long history but in very limited applications.  Solar domestic water heating has become an alternative but it is still subsidised, it has not made major inroads and it mainly substitutes for electrical, that is, coal-powered, energy.

Biofuels owe their existence to their exemption from the tax regime applied to petrol and have made little impact.  The penetration of biofuels is only really significant in countries such as Brazil where their use is mandated.

Although much publicised, alternatives constitute a very small and slow-growing presence.  In the OECD, renewables increased their share only from 2.1 to 3.4 per cent of primary energy supply between 1973 and 2000 -- despite two major oil crises in that period.  Nuclear power increased from 1.3 to 11 per cent.  It is worth noting that although the petroleum share declined over the same period, in absolute terms it still grew almost twice as fast as renewables.

Chart 4 shows the global picture from 1971 to 2020.  It illustrates the continuing dominance of coal, petroleum and gas.  Currently, alternative fuels supply no more than 1 per cent of the market for petroleum products in Australia.  Attempts to enforce significant further substitution would be at heavy economic and financial cost to the community in return for uncertain gains.

Chart 4:  Total World Energy Supply to 2020 -- by Fuel
(Millions of tonnes of oil equivalent)Source:  International Energy Agency.

On any level playing field, petrol wins hands down.

This is treated at greater length here than is justified by the promise of alternative fuels because there is always a vocal group of activists who can see the promised land of biofuels, gas, solar, wind and wave power, where all the problems of petroleum and other carbon fuels will be solved by doing away with the need for them.  This eco-smokescreen can encourage policy makers not to tackle those problems in the vain hope that they will magically disappear.

THE EXPORT POTENTIAL FOR REFINED PRODUCTS IS LIMITED

The pattern of Australia's trade in refined products is partly geographically determined.

Northern Australia imports the bulk of its product requirements from Singapore, which is a shorter transport haul than from the Australian refineries.  Therefore, this is not entirely a pattern of generalised import penetration.

The geographical offset is in the pattern of exports, where the major refineries supply Pacific destinations.  Exports of products are not insignificant.  In 2001-2002, they were twice the volume of imports, although this was unusually high.  The principal destinations were New Zealand and the Pacific Islands, with China and Singapore also major customers.  Actual Australian export volumes have tended to be steady over recent years at around 7,000 megalitres, but one quarter of this is LPG sold mainly to Japan and China.

New export potential for petroleum products seems likely to be niche and minimal.

China and India used to be major importers of product until two years ago and are now major exporters, particularly of gasoline.  Refinery capacity is planned to continue to grow strongly in the region even though there is already significant excess.

An estimate of capacity utilisation average for the Asia-Pacific region in recent years is shown in Table 3.  Although the absolute figures for Australia appear high, the important point is the decline in utilisation in major exporters such as Singapore, Taiwan and Thailand.  Increasing our output significantly in the face of greater overcapacity in the region looks a very difficult task.  Also, several of the biggest and fastest growing players, China, India and Taiwan have regulated markets so it will not be a question of open competition in those markets but more one of individual marketing deals.

Table 3:  Asia-Pacific Refinery Utilization (Percentages)

	1998	1999	2000	2001
Australia	107	102	93	94
China 1	64	66	75	75
India	106	91	89	95
Indonesia	91	89	93	90
Japan	85	84	85	85
Malaysia	83	87	83	84
Pakistan	103	94	86	95
Philippines	86	85	80	84
Singapore	85	80	72	69
S. Korea	88	94	95	92
Taiwan	85	91	85	81
Thailand	93	86	84	82
Asia-Pacific 2	85	85	85	85

¹ Based on all refineries
² Only the countries listed here

The demand outlook remains weak.  Singapore margins are very narrow -- below 2 per cent.  Historically, Asian margins were the best, followed by Europe and the US.  In recent years Asia has changed places with the US and now has the worst margins.

Any company contemplating investment in export capacity in Australia would consider our locational disadvantage, on the edge of the Asia-Pacific region, which implies high sea transport costs both for products and for the increasing proportion of feedstock we will be obliged to import in the years ahead.  This is compounded by the general investment disincentives discussed below.

Furthermore, it is expected that product specifications in Asia, the US and Europe will converge in the coming years, leading to globalised product markets and the elimination of niche opportunities based on fuel specifications.  No-one in their right mind would consider setting up a new export-dedicated refinery in Australia to exploit niches.

Overall, it's a tough environment in which to export, the outlook is not for major export surplus, nor are we geared up for it without massive investment, which the industry is most unlikely to attract.

SO THE INCENTIVE TO INVEST IS NOT STRONG

While there are strong pressures for the industry to restructure, there is little incentive to invest for this purpose.  Investments in the Australian industry have to compete with many alternatives across the globe and we are a small market.

Lack of sufficient return is the single biggest deterrent to investment in the industry at present.  There are other investment deterrents.  Surveying the prospects in Australia from a distant boardroom, the global executive would see:

• There is no prospect of strong growth in demand to offset the substantial risks that are associated with the large blocks of new investment that typify the industry.
• The corporate taxation regime is now less favourable than hitherto after the substitution of effective-life for accelerated depreciation.  The competing Singapore option offers a three-year write off.  The reduced corporate tax rates are not an incentive where returns are low.
• The regulatory cost burden is growing.  This applies to all Australian industry but is potent in overseas comparisons.  Tighter fuel standards, environmental restrictions, intervention in prices and industrial law are some of the factors.
• There is increased sovereign risk stemming from inconsistent regulations.  This arises from the existence of eight parliaments, which enact inconsistent laws.  Current examples are the higher fuel standards applied in Western Australia, the separate South Australian fuel standards, the use of methyl-tertiary-butyl-ether (MTBE) in fuel in NSW and Victoria (banned in Queensland and WA) and the interference in prices in WA and Victoria.  The already small fuel market is further fragmented by regulation.
• The sovereign risk also arises from uncertainty in the regulatory process.  There are unpredictable changes of direction (the deferral of the diesel sulphur excise differential [DSED]) and uncertainty in the face of conflicting interests (will the Government act on ethanol content -- will the ATO further attenuate effective life?).

All the factors listed above enter into the risk/reward calculation.  When the rewards are minimal, the risks take on an extra dimension.

The last factor in the list is particularly worrying as it suggests a systemic failure of government process.  This is often a feature of governments that have been in office for an extended period.  Sound and thorough consultative processes and announced policy are supervened by last-minute lobbying.

This seems to be what happened with the DSED.  Meanwhile, millions of dollars had been spent on the basis of the announced policy.  The proposed change was stalled with substantial costs to anyone who relied on the Government's promise.

The result is not only an increase in current sovereign risk.  It treats the industry partners with contempt.  It also undermines future processes.  With moves towards cleaner fuels, the wise strategy now would be for refiners to wait until regulation is enacted before investing.  This way they can be sure of the change.  The unfortunate corollary would be sharp, destabilising price-spikes.

The market for petroleum products in Australia will remain competitive.  Competition among oil producers and refiners alone would ensure this.  Also, it is clear that free trade in products will continue, so the persistent refinery capacity overhang in our region will also overhang our market, keeping sustained pressure on margins.

The prospect for the refining sector is a slow-growing domestic market and no blue-sky opportunities in the export markets.  This is not an environment in which the required investment will take place.

WHERE TO FROM HERE?

With restructuring, the industry will not expand much.  Without restructuring, the industry is likely to slowly contract, necessitating increased importation of products.

The clean fuels regulations, which are gradually emerging from national jurisdictions and converging internationally, could well be the catalyst for change in Australia.  They will require heavy new investment with uncertain returns.

WHAT INDUSTRY STRUCTURE DO WE NEED?

The short answer is:  we cannot know in detail.  The best structure has to be worked out in the light of relative efficiencies, market developments and broad policy.

Refineries are expensive to construct or to alter, so we are to some extent stuck with past decisions on refinery location and scale of production.  But the industry has demonstrated a capacity for both incremental and more radical changes in structure, given the right conditions.

We are also "stuck" with some important elements of policy which will partly determine the structure.  The open door to imports forces the industry to remain efficient and ultimately will force it to consolidate.

There are differing opinions on what the structure should be.

In the Downstream Petroleum Industry Framework 2002, the Department of Industry, Tourism and Resources set out key tenets to guide the future framework:

• A preference for market-based solutions.
• A strong, efficient, environmentally responsible industry supplying most of the nation's needs for products.
• Regulation only for market failure or national interest objectives.
• Regulation to be transparent and consistent.
• Reform and regulation to maximise longterm community benefit.

This industry vision has some prescriptive elements, although the Government has made it clear that it will not nominate an optimal number of refineries or a pattern of production.  This is in the context of the present reality, where the Australian Competition and Consumer Commission (ACCC) can determine the actual number of refineries in a negative fashion by forbidding mergers.

The Industry Framework is a mixture of economic and strategic objectives.  The references to market-based solutions and efficiency are economic criteria.  The reference to supplying the majority of Australia's needs is strategic and potentially in conflict.

One could infer from the key tenets that government has a vision for the industry but that it will not be "dirigiste" in effecting that vision.  At its most simplistic, the vision is little more than a wishlist with no new policy to back it up.  It is certainly not a preferred industry structure.  The current review of the industry by the Prime Minister's Energy Task Force may produce a more definitive policy and result in some pressure on the industry to ensure that the refiners take action to restructure within the framework of the vision.

The Australian Institute of Petroleum has argued for an industry policy for the refining sector to give all stakeholders some guidance and increased certainty about the future direction of the industry.

The general public would probably opt for a structure that guaranteed lower, more stable automotive fuel prices.  Unfortunately, they cannot have both in the short term.  A better industry structure would deliver lower average prices than continuation of the current structure.  A reduction of volatility would not, however, be guaranteed.  It is ironic that the intense political attention to this industry stems from a pricing characteristic which government interference has made worse.

One might argue that the investors in the industry are the ones entitled and best suited to determine its future.  In the extreme, they will do it anyway -- either by persisting or walking away.  At the very least, they ought to be able to redeploy their capital within the industry if they so wish.  Generally speaking, they will seek to maximise their returns and thus promote the most efficient use of the nation's resources.

At the public interest level, the value of government guidance is questionable.  Even if it were possible to confer increased certainty from the government level (which history teaches us to doubt) is this legitimate when the implicit outcome is to preserve the current level of activity and protect the current industry participants?  Attempts to achieve particular industry structures often lead to the preservation of inefficient, protected species.

For example, we might be better off as a nation importing more of our refined product needs from efficient refineries overseas and reallocating our resources to activities we do better here.  After all, self-sufficiency in refined products is limited without self-sufficiency in crude oil, which we expect to decline dramatically.

Australian refineries are not inefficient.  They no doubt compare well with many overseas refineries, especially where such refineries are in a protected market.  But they are not as efficient as they could be.  And, anyway, that is not the point.  Our market is open, so the competition we face is the best of the overseas, often with more favourable tax and subsidy regimes.  We want our refineries to be able to match them as viable entities.

This is not simply a question of closing the smallest refineries.  The Port Stanvac refinery in South Australia has a specialised lubricants capacity.  The Clyde refinery in Sydney has recently been upgraded to meet higher diesel fuel standards.  Also, any closure involves a very large investment in cleanup on which there is no commercial return.

A better approach might well be to allow refining companies to concentrate on what they do best.  Thus, in Brisbane, the Bulwer refinery might focus on diesel production where it has invested to meet higher diesel fuel standards, and the Lytton refinery on petrol.  The Altona and Geelong refineries could co-operate so that they were not both investing to meet cleaner fuel standards in all fuels.  Refinery alliances are not unprecedented.  Caltex and Shell have co-operated in this way in Thailand.

When considering the best structure for the industry, what it should be contemplating is a fairly defensive long-term strategy of:

• Improving what it already does;
• Containing costs rigorously;
• Investing in efficient technologies;
• Increasing the scale of production within the existing market parameters to fully exploit the geographical protection it has;  and
• Taking full advantage of the sunk costs inherent in existing refineries.

To do this it requires a supportive framework.

What is apparent is that it is unreasonable to simultaneously open our markets to international competition, Balkanise the industry and restrain it from putting together the best structure to compete.

The fact is that the detail of the decisions can only be made by the industry, relatively free of government direction of investment or divestment decisions.  The series of detailed decisions will then, as always, determine the overall structure of the industry.

THE CONTEXT IS A CONSISTENT ENERGY POLICY

Reform of the refining sector has to be conducted in the context of an efficient energy sector.  This, in turn, means consistent energy policies.

This paper will not attempt to deal with policies for the sector as a whole, but it is worth noting that no other sector has been subject to such conflicting policy objectives and instruments as energy.  There is total confusion as to what the various governments and agencies want of the sector and what they see as its future.  Energy policy is therefore piecemeal and the handmaiden to other policies -- social, regional, environmental and consumerist.

THE GOVERNMENT IS HERE TO HELP

Government intervention specifically aimed at the petroleum industry is extensive and detailed at every step -- from the moment the crude oil comes out of the ground to the point where it is emitted as exhaust from the tailpipe of a car.

The public interest is purportedly served in a number of ways by such interventions.

There is an obvious public interest in specifying standards for the production, transport and storage of petroleum given its volatility and potential flammability.  Related matters such as the cleanliness of fuels have gradually supplemented these health and safety standards.

A further refinement of such standards, which places heavy cost burdens on the industry currently, is environmental improvement.  For example, the massive shift to unleaded petrol, which has taken place over the last 15 years, is now taken for granted, although it represented a very significant structural adjustment.  By 31 March 2002, 69 per cent of the total motor vehicle fleet of 12.8 million vehicles were manufactured to use unleaded petrol compared with 51 per cent in 1997 and 27 per cent in 1991.  The current move to lower sulphur levels in diesel will cost the industry well in excess of $100 million.

Then there is the last resort of failed economic policymakers -- price control -- which, except in WA and Victoria, has thankfully disappeared from this sector after many wasted years.

The relevance of the regulatory burden is that it is often a drag on operational efficiency.  It also can act as a barrier to entry and to exit, limiting the flexibility of the response to changing prices and supply and demand conditions.

AND COMPETITION REGULATION CAN IMPEDE MORE EFFICIENT STRUCTURE

Competition regulation sounds like an oxymoron, but the intent is to foster competition by preventing or regulating market imperfections.

For the structure of the refining sector the crucial powers of the ACCC are those which regulate mergers and acquisitions (Section 50 of the Trade Practices Act) and those which permit authorisation of mergers that might otherwise breach the Act (Section 88 of the TPA).

The relevant provision of Section 50 prohibits mergers or asset acquisitions:

that would have the effect, or be likely to have the effect, of substantially lessening competition in a market.

It is potentially an extremely restrictive provision.  The ACCC is comfortable with this.  Moreover, the ACCC interpretation of what is "substantially lessening" and what is a "market" embraces conduct that might be seen as trivial and markets that appear quite small.

The ACCC has had an abiding and intense interest in the petroleum industry, which is thought to represent a special competition policy risk.  The level of concentration, with just four major domestic competitors, is high.  This, combined with consistent media attention, has provided justification for the ACCC to restrict rationalisation under Section 50.

The ACCC leans heavily on the "perfect competition" model involving numerous buyers and sellers and reliable price information.  It is reluctant to allow sellers to cooperate in anything, particularly where they are few in number and where their co-operation might lead to the adjustment of one or more of them out of the market.  Unfortunately, such adjustment will often take place anyway, with the bloody death of one or more competitors.

The ACCC's concerns are exaggerated.  But they are complemented by a persistent public misperception about petrol prices.  A large section of the public believes that the industry makes massive profits out of the wide retail price swings.  In fact, it barely breaks even.  This perception that price swings equals profits has been so exploited for political advantage and media excitement that it is now almost impossible for the truth to emerge.  The appointment of a shadow federal minister with responsibility for petroleum prices is just the latest manifestation of the enduring fairytale.

The industry regularly beats itself up for not convincing the public of the reality of petrol pricing and profit, but sadly there are currently far too many groups with an interest in the falsehood for the truth to prevail.

The future intensity of competition in this industry, if it is allowed to restructure, should not be in doubt.  Any rationalisation would in all likelihood still leave strong domestic competition in each major product category, with the industry operating perhaps at fewer sites but more efficiently.  In addition, there would be numerous potential importers and many independent retailers.

Concentration of ownership is a furphy.  The High Court has recently ruled in the Boral case that the market reality is more important than the perception of anti-competitiveness.  It noted that financial strength did not equate to market power and that meeting a competitor's prices would not be predatory action.  This decision could have been designed for the refining sector where the competitive reality of the market is regularly misrepresented, where the few local producers are treated as dominant despite never being able to exploit their position and where their pricing is regarded as predatory even though it yields little profit.

This is a market with few local producers but it is contestable.  Sustained high margins would be unlikely to occur given domestic competition, but if they did, they would be rapidly eroded by imports of product.

Proposed mergers have been permitted in the past.  Generally speaking, vertical mergers such as the Ampol/Solo merger have been less problematical than horizontal ones such as the Ampol/Caltex merger.  In any case, the process is slow and permission is generally only granted with severe conditions on divestiture.  There seems to have been no evaluation of the impact of the ACCC on the structure, competition and prices in the industry.  There are strong arguments for allowing greater flexibility.

AUTHORISATION COULD BE THE KEY

If Section 50 is an impassable barrier, the authorisation provisions of the Trade Practices Act ought to be the way to greater efficiency.  The tests under these provisions require a public benefit which outweighs the competition detriment.  The ACCC lists fostering business efficiency, industry rationalisation and import competitiveness as important public benefits.  These must outweigh the detriments for authorisation to be granted.

There is a strong prima facie case that rationalisation of this industry could satisfy these tests.  It would allow greater scale of production, economies in distribution and closure of the least efficient production units.  But the satisfaction of the tests comes through a negative, slow and difficult process.

Without going into whether the ACCC interpretations are reasonable, they are nonetheless applied and, in practice, it is extremely difficult to challenge them.

Likewise, the authorisation process can prove to be a blind alley.  To be authorised the proposed conduct must demonstrate sufficient public benefits.  The onus for demonstrating the benefits lies with the applicant.  Again the process depends crucially on the ACCC's consideration of the merits of the case and slow process can amount to rejection.

Any merger of the few companies that operate refineries in Australia or any reorganisation involving closure and/or joint operation of refineries or other facilities will immediately be subject to these processes.  The processes are slow and there are strong arguments for allowing greater flexibility here too.

POLICY OPTIONS

If government cannot help the industry to adjust, it should allow the industry to adjust.  It should put in place policies that support sensible change.  This would involve both improving the operating environment through deregulation and altering the balance of competition regulation so that the industry could restructure voluntarily.  The Commonwealth Government has already indicated a willingness to support both but has not yet delivered.

The ACCC has always regarded mergers or cooperation in this industry with distrust.

Any change to the Act to ease the provisions would be unlikely to succeed, given the stated attitudes of the Opposition and Democrats in the Senate.  Short of this, the option seems to be a more flexible use of the authorisation provisions in Division 1 of Part VII of the Act.  This would allow mergers and/or asset acquisitions that would comprise restructuring.

Under the authorisation criteria relating to efficiency, rationalisation and competitiveness, it would be possible to make a substantive case for restructure of the refining sector.

Joint operations that did not reduce production capacity might be seen as preserving sufficient competitive presence.  The continuing growth of imports and the presence of strong competition at the retail level would also be factors to be taken into account.

There is also an opportunity for governments generally to clean up the mass of energy tax/subsidy distortions which have accumulated over the years.

The ball would then be in the industry's court to bring forward new proposals if a new policy environment could be created.  This should not mean divestiture undertakings that artificially create new protected operations.

This could all happen within a very broad strategic framework, agreed with the industry, whereby Australia continued to be sure of sufficient refining capacity to meet a severe international fuel shortage.  That might not mean retention of the existing level of refining capacity, but some minimum that ensured the continued functioning of the economy in an extended emergency.

PRACTICAL STEPS

This Backgrounder recommends that:

• The Commonwealth government should provide explicit indications to the ACCC of the public benefits it sees from the rationalisation of the refining sector.  In particular, joint ventures should be contemplated.
• The ACCC give sufficient weight to the public interest benefits of restructuring to allow rationalisation of production facilities.
• All governments reduce distorting fuel subsidies and taxes that favour particular sectors or fuels.
• The State governments act immediately to harmonise their regulation of the industry.  This should happen as soon as practicable and not at some distant date after one or more elections.
• Each State should agree not to issue any new regulation inconsistent with other States.
• More specifically, that they should have a single set of fuel standards with which refiners can reasonably comply, withdraw from all forms of price regulation, and refrain from thwarting or distorting the rationalisation process.
• Governments generally not introduce new regulation mandating use of alternative fuels.

It would also help if the Government were to scrutinise more critically the claims of consumers, farmers, environmentalists, truckies, etc., within the Framework.  This would provide a more consistent view of the public interest and mitigate the potential for last-minute "raids" on impending regulation.

CONCLUSION

The choice for the industry appears to be between accelerated rationalisation and atrophy.  The process of change is something which the industry must plan and effect.  It cannot do this, however, without the active support of governments in Australia and the tacit support of the regulatory agencies.

The task is not impossible but it will require the States, in particular, to sink their differences and their special agendas and allow adjustment to take place.  It will also require greater open-mindedness at the ACCC.  For the time being, there is an expressed willingness at the Commonwealth level but no real solutions.  At the State level, all is still in disarray.

If nothing is done, atrophy is certain.  The refiners will continue to stumble along in a regulatory fog and will invest only when obliged to do so by changing fuel standards.  They will become increasingly vulnerable to low-priced imports and eventual closure.

---

REFERENCES

Asia Pacific Databook 2.  Refinery Configuration and Construction, FACTS/EWCI.

Australia Country Profile, The Petroleum Finance Company -- Downstream Monitoring Service, June 2002.

Australian Petroleum Statistics, DITR, monthly (various issues).

Australia's Downstream Industry, Energy Alert No. 23, July 2000, FACTS INC.

Downstream Oil Industry Financial Survey 1997-2001, Ernst and Young on behalf of the Australian Institute of Petroleum.

Downstream Petroleum Industry Framework 2002, Department of Industry, Tourism and Resources, November 2002.

Downstream Petroleum Products Action Agenda 1999, Industry/Government Working Group, February 1999.

Energy Insights, The Australian Oil Industry, April 2002, FACTS INC.

Energy News, Department of Industry, Tourism and Resources, March and June 2002.

"Global and Asian Oil Market Outlook", July/ August 2002, presentation by FACTS INC.

Household Expenditure Survey 1998-99, ABS Cat. 6535.0.

Manufacturing Industry 2000-01, ABS Cat. 8221.0.

Motor Vehicle Census 1997-2002, ABS Cat. 9309.0.

Petroleum Refining and Marketing in Australia -- Changes Ahead, Department of the Parliamentary Library.  Current Issues Brief 11, 2002.

Trade Practices Act 1974.

Ian Blackburne, Paper delivered to Engineers Australia Outlook Conference, February 2000.

Fereidun Fesharaki, Presentation to Asia Oil and Gas Conference, June 2002.

International Energy Agency, various statistical publications.

Ian McKenzie, "Petrol, Perception and Politics", ABARE Outlook Conference, March 2002.

Avoiding an EBA's Shackles

For many Australians, the union movement's industrial, "Campaign 2003" might seem unknown, almost irrelevant.  But for decision makers in many industries -- CEO's, company directors, financial analysts and other senior executives -- the unions' promise to launch multi-tiered industrial and activists campaigns against them in 2003 is causing concern.  The car and food manufacturing sectors, commercial construction, chemical and petroleum industries, and call centres and aviation perhaps represent the primary but not only industries on the unions' hit list.

The union campaign is organised around the opportunity presented by the expiry of thousands of Enterprise Bargaining Agreements (EBA) all at about the same time this year.  In this environment, unions are coordinating both their demands and their tactics to press for expanded EBA provisions.  In the impending negotiations, individual businesses are vulnerable because they negotiate from their individual perspectives, but unions coordinate across industries, delving for commercial pressure points to win their day.  Already, there is plenty of pressure activity happening "on the ground".

How then do business people manage or even make sense of the EBA demands unions put upon them?  What tools are available to assist the decision making process?

The financial implications of pay rises are simple and can be factored into assessments of negotiations.  But the raft of other demands made by unions tends to confuse assessments, creating difficulty in working out how some demands will impact on operations and why the demands are being made at all.  It is on these non-pay issues that firms and decision makers are at their most vulnerable.

For example, it is hard to evaluate the cost implication of a union demand to expand the powers of an EBA required "consultative committee".  What are the cost impacts of an EBA requirement that a company must ensure its suppliers have an EBA with a "relevant" union?  What are the implications of an EBA clause that forces non-union employees of the firm to pay $500 a year to a union?  Why should a company agree to a union demand that the company keep the use of casuals and labour hire within proscribed limits?  Why would a company agree to EBA prohibitions on the use of contractors?  What is the cost of having rosters and work timetables controlled through an EBA?

Making sense of these non-pay related clauses is difficult, particularly when the demands seem to fit some unknown but grand union agenda.  Ultimately a company must make decisions based on its specific needs, using assessment tools where available.  To this end, I have been analysing Enterprise Bargaining Agreements from the perspective of the impact on management prerogative.  I have published the results under my Capacity to Manage Index.

Through my specialist Work Reform Unit, I conduct case studies on management issues within industrial relations and labour environments.  When I looked at Enterprise Bargaining Agreements, I discovered that almost half of the clauses did not relate to employee incomes but seemed more designed to affect the way companies were managed.

This factor is hidden from the standard data on labour and management issues.  It's a big hole.  When analysts look at how firms perform, they are running half blind.  Without the full picture, it's impossible to accurately assess from a macro perspective what causes good or poor performance.

The first phase of this Capacity to Manage Index was released late last year and the second stage is being developed at the moment.  Companies are rated according to the results achieved from their EBAs.

In the first study, 50 EBAs from the food manufacturing sector and 35 from the commercial construction sector were assessed.  Clauses relating to pay issues were excluded so that the Index would focus solely on management items.  Clauses are rated as to whether they improve or diminish a firm's capacity to manage.  An overall score is achieved and firms are rated according to the EBA assessment.  The second study is focused on the car manufacturing industry and other industries will follow.

One of the first surprises from the study is the discovery of the extent to which EBAs conform to a single broad format.  In constructing the Index, I was not sure how many variables would exist.  But it was discovered that Australian EBAs conform to standard formats;  once the format had been unearthed the assessments became comparatively straight-forward.

In many ways this of itself is the first most important outcome of the research.  The concept behind enterprise bargaining developed under the Keating Labour government was that firms could break away from the once size fits all award system.  EBAs would give companies the ability to purpose design their formal employee agreements to suit the specific needs of each business and their employees.  But the early indications are that this has not happened.

Using the Capacity to Manage Index as a guide, EBAs look more like the old award system with minor variables between some companies.  This may explain the confusion sometimes experienced by CEOs.  Thinking that they are negotiating purpose designed employee agreements, the negotiation game in reality is to manoeuvre companies into agreeing to preordained formats.  Companies' greatest weakness is in not understanding the real game, because they find themselves accepting clauses that, on the surface, may seem innocuous but in fact have high operational, and sometimes legal, impact.

Take one common clause found in many EBAs, the requirement on a company to ensure that its suppliers have EBAs with "relevant" unions.  This clause may seem to mean little.  Companies signing such EBA clauses often already source most or all of their supplies from EBA registered firms.  But if this clause becomes accepted into an EBA, the sourcing of suppliers ceases to be an operational management issue and becomes an industrial relations issue, capable of becoming a dispute before an industrial relations commission.  Further, this clause clearly puts a limit on the capacity of the firm to source suppliers based on assessments of best available service, price or quality.

The financial implications of such clauses are impossible to assess but the Capacity to Manage Index rates this particular clause as a negative.  The "price" of such a clause is "Opportunity lost and opportunity never known".  All that can be known is that in thousands of different ways this reduction in the capacity to manage will daily downgrade the comparative ability of a firm to perform.  In addition, recent developments have suggested that this "supplier requirement" clause could put a company in breach of the Trade Practice Act.

A recent appeal against one of these clauses in a New South Wales case was conducted on the basis that the Trade Practices Act prevents companies entering an agreement with a union where the agreement imposes restrictive clauses on third parties.  The union in that case withdrew the EBA clause before the case could be heard.  But the firm's involved in the case had already become exposed by initially agreeing to the restrictive and potentially illegal clause.  This case highlights the need to be cautious, of management controlling clauses in EBAs.

The early results from the Capacity to Manage Index also give cause for concern that many Australian firms could be under-performing.  The generally poor Index ratings in the construction and food manufacturing sectors, suggest that these two industries could produce better results than currently is the case.  In the construction sector this was reinforced by the public complaints of the manager director of Grocon, Australia's largest construction company, that its industrial relations situation is hamstringing it's business.  This observation is consistent with Grocon's poor rating under the Capacity to Manage Index.  The negative scores of -20 and -22 on two of Grocon's EBAs suggests that each EBA has at least 20 management restrictive clauses that impede the ability of Grocon management to perform to peak capacity.

Not all is bleak.  A few companies have shown a break from the overwhelmingly negative ratings achieved.  Sanitarium and Uncle Bens scored in the positive range, as did two New South Wales electrical companies and a medium sized construction firm.  These were exceptions, demonstrating that companies do not have to give away their management right to manage.

My Capacity to Manage Index, is only one tool, and is not prescriptive of business success or failure.  Many factors affect a firm's performance.  What needs reiteration, however, is that no firm can allow itself to under-perform in any area.  The object of management must be to have all pistons firing at maximum capacity if full potential is to be reached.  Within this concept, keeping an eye on a firm's capacity to manage should be a normal process of sound management.

The process to assess capacity to manage

Establishing the methodology for the Capacity to Manage Index involved a detailed process of reading dozens of Enterprise Bargaining Agreements and looking for consistencies and patterns in clause types.  No predetermined idea of EBA clauses was held.

What was discovered is that most EBAs fall within broad frameworks where commonly, clauses refer to "consultative" committees, use of labour hire, casuals and AWAs, control of rosters, work allocation and many other areas normally considered that of management responsibility.  Clauses that related to remuneration and other areas not directly affecting daily management capacity were excluded from the assessment consideration.

This process of studying EBAs before undertaking the individual company assessments, enabled the methodology to be built "from the ground" so that it reflected the reality of EBAs rather than being imposed by predetermined concepts.  Once the EBA frameworks had been discovered this enabled an assessment grid to be established that facilitated a consistent and reliable assessment process.

When the assessment process began, assessors were required to be mindful of refining the grid if new clauses were discovered that had not previously been included.  Initially the assessment grid went through several reviews until it was finally settled and found to be applicable for each EBA being assessed.

Scores of +1, 0 or -1 were given to each EBA clause studied.  The plus, zero or minus allocation, indicated a clause had a positive, neutral or negative impact on management capacity to manage.  Scores were added giving each EBA a total, averaged rating.  Care was taken to prevent doubling up.  That is if two clauses, for example prevented managers from having control of rosters, only one -1 score was applied.

The following quotes from a random selection of EBAs were considered to reduce management capacity to manage.

• Plant closures will be restricted to one per year.
• During the life of this agreement the Company shall not employ persons covered by this agreement under an Australian Workplace Agreement.
• The Staff Consultative Council will be required to agree on issues at 100% consensus in order for the issue to become practice.
• All elections will be organised by the union.
• Contract Casual Labour:  It is agreed that the Company will utilise, only reputable providers and due consideration will be given to those providers recommended by the union.
• The Company will not engage any labour hire company to supply labour to ... Plant and production and maintenance work will continue to be undertaken by direct employees.
• Metal & Electrical contractors working on the site shall be advised that they are required to have appropriate industrial agreements with the relevant union.
• The current arrangements for filling vacancies shall apply ... full time employees, current casual list employees, then other external applicants.
• Permanent employees shall be given the option to work overtime before a casual employee is requested to work ...
• The implementation will be without prejudice to the Union's right to oppose the changes.
• The ratio of casual employees to permanent employees will not exceed ...% of the total number of permanent employees.

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Building on Bad Form

Australians rightly look with disdain and dismay at the endemic corruption in other countries.  But they need to start looking at home, for corruption is alive and flourishing.

The Report of the Cole Royal Commission, released last week, outlines in forensic detail both the nature and extent of the corruption in the building and construction industry.  The Report found:  violence to person and property to be common-place;  widespread misuse of money and property;  systematic flouting of the law;  violation of civil liberties;  and exploitation of positions of trust.

The cost of this lawlessness is enormous.  The building and construction sector has a turnover in excess of $40 billion nationwide ($9 billion in Victoria), a workforce in excess of 500,000 and links to all other sectors via the provision of essential capital services.  In Victoria -- where the lawlessness was found to be most rampant -- the cost, in terms of higher construction costs alone, is estimated to be around $3 billion per annum.  The problem, however, goes beyond the economy to very the fabric of society.

Unions play a pivotal role and, accordingly, were a central focus of the Inquiry.  The Inquiry, however, examined in detail all activities and players in the sector and found systemic failure.

It found that corruption, like a tango, requires cooperation or at least the acquiescence of other parties.  Employers and employer associations in the end agreed to most of the illegal and inappropriate dealings.  Moreover, they seldom pursued the many remedies available to them to bring the rule of law to the sector.  The Report makes clear that many employers and employer associations have benefited from the process.  In particular, in exchange for their capitulation, the unions help keep competitors at bay and sub-contractors in line.

The Inquiry found state governments, and in particular the Victorian Government, to be culpable.  The states have both an interest and a responsibility to maintain the rule of law in the sector.  They are the largest financiers of the sector and are largely responsible for the carriage of justice.  Yet the Inquiry found the states to have systematically failed to carry out their responsibilities and have, in effect, been the main underwriters and protectors of corrupt practices.  The Victorian Government not only refused to co-operate with the Inquiry but now refuses to accept its findings.  Given that the construction unions are some of the largest financial supporters of the ALP, the Bracks Government's actions raises concerns about its links to corrupt practices.

The unions readily admit that "virtually everything we do breaches part of the Act [Workplace Relations Act]".  They rationalise their actions by claiming that they "act in the name of workers against an unjust law".  This is both false and inadequate.  Generally, workers are not the beneficiaries of these actions but the losers.  The laws against assault and battery, destruction of property and misuse of trust funds are not unjust laws.

Moreover, as the Federal IR Minister recently stated:  "The rule of law is not a smorgasbord from which a few favoured items can be chosen and the rest ignored".

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Going Green Will Not Be Doyle's Salvation

Last week, Liberal State Opposition leader, Robert Doyle delivered an address to "re-establish our relevance and credibility and restore people's faith in our party".  In fact the address was a capitulation to populist beliefs that was devoid of any policy leadership.  Moreover it showed a lamentable failure to understand how recent elections had been won and lost and a total dismissal of the strengths of previous Liberal policies, the fruits of which the present Government is enjoying.

Mr Doyle anchored the Liberals policy future on two legs:  education and the environment.

With education, Mr Doyle was effusive in promoting "quality learning" and "inspired teaching", "empowering" students and so on.  Education is one of the vital issues for state politics and it is essential that a focus be placed on it.  But all we have is waffle and generalities.  The Liberals offer no specification about the need for a focus on the three Rs as opposed to the soft subjects that dominate an ever increasing share of the curriculum.  Mr Doyle showed no sign of absorbing the lessons of the UK and some US states where carrots and sticks, parental choice and school evaluation have led to improved standards.

A focus on the three Rs would provide voter appeal.  This and a radical package to provide improved basic education would also offer an opportunity for the Liberals to differentiate themselves from ALP policy.  Because Labor is so dominated by teacher unions, its policy is geared to avoiding scrutiny and on teaching the easy things rather than the more difficult subjects that better fit children for adult life in the workforce.

Mr Doyle also stated his intent to play the green card.  With an unfortunate lapse into contemporary Political Incorrectness he referred to the environment as the "crusade of our time".  His policy ambit covered the gamut from littering through greenhouse, water quality and a sewage outlet at Gunnamatta.  The message was we are going to the dogs.  He did offer a hint that he would put in plans to mitigate the sort of forest fires we have experienced -- presumably he meant burning off and fire breaks.  Even with this near universally approved approach, he could not bring himself to be specific.

But there are deeper problems with an uncritical acceptance that the environment is falling apart.  Such notions are par for the course for "concerned" urban voters who rarely venture outside the main cities.  But a dispassionate analysis shows this to be largely incorrect.  Water quality is at its best for 50 years in terms of salinity and other contaminants.  The Yarra and the Murray are more productive and attractive to tourists and other users than ever before.  Urban air pollution is at its lowest levels since the 1880s.  Even with the talismanic case of sewerage, data shows e coli levels around Victoria's coastline have not been lower for over a century.

The environment is of vital concern.  Where it has gone backwards it is usually because of land being socialised and locked away from productive activities in national parks that are infested with pests, feral cats and other introduced species.  The answer to better protection of the environment is to improve property rights, and Mr Doyle might have placed this stake in the ground.

While policies have to be influenced by research that shows concern, even misplaced concern, this must be combined with leadership.  Surely, Liberals stand for smaller government, lower taxes, and job creation through allowing individual initiative to prevail.  If they abandon these ramparts, not only do they offer little choice to the electorate but they shift the whole political spectrum towards larger government and policies that will lower productivity.

In this respect, Mr Doyle has been quick to jettison the Kennett legacy.  He declares times have changed since 1996.  And so they have.  But disowning the past reforms allows the present government unchallenged claims to their benefits.  Among these is a more competitive energy industry, a public transport system that for the first time in 50 years is winning market share and a balanced budget due to the highly successful privatisation program.

It is perhaps of greatest concern that in his major early defining speech, Mr Doyle adopted the me-tooism of NSW Liberal leader John Brogden.  Remarkably, Mr Doyle in his address recognised how John Brogden had gone backwards in the recent NSW elections.  Unambitiously he said, "We must not allow this to become our fate in 2006".  In NSW, Mr Brogden attempted a risky strategy of trying to outflank from the left a conservative but Green Labor Premier.  Mr Doyle has announced he is to attempt the same in Victoria.

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Luddites are Running the Show

Biotechnology may offer huge benefits, but Australia is increasingly choosing to follow the Luddites and to let the revolution pass us by.

Last month all political parties in NSW promised to ban new GM crops.  Indeed the National Party -- historically the party of farmers -- proposed the most stringent ban.  This followed decisions in Tasmania, Western Australia, and South Australia to put in place similar bans.

Why is Australia with its large, lightly subsidised, export oriented, and innovative rural sector deciding to ban the most promising advance in agricultural technology in a generation?

Certainly not as a result of scientific evidence, which overwhelmingly supports the technology and considers it safe.

The only GM crop currently grown commercially in Australia -- Bt-cotton -- has brought a 50 per cent reduction in pesticide use.  This has translated into lower costs and higher profits as well as a huge reduction in environmental impact.  A new variety of Bt-cotton is being tested which offers an even larger reduction in pesticide use and costs, yet it will be banned in the main cotton growing state -- NSW.

GM canola, currently being considered for commercial release in Australia, has been a roaring success overseas.  In Canada around 85 per cent of farmers have adopted GM varieties.  They have done so because it pays, providing on average a 30 per cent higher return than non-GM varieties.  The varieties face no price discount.  In the six years since the GM varieties were introduced, Canadian canola production has increased by 30 per cent.  Exports are also higher and in Japan are up by 50 per cent.

Two local varieties of GM canola are ready for release in Australia.  These varieties had been through years of rigorous testing.  Yesterday, the Gene Technology Regulator appointed by state and federal governments gave both GM canola varieties a clear bill of health.

The explanation for the collective flight from technology, evidence and rational decision-making is the influence of new class of Luddites.  Like their 19th century predecessors, the modern day Luddites seek to save the world from modernity.  Unlike their predecessors, however, the neo-Luddites are well-funded, well organised and have special privileges.

Funding has been important to the neo-Luddites' success.  According to The Wall Street Journal the European Union has over the last five years pumped around $300 million into international NGOs in an effort to stop the adoption of GM food around the world.  Australian companies are also plying the Luddites with cash in an effort to inhibit competition or to promote their niche in the market.  Many anti-biotech advocates make their livelihood from the organic industry and therefore have commercial incentives to demonise modern agriculture.  On top of this, most anti-biotech organisations are subsidised by governments.  The result is that there is more money to be made from demonising than promoting ag-biotech.

Fear and uncertainty have also played an important role.  The technology is novel and complex.  While the regulators and proponents of biotech have concentrated on dealing with these complexities, the Luddites have focused on seeding fear with an endless series of scare campaigns.  They have also been successful in demanding the impossible -- that is, certainty in an inherently uncertain world.

The key to their success, however, has been their ability to masquerade as angels.  They have captured the do-good institutions representing the environment, consumers, and the poor -- and with this the community's respect.  They have been able to distort and falsify with impunity.  They have been allowed to demonise a technology that offers so much to the very causes they purport to support, including a better environment, without being held to account.  They are also being allowed to pursue their own financial interest in the name of the public interest.

Given the success, money, fear and special treatment of the Luddites, politicians and farmers are starting to offer them support.

What is the future?  Well, look at Europe.  It has shown the way with similar bans and, as a result, investment in biotechnology research of all types has declined by 60 per cent, its research industry is fleeing to North America and its agricultural sector is going backwards.

One thing is for certain:  if the Luddites do save us from modernity, the environment and farmers will be the biggest losers.

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Ethics Industry's Ethical Dilemma

The ethics industry has a serious ethical dilemma.  While it seeks to impose the highest standards of transparency and probity on businesses and governments, it is silent about its own standards.  Indeed the ethics industry tolerates behaviour within its own ranks that neither it nor the community would tolerate elsewhere.

For evidence one need only examine The Good Reputation Index published by The Age and The Sydney Morning in each of the last three years.  The Index assesses the ethical, social, environmental, labour and financial performance of Australia's top 100 corporations through the perception of the "community stakeholders".

In the first Index in 2000, Leighton Holdings was rated the most ethical big corporation in the land.  This was despite Leighton suffering an adverse finding in a Royal Commission.  Moreover it was deemed by the NSW Casino Control Board as late as 1999 as unfit to have ownership control over a casino.

Recognising the need to improve its reputation, Leighton approached the St James Ethic Centre in the late 1990s for guidance on ethics in exchange for a six figure "contribution".  This was a sensible move by both parties.  The problem lies with the Centre's decision also to judge Leighton's ethical performance in the 2000 Index.  The Centre not only failed to disclose its financial relationship with Leighton but rated the firm tops on ethics.  As was later revealed the Centre had financial relationships with 37 of the 100 corporations in the Index and disclosed none of them.

After the Centre's ethical errors were exposed, it became a "Clayton's judge" in the second Index.  That is it gave a rating that was publicized but not included in the Index thereby avoiding the need to disclose financial relationships.

The Australia Conservation Foundation (ACF), one of the Index's judges of environmental standards has also failed to adequately disclose its funding relationships.  In the 2000 Index it made no disclosures.  In the 2001 and 2002 Indexes it stated that it received financial assistance from a number of firms, including Southcorp, "in pursuit of its (the ACF's) conservation objectives".

This was not accurate in respect of the ACF's relationship with Southcorp.  The agreement was for the ACF to, amongst other things, assist Southcorp in developing its environmental policies and programs.  Southcorp has stated their "intention was to get a good PR profile".  For these services Southcorp gave the ACF a six figure donation.

Southcorp appears to have been successful as the ACF has consistently rated Southcorp much higher than other judges.  For example, in the 2002 Index, Southcorp was ranked 82nd by the EPA of Victoria and 4th by the ACF.

World Vision, a judge of social performance in the 2002 Index, also failed to adequately disclose its corporate links.  It did state it has financial relationships with many of the companies covered by the Index;  however it failed to name them or describe the nature of the relationships.  When we asked World Vision to disclose its corporate sponsors, it declined, claiming commercial confidentiality.  In its pitch to corporations, World Vision claims a relationship which is "good for your brand".  How, if the relationship remains a secret?

I could go on.  Undisclosed commercial relations abound in the industry's dealings with corporations and governments.  The problem is not working with firms but rather in acting simultaneously as judge, jury, advocate and paid adviser without disclosure.

Gamekeepers Turn Poachers

The Cole royal commission could simply have produced yet another list of corrupt practices and persons in the construction industry.  But the recommendations of Terrence Cole have gone much further and exposed what no-one in the industry wants to publicly state, namely that key institutions that regulate the industry have failed.

All industries in a market economy are regulated by laws administered and enforced by government funded institutions.  The system of industrial relations tribunals in conjunction with the consumer watchdog, backed by the courts and ultimately the police, are supposed to ensure that all people have fair and equitable opportunities to work, earn a living and engage in business.  This underpins a free, civilised society and should have been operating in the construction industry.

But what Cole has documented is a pattern of unlawful activity so widespread and so accepted as a normal way of doing business, that the unlawfulness must be defined as systemic.  The institutions that were supposed to ensure equity and fairness have failed on such a scale that Cole has recommended overriding their powers and creating a new body charged to succeed where they have failed.

Cole does not specifically accuse the institutions of failure but his key recommendation leaves no other conclusion.  The lynch pin recommendation is for the establishment of an industry specific watchdog, the Australian Building and Construction Commission (ABCC) modelled along the lines of, and with powers similar to the Australian Consumer and Competition Commission.  Along with a new body to monitor compliance with occupational health and safety requirements, the ABCC will be charged to ensure that players in the industry cannot rort the game to achieve unfair advantage over others.

The ABCC is recommended to have powers to stop activities that are already illegal under either Federal and State industrial relations legislation, the Trades Practices Act, the States Fair Trading Acts and criminal law.  This includes the prevention of pattern bargaining, stopping of unregistered and/or secret agreements, the restriction of industrial agreements to employment matters, ensuring freedom of association, stopping the illegal removal of money from employee benefit funds and the prevention of intimidation, harassment and violence.

If the industrial relations commissions, the ACCC, appropriate government bureaucracies, the police, unions and employer associations had been doing or capable of doing their jobs, it should have been expected that Cole would have recommended fine-tuning of their powers.  But no!

Cole details how even police have stood by and watched unlawful behaviour and by their submissiveness condoned unlawfulness.  Nothing could be more telling of a system gone rotten!  Even further, Cole's list of individuals who have committed unlawful behaviour, come mostly from within the ranks of the institutions that were supposed to ensure fairness.

The only institutions with a tick from Cole are the Australian Tax Office and the immigration department.  Apparently both these authorities robustly enforce their responsibilities in the construction industry.

All other institutions are found wanting.  Employer associations and unions receive special attention with recommendations that their officials be trained in the requirements of the law, pass tests to demonstrate they understand the law and be deregistered as officials if they fail to comply with or endeavour to ensure others comply with the law.

Ultimately the failure that Cole details is not that of market failure, but rather failure of the market regulators.

Cole recommends establishing a new regulator that is dedicated to the construction industry and with the powers, skills and resources to undertake its tasks.  This is to be created via amendments to the Federal Industrial Relations Act but realising these amendments is where the next level of debate will be telling.

Unions have, with a predictability that is damaging their cause, announced vehement opposition to the creation of the ABCC.  However it is not unions who threaten implementation of Cole's recommendations.

Systemic unlawfulness only becomes systemic because people in positions to move against unlawfulness either turn a blind eye or for example quietly damage the career of an official who tries to do something.  The real treat to Cole's recommendations will come quietly and insidiously from behind closed doors, from elements within the current institutions that fear losing their existing power to the new regulator.

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Managing the Murray

Managing the Murray River is arguably the nation's leading policy challenge.

The river supports a $5 billion agricultural industry, supplies water for drinking and recreation to many communities and people and it is the nation's most important freshwater ecosystem.

There is also little slack in the system.  It is currently exploited at close to its hydrological, economic and environmental limits.  Therefore any increase in water -- say, for the environmental use -- must come at a cost of commercial use.  There is capacity to increase the efficiency of water use, but the experts generally agree that the scope is limited.

The task is therefore to optimise the use of the water between commercial and environmental uses.

Over the last decade there has been a general acceptance that the health of the river would be in danger if any more water was allocated to irrigation.  As a result, irrigation volumes have been capped for nearly 10 years.

Environmentalists are now demanding a massive shift in policy which has dire consequences for rural Victoria.  The so-called Wentworth Group are, for example, lobbying governments to transfer at least 1,600 gigalitres and up to 3,000 gigalitres from irrigators to environmental flow.  These volumes represent between 50 and 100 per cent of total water reliably available to NSW and Victorian irrigators and as such would all but eliminate regular irrigation by Murray farmers.

Similar proposals have been promoted by other environmental groups and they are receiving the attention if not the support of urban politicians and the public.

What is this basis for this claim?  While there is widespread belief that the Murray is under environmental stress, there is little hard data to back these beliefs.  Indeed the first comprehensive audit of the river's ecological conditions is now underway.  Moreover, the only pollutant for which there is good data is salt and, contrary to public perceptions, salinity levels have tended to decrease over the last twenty years in the river outside of South Australia.  Some scientists have predicted that large and unacceptable increases in salinity levels will take place in the river over the next decades.  These forecasts are, however, based on theoretical projections and not hard data.

Indeed the latest Report of the River Murray Scientific Panel on Environmental Flows states "there is limited information upon which to make quantitative links between hydrology and the ecological health of the river and the floodplain" and "Knowledge of the species ecology is woefully defective in many key areas and is hampered by lack of historical information".

In short, the basic data on the state of the river's environment and the effects of increasing environmental flows is rudimentary and woefully inadequate to support anything like the Wentworth Group's proposal.  It is certainly inadequate to justify eliminating a $5 billion rural industry.

The problem is that despite the importance of the River, inadequate resources have been applied to understanding and mapping its environment.  And in the absence of basic data all we have is opinion which is inherently subjective, malleable and divergent.

The River and it many users deserve far batter.

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Private Property Rights: the Key to Efficient Rural Water Use

WATER IN AUSTRALIA

Water has always been a defining issue in Australia's prosperity.  And in recent decades irrigation has grown rapidly.  Even so, only two per cent of Australia is irrigated, one of the lowest proportions amongst among OECD countries.

In Australia's first century of European settlement, agricultural productivity came to equal that of anywhere in the world.  Gains continue to be made -- output has doubled over the past fifty years, a growth that could not have taken place without a similar expansion of irrigation.  The Murray-Darling, which comprises 14 per cent of Australia's land mass including half of Victoria, is our most important agricultural province.  Its irrigated and non-irrigated output, each at $5 billion, comprise a third of Australian agricultural output.

Most of the uses of water involve choices or compromises -- drinking water versus irrigation versus industrial and so on.  Some, however, involve complementarities, particularly flood mitigation and certain recreational uses, like water sports, that are facilitated by storage and consistent availability.

In many cases, water will perform sequential functions -- the same water can be used and re-used for irrigation, used for industrial cooling and finish as drinking water.

Two conditions are required if water with different, sometimes competing, benefits is be optimally used.  First, its ownership must be clearly specified and the owners' obligations to other users (or claims from other beneficiaries) must be well understood.  Secondly, each property right must be tradable to enable acquisition by those who can extract more value from it.

People acquire rights to property initially through a variety of routes.  One of these is seizure of something that was originally of little value until it was acquired and improved.  Squatters assume rights in this way.  No matter how they are first acquired, the rights need to be safe from theft and government seizure.  This provides the incentive for property owners and others to search out ways to increase its value or other benefits.

An owner's diminished security in a property right means it will be used less productively.  For example, if property is to revert to someone else or to the government, owners will milk it for its current use value rather than invest;  in other words they will sacrifice future gain for present benefits.

As a result, when title to property depends on continuing governmental assent, the lack of certainty brings lower incomes.  One outcome of this can be observed in the Murray-Darling system.  Water rights on the Victorian side of the Murray are secure, while those on the NSW side have been over-allocated and are subject to administrative discretion, including having a secure duration of only 10 years.  The result is that farmers on the Victorian side plant more valuable perennial crops while those in NSW tend to focus on annual crops, especially rice.

Some claim that Victoria's more robust property rights mean that the State Government has lost "capability" to manage compared with NSW.  The corollary of this is the increased risk and associated lower value of production north of the Murray.  Governments that give themselves increased capacity to direct production or take individuals properties need to accept lower levels of income and output.

IRRIGATION AND SALINITY

Issues stemming from irrigation comprise two types:  those impacting on the environment and those impacting on private uses.

Increased salinity is the main concern about the Murray-Darling.  This is fundamentally a conflict of interest between productive users -- the complaint of "damaged goods" by downsteam users against those upstream.

The Murray-Darling Basin Salinity Strategy 2001-2015 estimated that increased salinity will mean costs of $294 million per annum to the basin.  Yet data on the salinity of the Murray-Darling shows levels upstream of South Australia are lower than they were in the early 1980s.  This indicates the solutions lie in South Australia.

In any event, full and secure specification of rights and obligations of commercial parties will allow any dispute to be resolved as long as the impacts are measurable and their causes identifiable.  In this respect, technology to measure salt in water and trace increases to particular locations is readily available.

There has been over a century of agreements regarding the allocation of water rights between jurisdictions and to individual irrigators.  Nonetheless, there is likely to be constant bickering over water rights.  This will intensify if State Governments seek to sanctify proposals for changing the carve-up by claiming to promote an improved environment.

Identifying individual ownership rights to water and allowing trade will maximise the value of water.  But if the impending salinity problem is as great as some claim, other solutions might well include buying out some allocated irrigators' rights.  However, alternatives may be to remove salt from the water by engineering solutions or simply to live with higher salt levels.

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Land Management in Review

Since 1984 Russell Smith has lived on the edge of the Bogong High Plains.

Up until the Australia Day fire attack, the adjacent Alpine National Park was a dry forest with almost impenetrable noxious blackberry, sweet briar and forest floor litter.

The area had not been burned in 100 years.  It was a disaster waiting to happen.

The public lands are managed by Parks Victoria and the Department of Sustainability and Environment, or as we say, the Department of Scorched Earth.

The lands are breeding grounds for feral dogs, cats and goats, blackberry, St John's wort, sweet briar, broom, Patterson's curse -- the list goes on.

It was almost impossible to gain access to the pristine High Country rivers because of weed infestation, but the annual green spotted tree frog count still goes on in the Bundarrah headwaters.

Fire prevention/ minimisation is part of the management of public lands;  but nothing has been done.  Optimum forest floor litter coverage for ecological balance is 4 tonnes a hectare;  in my area the litter was hundreds of tonnes.

Horses could not traverse parts and travel by foot was exceedingly difficult.  There had been no official fuel reduction burning in living memory.

Now fire has consumed more than 1.1 million hectares.

But will lessons be learned from this disaster?  For the first few days of the fires, the public land management authorities allowed the fire to burn and thereby gain ground and momentum.  It was on public land, but there was very little information available.  The local CFA was being told nothing and had nothing to pass on.

By January 14, Russell had a phone call from the Swifts Creek incident control centre.  The person had no local knowledge and refused to provide information on the Feathertop fire, as it was in another fire control area.

On January 21, there was a weak southeasterly wind blowing and Russell asked permission to start a back-burn into the national park.  He was refused.

Knowing the fuel problem on the ground and that the weather was to get worse, Russell decided to back-burn along my boundaries -- it proved to be the right decision.  It saved his property.

The next few days were a disaster of organisation.  Information was either wrong or non-existent.  Suggestions to request defence resources were ignored and they never knew when there would be extra resources available.

Russell had been requesting the department to force an absentee owner to clear his property for 10 years, to no avail.  Omeo CFA was left out of the loop until a week after January 26.

The incident controller did not visit the northern fire areas at any time.  Crews on the ground did not receive briefings.  Local knowledge was not used to guide outside crews.

Unless locals wore a DSE uniform they were not listened to at all.  Information-passing telephone operators did not have any local knowledge or even maps.

Given the technology available, there were periods when communication ceased -- there is no excuse whatsoever.

There needs to be political will to ensure proper management practices are put into place.  Above all, there should be standardised procedures and joint regional exercises carried out.

There must be no division of responsibility between authorities on the ground and those responsible for resource management should not be in charge of the fires -- a clear conflict of interest.

But the most important thing of all is that MPs must accept responsibility for their actions.

Russell didn't see one professed greenie or Senator Bob Brown at the ACT, Kosciuszko or Victorian fires -- so much for commitment.

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The Power of Ideas

Last week a great Victorian, Dr John Paterson, passed away.

John was one of those often vilified public servants-cum-economists who helped make Australia's miracle economy, in whose praise by the OECD now sings and of whose benefits well all now enjoy.

John worked in the back blocks of reform, which is at the state level on water, health and infrastructure.  He was not one of the new bred of "policrats" who now dominate the halls of power.  He was a true public servant.  He worked constructively for Labor and Coalition Governments;  gave advice on basis of the public interest rather than on political merits;  and earned his rank by force of intellect and competence rather than mateship or ideological allegiances.

John's seminal contribution was to reform of water policy.  His ideas were simple.  He argued that people treat best what they pay for and therefore they should pay according to the amount of water they use.  He argued that building dams imposes costs -- economic and environmental -- and therefore construction of dams should be postponed where water savings measures were cost-effective.  He argued that people need rights over future use in order to invest in water saving capital or shift to higher valued uses, thus secure water rights are an essential feature of water policy.

These ideas may have been simple but they were a revolution in Newcastle were John first introduced them.  Despite concerted resistance, through force of intellect, dedication and organisation skill, John's simple ideas gain force.  Water consumption per capita in the Hunter Valley Water is now the lowest in the country.  And the principles he pioneered there are now in general use around Australia.

In the early 1980s John returned to Victoria as Director-General of Water Resources.  He again introduced his simple ideas along with cutting over 300 separate water boards in the State to a manageable handful.  Here the culture of dam building was deeply entrenched as was the belief that water should not be priced.  Again, despite the resistance, John's ideas gained hold.  Not only have no dams been necessary in Victoria over the last twenty years, but Victoria has far and away the best water rights system in the country, rights that are the foundation of greater rural prosperity in this state.

In late 1989, John shifted to community services.  Under the Kennett Government he became Secretary of the Department of Health and Community Services.  He oversaw the "case mix" system of funding, a form of market provision that directs funding for individual types of treatment to the most efficient hospitals.  This too was adopted elsewhere and continues to revolutionise health care around the country.  He also shifted hospitals-beds to the suburbs (where patients live) and started exposing the incoherent mess that is health funding.  John also contributed to reform of the ineffective and inefficient ambulance services.  While the information system put in place by a private contractor was not perfect it was far superior to what it replaced and has saved many lives.

John's central contribution was to drive reforms that not only saved money and resources but delivered better service to the public.  This is the essence of a now vibrant economy.

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Why Aid to Poor Countries Has Failed

The Elusive Quest for Growth:  Economists' Adventures and Misadventures in the Tropics
by William Easterly
(The MIT Press, Cambridge Mass, 2002)

William Easterly is an American economist from the World Bank.  In this book, he reflects on the mistakes made by the World Bank and the International Monetary Fund over aid funding to poor countries since World War II.  It is thick with real insights.  It relates a string of aid and development policy fashions over the period and tests them against their outcomes.  The answer, of course, is a string of policy failures.  Easterly seeks the answers.

Take one very prominent example:  the Jubilee 2000 campaign to forgive the debt of poor countries.  The churches, with prominent figures such as the Pope and the Dalai Lama, and the usual motley lot of do-gooders with their stars such as Bono of rock group U2, pressed Western governments to forgive the debt of the poorest countries.  Let them start afresh without this burden placed on them by the West and all will be well, was the argument.  As a true economist, Easterly tested the incentives in this policy of debt forgiveness.  In the first instance, the big problem is that debt forgiveness is not new.  The World Bank/ IMF Highly Indebted Poor Countries Initiative, now running at $27 billion, stands on the shoulders of decades of previous rounds of debt forgiveness.

The promise of Jubilee 2000 is no different to all of those that have gone before.  "The debt campaigners treated debt as a natural disaster that just happened to strike poor countries".  The truth is not so charitable.  Countries that borrowed heavily did so because they were willing to mortgage their future.  They were irresponsible, they sold productive assets into unproductive hands, they built unproductive infrastructure, they favoured one ethnic group over another, or one region over another, they ran inflated economies, they were corrupt, they waged war, they allowed black markets to develop because they controlled exchange rates and interest rates.  And all the rest of the sordid details.

Data for 41 highly indebted countries -- Angola, Benin, Bolivia ... Zambia -- show that total debt forgiveness from 1989 to 1997 was $33 billion, while their new borrowing in the same period was $41 billion.  Moreover, new borrowing was highest in the countries that received the most debt relief.  In other words, the system rewarded debt;  the incentives were terribly wrong.  Clearly, there were irresponsible lenders as well as irresponsible borrowers.

What to do?

Easterly's insights -- based on and learning from his own and his profession's readily admitted mistakes -- are those of an obviously brilliant economist.  An economist brought to book by experience, or as one commentator remarked, "a lifetime idealist mugged at last by reality".  These insights are conceptually simple:  first, growth helps the poor, and second, people, rich and poor, governments and donors, respond to incentives.

First, he asks,

Does the government of each nation face incentives to create private-sector growth, or does it face incentives to steal from private business?  In a polarised and undemocratic society, where class-based or ethnically based interest groups are in a vicious competition for loot, the answer is probably the latter ... In a democratic society with institutions that protect the right of minority interest groups, institutions that protect the right of private property and individual economic freedoms, governments face the right incentives to create private sector growth.

Second,

Does each donor give a vested amount of aid to each country, so as to justify next year's aid budget? ... Do the World Bank and the IMF give loans to the Mobutus of the world, or support aid to governments that can present credible intentions to build national infrastructure and help the poor?

Third, individuals and businesses may face poor incentives from bad governments, but additionally they face low incentives to grow because their productivity depends on that of other poor people.  Aid that matches grants to the poor with increases in their own income as opposed to penalties, which is standard in welfare systems, can help correct poor incentives.

Easterly's contribution, when matched with Hernando De Soto's, Mystery of Capital, which brilliantly argues the case for property rights for the poor as the path to wealth in the Third World, provide a welcome intellectual fillip to those who view themselves as both on the right and in the right.  It is a splendid book.

Skewering the Dogma

The Blank Slate:  The Modern Denial of Human Nature
by Steven Pinker
(Allen Lane, 2002, $29.95)

When I was a lad at school, my English teacher defined for the class the meaning of "dogmatic".  By way of illustration she intoned "the dogmatic scientist".  I was silently outraged.  Scientists are seekers after truth.  "The dogmatic English teacher" would be more apt!

Sorry teacher.  You were right.  I was wrong.

My disillusionment with scientists has been long in building, and is now complete thanks to Steven Pinker's new book:  The Blank Slate:  The Modern Denial of Human Nature.

While it has destroyed the remaining illusions I had about scientists, it has offset this by affirming my belief in science.  Not, I hasten to add, that science's current answers are right, but that science is a self-correcting system.

The principle purpose of this book is to refute a set of assumptions about humanity that inform, and arguably do great damage to, studies of humanity.  These, he says, have been made obsolete by advances in studies of the mind.  Those assumptions are:  the Blank Slate, the Noble Savage and the Ghost in the Machine.

The Blank Slate is the notion that out minds are infinitely malleable, especially as children.  The concept of the Noble Savage is that the horrid aspects of life are due to that malleability being misemployed to pervert us, when compared to native persons who are not so twisted and thus live happy lives.  The Ghost in the Machine is a pithy term for Cartesian dualism:  that our minds are "entirely different" to the bodies which house them.

Pinker comprehensively demolishes all three.  He approaches the issue from the perspective of an evolutionary psychologist:  the capabilities (including the mental capabilities) of people were evolved, as described by Darwinian models, in order to meet their survival and reproductive requirements.  The evolutionary variation that distinguishes humanity as a species virtually all took place during the relatively lengthy period in which humans and their precursors lived as hunter-gatherer bands, not the mere ten millennia of settlement and large-scale social organisation.

This means that we are not born with minds that are ready to absorb whatever culture cares to imprint, without limit, but are equipped with a wide range of mental mechanisms (or an impetus to develop those mechanisms during the first years of life) that proved useful for our earlier hunter-gatherer lifestyle.  Some of these mechanisms have been adapted for our more complex modern societies, but that does not detract from their importance.

Pinker assembles a strong empirical case from the neurological sciences to prove his point, and ties this in with other scholarly fields, such as anthropology.  In doing this he engages in the dangerous task of choosing:  will he go with the mainstream social scientists, or those dissidents who are roundly condemned by their colleagues?  He has chosen the latter, rightly recognising that much anthropology has been corrupted by a post-modern theoretical foundation that renders it useless.  He draws on Napoleon Chagnon's studies of the South American Yanomamö tribes as a window into how humans related to each other before the development of more widely organised societies:  in a word, appallingly.  Rousseau was wrong.  By our modern sensibilities, the savages were anything but noble.

Along the way he takes on those scientists who oppose the concept of a human nature, highlighting the way some resorted to dreadful misquoting so that, for instance, geneticist Richard Lewontin and neuroscientist Steven Rose could mutate Richard Dawkin's "[genes] created us, body and mind" into "[genes] control us, body and mind".  Quite a difference.

I suppose scientists can, indeed, be dogmatic.

Pinker also defends the fact that our brains have a set of built-in modes of operation, and certain built-in limitations, from attacks by the religious and cultural right.

This is not the end of the matter.  He persuasively argues not only that this "mechanistic" view of humans does not justify any abdication of personal responsibility for uncivilised behaviour, but that it provides a stronger basis for morality than either Marxist atheism or any of the various faiths.

The reason is that, for all practical purposes, it leaves our conception of freewill undamaged.  The mind, which forms our nature, may be mechanistic, as indeed may be the processes of Darwinian evolution which formed the mind, but it is also an "open-ended combinatorial system" which yields infinite variety within the bounds of what it is to be human.

This book is a powerful addition to the popular exposition of science.  For me, it also provides a powerful underpinning to FA Hayek's The Fatal Conceit.  Hayek assumes a human nature, and a state of nature in which humanity operated through most of its past.  Pinker proves it.