Separation of Retail and Distribution in Electricity Supply

Energy Forum Papers

EXECUTIVE SUMMARY

Requiring distribution and retailing of electricity to be undertaken by legally separated firms is unnecessary.  Regulated line charges and access conditions ensures full competition in supply.  Directing businesses to place distribution and retailing within separate companies adds to operational costs and prices, and overrides the wishes of those customers who prefer to have one supplier for both energy and distribution.

It is essential to have accounting separation of retail and distribution business in the electricity supply industry.  Requiring legal separation of these two parts of the electricity supply industry is unnecessary.

Although there is a plausible case for enhancing competition by separating retail and distribution into separate businesses, this has two major deficiencies:

• additional costs of overheads and bill management would be incurred and passed on the customer;  counterbalancing benefits are not evident;  and
• those customers who wish to deal with only one supplier will be inconvenienced;  this is particularly the case with smaller customers.

The availability of rival suppliers, who have low barriers to entry, puts considerable pressure on incumbent distributor/retailers to ensure they remain competitive and it would be wasteful to impose needless costs.

Competitive outcomes in the UK and Victoria have proven that vigorous retail competition can take place without legal separation between retail and distribution.  In both these jurisdictions, accounting separation between the two arms of the distributor/retailer and regulated line charges that are available to all retailers has ensured strong competition and customer orientation.

The high degree of "churning" in both the UK and Victoria -- where over 40 per cent of contestable customers take their retail supply from a non-host retailer -- demonstrates the effectiveness of the present accounting separation approach.  The benefits of lower prices have extended to customers generally, including those that have remained with their host retailer.  Retail prices to Victorian contestable customers in the 750 kWh/year class have shown estimated average reductions of at least 9 per cent.

Drawing from the experiences in New Zealand where all customers are contestable, a lesser degree of switching is expected with smaller customers.  However this largely reflects the relatively high metering costs such customers would need to incur and their preference for having a common distributor and retailer.

INTRODUCTION

A major approach in both the Victorian and NSW electricity market restructuring has been the structural separation of generation from transmission and system control, and from distribution and retailing.

Requiring the separation of these elements of the electricity supply industry was prompted by a number of factors.  Important among these was the wish to prevent businesses using their monopoly positions in ways that would impede the achievement of efficiencies from competition.  With generation, barriers to entry could exist as a result of high fixed costs and low variable costs.  An integrated monopoly has considerable incentive to engage in cross-subsidisation which penalises rival suppliers.

In neither Victoria nor NSW are all elements of the structural separation required to be permanent and, in fact, the parent company of one of the Victorian distributors is part owner of a major generator, whilst two of the NSW distributors have taken equity in new generation facilities.

As well as these state based reforms, the initial separation of distribution and generation was an essential goal of national reforms.  South Australia's early reluctance to break the nexus between its generation and distribution led to an Industry Commission review and that state's agreement to legislate for a full legal separation.

The initial requirement to split generation from retail was a major feature of the UK reforms on which those in Australia have been based.  That country too has permitted subsequent investment by distributors in generation.  Indeed, UK retailers are now responsible for a significant portion of energy generation, while UK generators have won a high share of the contestable retail market from retailer/distributors.

In California, where the provision of electricity was always largely in private hands, the Public Utilities Commission (CPUC) did not rule that separation must take place.  The CPUC did require an independent system operator in control of transmission and an independent market control system.  It also put in place incentives for the three major integrated suppliers to structurally separate distribution/retailing from generation.  All three are following this course.

There are very sound reasons why previously integrated structures that have developed under government monopolies or government control should start their new existence with separate production, transmission and distribution facilities.  Such separation allows a genuine market to develop unencumbered by any incentive to favour a related firm.  It also does not rule out future reintegration should there becompelling economies to be gained from this.

The reasons for requiring de-integration are not present in the case of retail/distribution and few jurisdictions have required it.  In retailing, fixed costs and therefore barriers to entry are low where the retailer is assured of fair access to the wires and where there is an availability of competitive power supplies.  Low entry barriers mean the distributor cannot recoup the costs of squeezing out a rival retailer by subsequently raising its own prices since another rival would quickly emerge.

RETAIL AND DISTRIBUTION SEPARATION

CONSIDERATIONS IN ELECTRICITY SUPPLY

It is inputs into a shared system that are most obviously open to discriminatory treatment.  Once power is in the system it follows immutable laws of physics rather than being subject to human discretion.  A system controller could operate in a non-neutral fashion in ways that benefit individual participants, e.g. setting power interruption protocols that favoured certain regions;  or offloading rival generators where the system is producing surplus power.  A transmission business too could favour related businesses in its investment and planning decisions.  For these sorts of reasons it is essential that system control be totally detached from other parts of the supply industry and highly desirable for transmission also to be independent.

It is more difficult for a distribution wire owner to put in place strategies that favour its related parties where agreement to open access is clearly understood and regulated.  The incentive against granting any favourable treatment to a related retailer is further reinforced by the charging requirements for the wires.  Because the wires are treated as a natural monopoly, rates are specified by the regulator.  In addition there will eventually be full opportunity for by-pass as a discouragement to excessive charging and economic inefficiencies.

The main advantages a retailer/distributor may have within its home territory are:

• the knowledge it has about the load profile of different customers;
• an ability to bundle energy with other services so that economies are made and keener prices can be set;
• superior information it might have about the true costs of particular parts of the network, which may allow it to cross subsidise retail services to customers whose wire charges are set too low.

In practice, the following discussion shows these advantages to be slight.

Load profile advantages

There is an advantage in having automatic access to customers' load profiles and regulators will require confidentiality between the two arms of the business;  ⁽¹⁾ any advantage the distributor's retail arm might have is further muted by the ability of the customer to seek a better deal by providing this information to other retailers.  However, the distributor is in a preferred position for those customers who are less inclined to search out what are likely to be only modest savings.  This is reinforced to the extent that the host distributor would charge other parties or the customer for providing historical data.

Bundling of services

Economies are available to the distributor which has to have customer service facilities in its own area.  That said, it would be economic vandalism if costs were purposely increased by disallowing combined uses of labour unless there were strong advantages stemming from a resulting increase in competition.

Cross-subsidies where costs are set too low

It is most unlikely that a regulator will know as much about the costs a firm incurs as the business itself knows.  There will be areas of a region that cost less to service than other areas and the superior information that the retailer/distributor has could lead it to pitch particularly competitive prices in that area.  Accounting separation addresses this, albeit not perfectly.

There would be concern if a transmission company also owned part of the distribution network because this may give rise to actions that favour the part that is under common ownership.

ELECTRICITY INDUSTRY REVIEWS

The above considerations have been tested in a number of studies.

The National Electricity Code is largely silent on retail arrangements -- in fact Chapter 5 states that retail trading is left to the jurisdictional regulator.  All network service providers must agree to an access arrangement under the provisions of the ACCC.  The Code limits its statements to ones that describe how pricing should be arranged.

Similarly, in neither of the NSW and Victorian legal instruments is there any provision for requiring structural separation of distribution from retailing.  However, in July 1996, the NSW Electricity Reform Taskforce issued a paper ⁽²⁾ requiring, "a licence holder to maintain separation of its licensed 'monopoly service' business from other business affairs." Separation was not envisaged to be necessary in the case of a retail licence but for a distributor, (which is automatically obliged also to have a retail licence), the separation was to begin immediately and to cover:

• "keeping separate accounting and business records;  and
• the allocation and costing of jointly used resources on an arms length basis."

The Industry Commission (IC) in its review of South Australia ⁽³⁾ pursued a line of analysis sympathetic to the NSW Taskforce paper's approach, arguing that:

"a potential problem with integrating distribution and retail is that it creates some incentives to operate in an anti-competitive manner.  For instance, there would be the scope and incentive to use the network side of the business to protect its retail business."

The IC went on to say:

"Through the course of the Commission's review, various views were put to the Commission opposing the separation of distribution and retail, including:

• the ability of the retail staff to offer 'effective' innovative solutions to demand side management would be impaired;
• both businesses essentially deal with the same customers;
• the asset backing of the network business, and its regulated cash flow provides diversification against the riskier, low asset retail business;
• the combined organisation would be better able to develop pricing packages to address capacity constraints and smooth load;
• the small margins in retail, the low volume of sales to individual households and small business, and the cost of enticing customers to switch retailers;  and
• the uncertainty about future pool prices in the national market."

Added to these issues is the fact that where customers wish, out of inertia, to remain with their incumbent retailer, it is better that their retailer has a significant stake as the wires business with all the obligations and asset backing this entails.  Moreover, should a non-wire owning retailer default, an incumbent distributor/marketer is best placed to be required to operate as the fall-back supplier, (a retailer of last resort).

The IC concluded:

"The evidence provided to the Commission suggested that there are likely to be some practical difficulties in separating distribution and retail, at least in the early stages of the national electricity market." (Chapter 6 p. 108).

Hence, while showing a preference for disaggregating retail and distribution, the IC was not persuaded that their would be sufficient economies to recommend such a course.  It considered that, "Retention of retail with network activities will therefore require a significant regulatory effort on the part of the proposed regulator.  It will be important that regulation of distribution access be rigorous and that ring-fencing of retail and distribution have a high degree of transparency."

Queensland is the only other Australian jurisdiction that has addressed these matters.  Following an inquiry, ⁽⁴⁾ the Queensland Government has announced that it will retain the existing distributors but hive off retailing into three separate businesses.

There is, however, no apparent call for such separation in either the US or UK.  Indeed, neither the Californian nor the Federal US regulations even discuss a need to disaggregate retail activities from distribution.

THE GAS CODE AND ISSUES RAISED BY THE NSW INDEPENDENT PRICING AND REGULATORY TRIBUNAL (IPART)

IPART has drawn attention to the different approach to separation in the gas and electricity codes.  It intends to require the structural separation of retail from distribution in electricity. ⁽⁵⁾

The draft National Third Party Access Code for gas specifies in s 4(2) that the Regulator may require the business to have a separate staff and directors for the Service Provider independent of those controlling other parts of the business.  There is a saving clause 4(2)(b) which requires that the ring fencing should not impose unreasonable compliance costs.

Irrespective of the merits of structural separation for gas, there are significant differences between gas and electricity.  The means of transporting gas are more flexible than those for electricity.  The nature of the product and its storability mark gas as being different from the instantaneous nature of electricity supply.  In addition, the constraints on gas pipeline capacity on peak days and during needle peaks are not commonly found in electricity, the lines for which have ample capacity.  No Australian electricity generator has, as a result of this, shown any interest in taking out insurance to ensure its load will be scheduled.

In the case of gas there is much support for structural separation.  Following deregulation in the US, virtually all major pipelines transformed themselves solely to transport providers.  Energy Probe has made representations to reviews of gas and electricity in Manitoba and Ontario. ⁽⁶⁾

THE CASE AGAINST REQUIRING SEPARATION

The reasons for requiring a split of retail and distribution are:

• to simplify the regulator's task in managing the distribution side of the business;
• to guard against anti-competitive activity.

Simplification of the regulator's management of distribution

The key issues in requiring firms to take actions that they would not willingly take of their own volition is whether there is a net gain to the community.  The net gain would have to take into consideration improvements to market operations, any loss of confidence based on reversing previous expectations of regulatory approach and costs that would be incurred to the regulated firms (and therefore borne either by their shareholders or customers) and to the community in terms of regulatory resources.

In the case of the electricity industry, regulatory intervention would be undertaken from a pro-competition perspective, but intervention it would be.  The degree to which competitive rivalry gains would be made to offset any costs becomes a pragmatic question.  Although lower costs to the regulator is an important consideration, we need to avoid incurring additional costs to the industry that more than offset these.

The costs to the distributor/retailer are likely to comprise additional personnel for separate boards, call centres, maintenance staff, reporting requirements and so on.  AGL has estimated these separation requirements for its gas supply business in NSW as adding three percent to its costs.  It is likely that such cost increases will be passed on to customers.

Combating anti-competitive behaviour

Anti competitive behaviour can refer to either predatory pricing or to benefits offered to a sister retail company that are not available to other retail businesses.

There is a negligible possibility of predatory pricing in the contemporary Australian electricity markets that have a number of different suppliers and low entry barriers.  A firm hoping to deter a rival by "buying" customers would see any subsequent attempts to recoup its costs frustrated by other rivals undercutting it on any excess price it subsequently attempted to charge.

The question remains whether, at least in the case of electricity, a host retailer is able to benefit from cost shifting and whether it is cost-effective to prevent this.  There is very modest scope for cost shifting between retail and wholesale.  We estimate these at a maximum of 2 per cent of the distribution revenue -- and well managed reporting procedures could significantly reduce this.

Furthermore, separation into different retail and distribution companies will not be effective in preventing secret and favourable discounts to host retailers with a common shareholding.  If a gain is available, the management of the separate entities will find ways to exploit it.

Access rules provide the best means of preventing this.  The customer must be made aware that any tariff offered by the incumbent distributor is also available to other retailers.  Providing this course is followed, the incumbent obtains no advantage through discounting.

Appraisal of competitive outcomes

The benefits of requiring a separation for electricity, while conceptually present, are not apparent in practice.  If the incumbent distributor/retailer were to enjoy strong market advantages, we would expect to see little change in market positions where customers are made contestable.  In fact, the experience in Victoria and the UK has been that some 40 per cent of customers have switched retailer once given the opportunity.

Moreover, contestability without structural separation, even where customers have remained with their host retailer, has delivered gains to customers across the board.  Retail prices to Victorian contestable customers in the 750 kWh/year class have shown average reductions variously estimated to be between 9 and 15 per cent.  These reductions have been achieved by customers who have stayed with their host retailer as well as those that have shifted.

The switching that has taken place has been much higher than had been anticipated.  There are a several reasons why little change in retailer was to be expected.  First, the margins for retailers are relatively slender -- most estimates in Victoria prior to privatisation estimated that over 90 per cent of the distribution businesses' profits would be derived from their wires business.  Secondly, all retailers derive their basic power from a common source and the scope to offer low prices to attract business was not considered to be great.  Thirdly, there was expected to be a considerable amount of inertia and uncertainty, especially at the early stages of the contestable market.

It may be that an even higher degree of retail churning would have occurred had the nexus between wires and retailing been forcibly severed.  But there have been few voices claiming this in Australia.

One country in which a relatively lowproportion of power, 7.5 per cent, is delivered over the lines of non-host retailers is New Zealand.  In that country all customers are contestable and there is no structural separation, beyond accounting separation as in Victoria.  The relatively low inroads made by non-host retailers in New Zealand may be partly due to the fact that over 60 firms share the retail business.  Accordingly, the retailer/distributors are small (or were prior to a very recent spate of takeovers).  It is also likely to be partly due to the comparatively high cost of sophisticated metering smaller users would incur and the relatively low incentives rivals have to seek out new business in that half of the total market comprising smaller users.

Cheaper metering and increased market aggression in New Zealand may bring a higher share to non-host retailers, but most smaller users are likely to see merit in remaining with their host, especially as this gives them a single contact point in the event of difficulties.

Barriers to entry in retailing are low and competition, even at the margin, is likely to narrow any price differentials.  Though the cost savings from a combined retail and distribution business confer an advantage on the incumbent, it is surely not appropriate to force change by requiring costs to be incurred and inconveniencing the customer when there are negligible gains to be achieved.

CONCLUDING COMMENTS

The results of the contestability process to date are prima facie evidence of a lack of market power on the part of the incumbent wires business to prevent rivals from competing on a level basis.  The fact that forced separation would result in costs being incurred indicates that such a measure is not justified.

Costs aside, the most powerful argument in favour of not requiring structural separation is that mandatory separation might disadvantage those customers who wish to be inert in the electricity market.  Some customers may wish simply to retain their existing supplier on the basis that it is not worth the effort of searching out a new retailer but want continued supply by a retailer with sufficient assets to guarantee a continuation of their existing service.  A retail-only firm may not be in such a secure position.

Providing service has been satisfactory, as in all businesses, there is likely to be some advantage in being the existing retailer.  This is not, of course, sufficient reason to prevent incumbency.  Even a highly protected incumbent is constrained in its ability to exploit any consumer preference it might hold.  And the electricity retailers have little such protection.  Larger customers have already demonstrated this and even for smaller customers the lower costs of smart meters, and the operations of rival retailers and energy brokers making use of load profiling places severe restrictions on the incumbent's ability to charge a premium price.

---

ENDNOTES

1.  In Victoria, the Regulator's Guideline No. 1 says:  "A licensee must not (without a customer's explicit informed consent) make available to its retail arm customer information that would give the retail arm an advantage vis a vis another retailer." (para 7.2.2)

2.  "The NSW Electricity Supply Industry:  Information Paper on the Transition to Full Retail Competition", NSW Electricity Taskforce, July 1996.

3.  "The Electricity Industry in South Australia", Industry Commission, April 1996.

4.  "Reform of the Queensland Electricity Supply Industry", Queensland Electricity Structure Task Force, December 1996.

5.  In "NSW Energy Access:  A Guide", The Independent Pricing and Regulatory Tribunal of NSW (Sept. 1996), said, "An effective network access regime and accounting and behavioural separation will together ensure that the regulated monopoly network business does not shield the retail supply business from competition." (p. 5)

6.  Energy Probe's Prefiled Evidence in Manitoba Public Utilities Board June 1996 Inquiry into the Future Role of Centra Gas Manitoba argued:

Separating Gas Merchant from Distribution Functions in Manitoba

Incomplete divestiture of the merchant business would be a costly second-best relative to complete separation.  Problems created by adopting the second best include the question of how to manage and regulate affiliate transactions, who should bear the cost of regulating affiliate transactions, how to impute a value for the use of the utility's name, what to do about the utility's special access to information about customers such as load patterns and credit history, and how to ensure comparability of service to affiliates and competitors.... In the event of incomplete divestiture, affiliated companies and utility parents will have powerful profit-based incentives to skew the outcome in their own interest..

Cleanly separating the merchant function from the distributor through a change in ownership eliminates these difficult problems.  Affiliate transactions would not be an issue because the divergent interests of different owners would eliminate the problem of cross-subsidies.  Without the risk of cross-subsidies, there would be no need for regulatory oversight over the merchant.  The value of utility's name and reputation would be recognized in the sale price.  Similarly, information obtained by the utility merchant would be recognized in the sale price but after the sale, the former utility merchant would have to obtain market information by the same means available to any other vendor.

In its January 1996 submission to the review of Ontario's Electricity System, Energy Probe called for disaggregation, including structural separation of distribution and retailing.  But the submission did not offer a clear path to effect this and suggested a transition period would be necessary.

Shooting the messenge

In her emotional and somewhat prejudiced article (The Age, 3/11) Sharon Beder seems to condemn all who question the accepted environmental doctrine on global warming and the need to take urgent and drastic action regardless of the cost to society.  She offers not one whit of evidence to counter the arguments of those who question the dogma but chooses to condemn the messengers (of whom I am one) because of the livery she believes they wear.  To impugn the integrity of scientists and economists with whose views she disagrees because a component of their resources comes from industry is insulting.  It would be equally silly and presumably untrue if I were to question her integrity because she needs to keep up a refractory environmental image to advance her career.

Let me make just three rebuttals of her unfair implications.  She fails to mention that one of the scientists she demonises, Professor Richard Linden is a highly respected fellow of the US Academy of Science;  he buttresses his criticism of unwarranted climate change alarms with very sound science.  She ignores the fact that Brian Tucker was writing articles on the scientific uncertainty associated with global warming while still in CSIRO.  And she ignores the widely accepted advice of the economic modellers in the Australian Bureau of Agricultural and Resource Economics that extra funding should be sought externally to ease the drain on Treasury.

One danger in Dr Beder's article is her tendency to polarise politically the global warming issue.  If climate change is indeed as important as she (and I) aver, then the policy to cope should be feasible, effective and based on rational argument -- not wild assertions aimed at criticising a Government that has Australia's interests at heart.

ADVERTISEMENT

Reliability Panel on Guidelines for NEMMCO Market Intervention

Energy Forum Papers

SUMMARY

Concerns about reliability in electricity supply and failure of the market to invest have already called forth some interventions by the authorities.  These do not augur well for a market designed to operate with minimal intervention.

It may be that certain unique facets of the electricity supply industry require a departure from a pure market that is similar to other commodity markets.  The upshot of regulatory override measures need to be thoroughly examined.  Regulatory interventions that prevail over outcomes based on the mutual interests of willing buyers and willing sellers will create other distortions.  On past experience, many such distortions are more harmful than the deficiencies they seek to correct.

For these reasons the best approach, providing we can be assured that monopoly is absent (or at least is only transient) is to rescind any distortions that the market rules themselves have put in place but to do so in ways that do not disturb commercial decisions taken in good faith.  Should interventionary measures be considered unavoidable, these are best handled by using market mechanisms.  This makes it preferable to seek bids for additional supply/voluntary load shedding rather than requiring firms to operate.

THE ISSUES

There are concerns that the "energy only" market that has been established, together with the $5,000 price cap on VoLL, puts at risk the reliability of the electricity supply system.  These concerns may be addressed in a number of ways, although we cannot be clear about the outcome of such treatments.  Possible approaches are:

• to accept a greater level of unreliability than appears to be offered by the present market structure;
• to raise the price of VoLL so as to encourage a greater availability of flexible, high energy cost plant that will expect to run only occasionally;
• to introduce provisions, similar to the England and Wales LoLP*VoLL payments, under which consumers are required to make payments for reliability;
• for the market manager to bid for additional plant availability with the price paid for that additional plant being confined to that plant only (the Reserve Trader provisions and the administrative arrangements required for the current summer by the Victorian ORG are variations of this);
• for the market manager to require plant to operate at an administered price when the system is envisaged to be under stress.

COMPETITION AND MARKET FAILURE

These proposed measures are often said to be required because of market failure.  Market failure is a precise term in economics that refers to the inability of markets to provide the lowest cost solution because of the occurrence of monopoly.  It is not a situation which occurs when a market outcome does not accord with what regulators expect to occur.

A form of market failure also may occur because of failure of governments to ensure stability in contractual arrangements and certainty over property rights.  This is more correctly a form of government failure due to distorted incentives.  In such situations markets may not operate efficiently.  The market may also fail as a result of such interventions if price restraints prevent a supply and demand equilibrium.  In such cases rationing must be employed.

The events in Auckland and Queensland testify to the deficiencies of government operated and owned systems.  Governments are likely to overbuild -- as they have in the past in NSW and Victoria -- or underbuild and stint on maintenance.

The introduction of a market for electricity is among the most radical changes in economic management.  Not only do we have the wide Government ownership but we have:

• monopoly aspects of the system,
• a non-storable good,
• an inability of many customers to receive and take short term actions based on price information
• a shared distribution system, which impedes the wide variation in user demand profiles from being registered;  as a consequence free rider aspects that might rule out a market free of all intervention.

Competition is one essential condition to market efficiency.  Efficient markets also require secure property rights and rules that change only by mutual consent or with long lead times that allow investment decisions and contracts to be unwound.  Changes in rules or regulatory seizures of property add risks that will reduce the investments firms make and cause commercial activities to be conducted in ways that are less than optimal.  They may, for example, lead firms to concentrate on short term contracting because of concerns that longer term contracts will be overridden.

It is these twin provisions of requiring minimal government intervention in markets with the requirement of stable regulatory framework that presents dilemmas for the operations of the electricity market.  Changes in market rules will reduce the value of certain contracts that were undertaken in good faith, yet if the market rules are themselves bringing inefficient outcomes, some changes would appear to be necessary.

The interventions in the market that have been seen to date are an unfortunate start to a system designed to be free of Government interference.  These include the requirement by the Victorian Regulator-General that retailers contract for reserve power, the commissioning of QNI as a regulated link and the on-going debate on this issue about Riverlink.

While such decisions as these doubtless pollute the notion of an electricity market that is no less free than other commodity markets, interventions along these lines may still prove to be inevitable.  Alex Henney in a recent report for the UK Minister for Energy and pool members envisages a major role for a variant of the NEMMCO powers over spinning reserve, continued (though changed) payments for capacity and possibly some reserve trader powers.

A key issue highlighted by Henney's report is the need for owners of rarely run plant to receive adequate remuneration.  The UK capacity payments associated with LoLP are not considered a success.  But the question is what is to replace them in a structure where, as Henney defines it, "The majority of customers buy energy PLUS generation reliability.  Many customers either cannot exercise choice in generation reliability by responding to price and many do not wish to exercise choice because they have bought electricity on fixed price terms and expect a reliable supply."

One market rule that may be impeding the adequate availability of reliable power supply is the cross-ownership rules that prevent distributors, in Victoria at least, from owning power plant.  For a retailer, owning some power plant is equivalent to taking out insurance or to self insuring by accepting the risk of very high prices.  Of course such an outcome may be achieved by taking a long term hedge contract with an existing generator but the retailer may see ownership as providing additional security or a lower cost option.

ADDRESSING THE OPTIONS

RELIABILITY STANDARDS

Present standards based on the outage level due to lack of generation require reserve capacity of 500 MW in the Victorian region, 831 MW in NSW and 250 MW in South Australia.  As the NEMMCO analysis has shown, considerably greater outages are likely to result from distribution line failures than from shortage of generation.  It has been over 12 years since the power supply failed in Victoria because of lack of generation.  No system can ever be 100 per cent secure.

In Victoria in 1997 some $20 million was spent at the regulator's direction on reserve power that has proved unnecessary.  If firms and consumers are being required to expend additional sums for reliability the regulator should be certain that they actually value that trade-off and that the money is spent in the best way to avoid the failure.

REMOVAL OF THE PRICE CAP

The price cap on electricity sits ill with the notion of a free market.  Price restraints are among the most egregious of regulatory instruments Unlike other interventions, they may prevent allocation of products to the parties valuing them most.  However, the complications of the shared nature of electricity distribution/transmission systems may make this less important than in other markets.

Furthermore, any early moves to remove, or markedly increase the price caps could give rise to other structural instabilities.  While market participants could reasonably expect the price cap to increase, total removal would not have been anticipated.  Those generators that signed long term contracts expecting a maximum price of $5000 per MWh would incur costs of insurance far in excess of what they anticipated against their being unable to operate.  Retailers would incur similarly high costs.

In this respect, there have been estimates of $250,000 per MWh as the price that electricity must reach in order to justify a plant operating to meet a 10 per cent probability of demand requirement of 5-7 hours.

INTRODUCE A CAPACITY PAYMENT

In the design of the Victorian and National Market, the twin component payment for energy and reliability was rejected.  While many consumer markets with high fixed costs, for example telephonic services, have two part tariffs, the view was taken that the outcome would be most efficiently achieved if the market were to be one of energy only.  In this respect, the relatively high (8% plus) payment for capacity in the England and Wales market was a consideration.

There are continued concerns that such a high payment in the UK may be due to generators gaming market rules that are unnecessarily vulnerable to such activity when capacity payments are involved.  In particular, a capacity payment is best designed for long term availability rather than the simple day-ahead basis as used in the England and Wales market.  But it is difficult to devise longer term capacity payments so that there are the appropriate premia, for example to fast start-up plant.

Moreover, a capacity payment involves a government agency making forecasts and the aim of the market is to avoid this.  All that said, the interventions regulators have deemed to have been necessary to date indicate weaknesses in the existing approach.

RESERVE TRADER APPROACHES

A superficially attractive route to ensuring greater system security is to buy top-up energy at a premium price without that price being reflected in the price for all energy.  This involves segregating the top-up energy from that traded in the main market.

One extreme variation of this is to have a market where all suppliers are paid the price they bid rather than SMP.  In the long run it can be demonstrated that the outcome from this approach for the market price as a whole will be the same as the single price outcome.  But to arrive at this outcome is likely to involve suppliers in considerable expense as they sift through the capabilities and market strategies of their competitors.

Whether a more limited version of this approach through a reserve trader will prove a practicable alternative is untested.  Such measures were generally found to be offensive by the ACCC and other parties because they involved governments determining needs rather than the needs being resolved by the atomised interactions of the many market participants.  As was addressed above with reference to capacity payments, in general, the new market seeks to escape intervention by the authorities because of the sort of "government failure" which is endemic with such intervention.

PLANT BEING REQUIRED TO RUN

When the market manager requires plant to run under terms its owners do not find satisfactory, this indicates deep-seated problems in the market structure.  There may be occasions in conditions of extreme emergency where such actions are unavoidable, but these should generally be confined to conditions like the total breakdown that has occurred in Auckland.

Aside from such situations, high prices may be demanded by a provider with some monopoly powers in the market.  Requiring such a provider to reduce the prices demanded is an extreme step and one likely to bring counter-productive responses.

Requiring a plant owner to operate is expropriation.  As a short term fix it can be highly effective but such measures totally undermine the incentive structure on which free markets are based.  Unless the target business was previously earning super profits, the firm owning the units targeted will seek to move them to other uses (perhaps overseas) where they can earn a higher reward.  At the very least such moves will deter maintenance on the units and prevent any further units being commissioned.

Market power is best combated by having the structure arranged so that monopoly is avoided.  But as long as there is freedom of entry (and investments are not so lumpy as to prevent small scale entry) and/or there is an ability of customers to react to high prices, there can only ever be a transient monopoly.  The high prices will stimulate activity on the supply and/or demand side which will prevent the monopoly recurring.  There is evidence to suggest considerable potential flexibility in electricity demand and supply sides, although this is not yet conclusive.

CONCLUDING COMMENTS

The market as presently designed may or may not be incapable of providing the degree of generator reliability demanded by consumers.  If it is deficient in this respect, this may reflect either residual regulatory measures like cross ownership rules or the price cap, or some intrinsic deficiencies as a result of the shared nature of electricity supply.

Any measures to correct possible deficiencies should be taken with the knowledge that regulatory interventions will spawn market based reactions that could lead to even more interventions.  Changes to market rules should also be taken so that they do not disturb commercial decisions taken in good faith.

A review of the market rules will shortly be underway.  In the interim, any market interventions that are contemplated are best taken within a framework that makes use of the market system.  In other words, if supplementary power is to be required, this is best obtained by a reserve trader seeking bids for reserve power and voluntary load shedding rather than by direction.

Soaking the Poor: Discriminatory Taxation of Tobacco, Alcohol and Gambling

Backgrounder

Taxes ranging from over 40 per cent to a mammoth 339 per cent on alcohol, tobacco and gambling have mercilessly exploited the consumer's fondness for these goods and services.  The only other bundle of taxes that come within this range -- those on petrol, at about 130 per cent -- at least have the justification that they are a proxy means of collecting revenue for roads.

Soaking the Poor is an apt description of the effects of very high taxes on a narrow range of products that tend to represent a greater share of the consumption of the less well-off.  The taxes lift fully 10 per cent of the income of the poorest members of society, a matter that receives remarkably little attention from those claiming to represent their interests.

Governments -- particularly State Governments -- have become heavily reliant on the revenues from these taxes.  They account for a fifth of States' own revenue-raising and over a quarter in the case of Queensland and Tasmania.  These shares have been showing a steady increase because of the narrow base the States have in their taxation opportunities.

The unfairness of these taxes and the distortions they bring about are testimony to the inefficient, ad hoc base of our tax structure.  Radical reform is required to bring us closer to the tax neutrality which is the hallmark of an efficient and fair society.

SUMMARY AND CONCLUSIONS

INTRODUCTION

Those seeking to develop a fair and efficient taxation system for Australia face many dilemmas.  The fundamental problems have been outlined in the first paper in this series, Restoring the Balance:  Tax Reform for the Australian Federation.  Among these problems is the very high proportion of taxes levied directly on income.  These include taxes that effectively penalise saving, and taxes (like the Financial Institutions Duty) on transactions which discourage funds moving to areas where they have greatest value.

It has been generally agreed for some time now that reform of Australia's taxation system should include a re-balance which involves decreasing taxes on income and increasing taxes on consumption.  In addition, fundamental changes are required to the present system of indirect taxation in Australia.  The ideal indirect taxation system is one which has a single rate, simple tax on final consumption without exemptions;  and Australia's hotchpotch of different rates and exclusions induces vast distortions, with the economic waste these bring, across the whole economy.

ISSUES IN INDIRECT TAXATION RATES

Within the indirect tax net, there is a polarisation of demands.

On the one hand, traditional notions of fairness have decreed that taxation of the "necessities of life" should be avoided -- a point of view which strongly emerged during the Fightback! debate a few years ago.  On the other hand, taxing luxuries or non-necessities, by definition, means taxing things that consumers can do without and which they will consume less of once the tax is incorporated into the price.  Less consumption means lower revenue.  Fur coats and luxury motor vehicles cannot be taxed much more than at present, since this would lead consumers to evade the tax by ceasing to spend -- the revenue raised may even be diminished, and the only point of the tax would be the satisfaction of soaking those of the rich who remained obdurate enough to buy at the new high price.

Although there are basic necessities of life, it is clear that all citizens in affluent societies have a relative abundance of these.  The average Chinese citizen earns perhaps a fifth of the income of the poorest segment of Australian society (and even manages to save 40 per cent of his or her income).  Indeed, although food is undoubtedly a necessity, within western societies the more serious problem among the poorest sectors is obesity rather than malnutrition.

Similarly, the notions of luxury and necessity are a judgement in the eye of the beholder.  And the judgement itself echoes with the sounds of the puritanical sentiment that people -- and especially the less affluent -- ought to spend money only on the goods and services that keep body and soul together.  Increased affluence, however, means that yesterday's luxuries tend to migrate into the necessity camp.  (So, for instance, the initially costly safety features that make expensive cars expensive eventually become part of the mass car market.)

Because people can choose not to consume those "frivolous" expenditures that become too expensive, the most effective taxes are those levied on goods and services that are relatively unresponsive to changes in price.  Although the traditional necessities -- food, clothing and shelter -- are already "over-consumed" on a strict basis of need, if the tax net is cast sufficiently widely on these products there is likely to be little leakage to untaxed or less-taxed goods.  Because of political opposition, however, it is unlikely that an Australian government could introduce a tax system that markedly raised revenue in these directions.

Compounding these difficulties, the area of demand that is growing most rapidly and which remains most lightly taxed is services.  The failure of the GST to obtain electoral approval means that this, too, appears to be closed off from early action which might enable a re-balancing of the taxation burden between taxes on income and taxes on consumption.  Yet many services epitomise the idea of non-essentiality;  and the fact that goods and services are often substitutable (so that one can hire an accountant or buy an accounting software package, for instance) merely reinforces the anomalies.  Moreover, a high share of expenditure on (untaxed) services is characteristic of the consumption patterns of the more affluent.

THE TAX RATES ON ALCOHOL, TOBACCO AND GAMBLING

Within this jumble of revenue needs and taxation constraints, alcohol, tobacco and gambling have a rare position.  These goods and services are thought of as non-necessities, have reasonably few substitutes, a demand profile that changes relatively little in response to price changes, and are considered by many to have some undesirable features, features which allegedly require public intervention.

Alcohol, tobacco and gambling have the highest levels of tax of any goods and services.  The cascading effect of State and Commonwealth taxes brings the total tax on wine, the most favourably treated of these goods and services, to 41 per cent of wholesale value.  This is comparable to the burden on luxury cars, the most highly taxed other good.  The tax rate on gambling exceeds that on luxury cars.  Beer pays 91 per cent, while spirits and tobacco pay a massive 253 per cent and 339 per cent respectively.

The discriminatory taxes on tobacco, alcohol and gambling fall particularly heavily on poorer people.  On average, those having the lowest fifth of income levels pay some $15 per week in taxes on these goods and services, nearly half as much as those whose income is ten times as great.  Put differently, those in the lowest income category are paying 10 per cent of their income in taxes on alcohol, tobacco and gambling, while those in the highest income category are paying only 2 per cent.

Not only are the taxes on these goods and services extortionate, but their design is skewed so that the impact is heaviest on the less affluent.  This is most apparent in the case of alcohol, where beer -- the preferred beverage of the less well-off -- is taxed at over twice the rate of wine, the preferred beverage of the better-off.

The punitive tax rates on goods and services that are consumed so relatively heavily by those on the lowest incomes does not square with the fairness which purports to be one of the overriding goals of taxation.  It is remarkable that so few voices among those challenging the equity of the present tax system are raised against the very taxes that impact most heavily on the poor.

CONTRIBUTION OF ALCOHOL, TOBACCO AND GAMING TO GOVERNMENT REVENUES

State Governments depend on this group of goods and services for nearly 20 per cent of their own revenue-raising.  This reliance on a narrow expenditure base and the general imbalance of the State governments' expenditure requirements and their revenue-raising capacities is symptomatic of the fragility of Australia's present taxation arrangements.

TAXES, THE CONSUMER AND ECONOMIC DEVELOPMENT

All taxes distort production and consumption decisions.  They create a wedge between what consumers are prepared to pay and what producers are prepared to offer.  Normally, the higher the tax, the greater the distortion.  A high tax either chokes off demand and shifts consumers to less preferred purchases, or it soaks up income that would otherwise be spent on other purchases.  The result is that the consumers' wants are less satisfactorily met.

Governments require revenues for their expenditure requirements.  The extent of their income take, however, at thirty per cent-plus of Gross National Product in most developed economies, is far in excess of the level where it does little damage to productivity and the growth of national output.

The least distortionary form of tax is one imposed on expenditure and at a single rate.  Such a tax would not be a burden on income that is not actually spent, and so would avoid discouraging saving and its corollary, capital investment.  Nor would it fall on financial transactions -- impositions on these expenditures lead to actions designed to evade tax, resulting in a reluctance to shift funds to their most productive uses.

DISCRIMINATORY TAXATION

Discriminatory taxation is levied in response to three main factors:

• the effect on demand for the good or service following the influence of the tax on price;
• the political acceptability of taxing it;  and
• the ease of collection.

The responsiveness of demand and supply is crucial if revenue is to be raised.  Imposing a high tax on a narrowly-defined product will cause demand to shift to cheaper products.  Conversely, placing a lower tax on a product with similar features to other taxed products will cause demand to migrate toward that lower-taxed product, thus reducing aggregate revenues as well as distorting demand itself.

Political acceptability covers several dimensions.  In some circles, it means taxing more heavily those goods that are mainly produced overseas, under the misapprehension that it is the foreigner who pays.  More legitimately, it means taxing luxuries on the basis, first, that such measures impact more heavily on those with higher incomes who can better afford to pay the taxes, and, second, that the luxuries are, by definition, not required by notions of essentiality.  The problem is that there is no objective definition of luxuries, and yesterday's extravagances often become today's necessities.

The political acceptability of high taxes on certain alcoholic products and on tobacco has long been evident.  In the case of distilled spirits, the level of taxation is so high that the government's share of the product's aggregate value considerably exceeds the owner's.  For many governments, this has meant that they have, for most practical purposes, assumed ownership for themselves.  Indeed, until recently, the control of entry into storage areas was not vested with the wholesaler or manufacturer but with an excise official.  This was abandoned only when it was seen to be unwieldy and costly.

The most heavily taxed items, like spirits, beer and cigarettes, have the bulk of their taxation levied as a volume-based excise (which shields their real taxation rates from public scrutiny).  In the past, because tax increases on these products brought an unfavourable electoral reaction, their increases tended to be uneven, in response to the electoral calendar.  Tax increases -- either to regain the real level of taxation in periods of inflation, or to increase that real rate -- tended to take place when no election was expected.

Over the past dozen years, excise has been linked to the Consumer Price Index.  This is designed to even out the tax increases, and to make them as smooth as increases in the Wholesale Sales Tax which take place automatically as the prices of taxed goods increase.

In addition to indexation, there have been further discretionary tax and franchise fee increases on some excised products.  In the case of tobacco, increases have even been brought in at ostensibly unfavourable junctures of the electoral cycle -- the perceived adverse effects of the product are apparently such that increases in its tax rate now incur little odium.

LEVELS OF TAX ON ALCOHOL, TOBACCO AND GAMING

Alcohol and tobacco carry several layers of tax.  Beer and spirits have Commonwealth Wholesale Sales Tax at 22 per cent (for wine and other alcohol it is 26 per cent), and excise taxes (or their equivalents in customs duty).  All alcohol products also face State franchise taxes.  Tobacco does not pay Wholesale Sales Tax, but has very high excise duties.

Comparable tax rates are difficult to assemble in the case of gambling, because the product does not have an easily defined wholesale value, and expenditure levels bear little resemblance to the data derivable from the Household Expenditure Survey of the Australian Bureau of Statistics.  Most expenditures on gambling are also, of course, returned to winners.  The tax rates cited below are based on revenues collected and National Accounts data on net expenditure by households gaming activity.

These tax rates are converted into a share of expenditure, taking into account the retail mark-up.  The tax share of expenditure is lower than the tax on output, even without a retail mark-up, because the rate is expressed as a percentage of the sum of the tax and the pre-tax price.  (The figures for gaming already include the retail mark-up.)  The tax rates are shown in Table 1.

Table 1:  Tax Rates on Alcohol, Tobacco and Gambling (%)

	Wholesale sales tax equivalent			Tax share of expenditure
	C/W	State	Total
Alcohol
beer	70	21	91	35
wine + undefined*	26	15	41	22
spirits	215	38	253	52
Tobacco	120	219	339	62
Gambling	0	42	42	30

Source:  State and Commonwealth Taxation Statistics and revenue collections.

*Note:  undefined alcohol refers largely to cider and alcoholic sodas.

The average share of tax in final consumption of all goods and services is 10 per cent.  Even wine has a tax rate twice that level, while the tax on spirits and tobacco is five and six times the average.  Taxes are higher on alcohol, tobacco and gambling products than on almost all other goods.  Expressed in Wholesale Sales Tax equivalents, the tax on tobacco is in fact the highest level of tax that is levied, that on spirits the second highest, beer the third.  The only other product that comes close to these tax rates is luxury motor vehicles at 46 per cent (a level which is in fact lower than the tax on gambling once the retail mark-up on cars is included).

INTERNATIONAL COMPARISONS

High tax rates on these goods are found in most countries throughout the world.  The taxation levels often reflect long-standing historical factors, and vary in response to particular social and economic pressures and the lobbying power of producer and consumer interests.  In this respect, wine has long been able to win favourable taxation treatment in countries with strong domestic industries.  Low rates for wine are seen in France, Italy, Germany, the US and to some degree Australia.  Beer taxes are low in France, Germany and the US.  (They are also low in Switzerland where a constitutional amendment would be required to lift the tax rate.)  In Japan, the traditional use of sochu and sake has left wine and spirits at lower tax rates than beer.

Average tax levels also tend to be somewhat distorted by the very high rates in the Scandinavian countries.  In those countries, however, duty-free and illegally distilled liquor is believed to form some thirty per cent of alcoholic consumption as a result of the punitive tax regimes -- such alcoholic consumption is also believed to form a sizeable 18 per cent of the Canadian total.  Table 2 contains some international comparisons.

Table 2:  Approximate Tax Burden On Alcoholic Beverages (1991)* (per cent)

Country	Beer	Spirits	Wine
Australia	31	48	21
Canada	53	82	69
France	17	42	17
Germany	19	64	12
Italy	26	36	8
Japan	44	23	22
NZ	30	39	32
UK	32	48	35
US	18	45	17
All Developed Countries (avge)	32	55	30

Source:  Brewing Association of Canada.

*Note:  The rates for Australia are equivalent to those shown in the final column of Table 1.  There have been some minor tax changes since 1991.

The difference between the taxation rates of these similar products contains some noteworthy points.  Among these is that, in 1991, Australia actually had the distinction of both the lowest ratio of wine-to-beer tax among OECD countries and the highest ratio of spirits-to-beer taxes.  This suggests that the distortion between these similar goods is much too great.  This sort of indication did not persuade the majority authors of the recent Wine Industry Inquiry markedly to re-balance the tax rates on the different product categories, because they were not convinced that there was sufficient evidence that the products formed the same basic market.

In the case of tobacco, high tax rates are also set in most other countries.

Table 3:  Share Of Final Sales Price (including taxes)
Of Tobacco Accounted For By Taxes (per cent)

Country	Tax Effect
Australia*	65
Canada	53–72
France	76
Germany	70
Italy	73
Japan	60
NZ	68
UK	78
US	19–43

Source:  Tobacco Institute of Australia.

*Note:  The Australian rate differs from Table 1 due to slightly different base price assumptions.

One feature of Australia's taxation base is the high proportion that is raised in direct income taxes.  The corollary is a low proportion collected in indirect taxes.  Hence, although Australia's taxes on tobacco and alcohol are not markedly different from those of other countries, relative to other indirect tax collections they are very high.

EFFECT OF THESE "LUXURY" TAXES ON DIFFERENT GROUPS

THE DIFFERENT PATTERNS OF EXPENDITURE

In their incidence, the taxes strike at a relatively narrow class of consumption.  In doing so, they are highly regressive, having a particularly severe impact on lower income earners.

The extent of this is not easy to track, since respondents to statistical surveys consistently understate their expenditures on these goods and services.  The Household Expenditure Survey of the Australian Bureau of Statistics accounts for only 65 per cent of the known consumption of alcohol, 61 per cent of tobacco and 25 per cent of gaming.  The identification of only 25 per cent of gaming expenditure presents particular analytical problems.

While some of the alcohol shortfall could be attributed to corporate entertainment, this could not be the case for tobacco or gaming.

The following data take the 1993–94 Household Expenditure statistics for five strata of income levels.  The shortfall of declared expenditure from known consumption is reallocated to the different income strata in proportion to their declared levels of expenditure.

Table 4:  Weekly Expenditures By Income Group

	lowest 20%	Second quintile	Third quintile	Fourth quintile	Highest 20%	All households
Pre-tax average household income	$151.66	$353.91	$592.28	$909.22	$1,608.77	$723.26
Expenditure on:
Alcohol (total)	$11.72	$18.25	$26.41	$31.01	$45.65	$26.88
beer	$7.26	$10.29	$15.18	$17.65	$20.65	$14.29
wine + undefined	$2.55	$4.54	$6.52	$7.94	$16.34	$7.77
spirits	$1.91	$3.42	$4.71	$5.42	$8.66	$4.82
Tobacco	$10.46	$15.44	$16.87	$17.74	$14.85	$15.07
Gambling	$16.64	$20.08	$21.64	$19.88	$25.20	$20.68

There is a vast disparity in the share of household income that is spent on this narrow range of goods and services.  The expenditures in aggregate amount to a little under 9 per cent of household income.  For the poorest fifth of the community, however, they account for 26 per cent of income and are 15 per cent for the next poorest fifth.  By contrast, they account for only 5 per cent of the income of the highest-earning fifth of households and 8 per cent of the next highest fifth.

These disparities are not markedly changed if gaming is excluded.  The proportions of income accounted for by alcohol and tobacco taxes from the lowest fifth is 15 per cent, compared to 4 per cent from the highest fifth.  Figure 1 below illustrates these data.

Figure 1:  Expenditure Shares by Income Group

THE TAXATION IMPACT

The combination of very high tax rates on these goods and services and their high usage by lower-income categories places a disproportionately high burden on lower-income earners.  Some 10 per cent of the income of the lowest fifth of income earners is accounted for by tax paid on alcohol, tobacco and gambling.  For all income categories, the average is 3–4 per cent, while for the highest earners, the average is 2 per cent of income and 2.7 per cent of after-tax income.  Table 5 summarises these estimates.

Table 5:  Taxation Paid By Different Income Categories ($ per week)

	lowest 20%	Second quintile	Third quintile	Fourth quintile	Highest 20%	All households
Average household income	$151.66	$353.91	$592.28	$909.22	$1,608.77	$723.26
Disposable income	$149.59	$335.90	$511.93	$737.88	$1195.90	$586.23
Tax on:
Alcohol (total)	$4.09	$6.38	$9.20	$10.75	$15.32	$9.21
beer	$2.54	$3.60	$5.31	$6.18	$7.23	$5.00
wine + undefined	$0.56	$1.00	$1.44	$1.75	$3.59	$1.71
spirits	$0.99	$1.78	$2.45	$2.82	$4.50	$2.50
Tobacco	$6.48	$9.57	$10.46	$11.00	$9.21	$9.34
Gambling	$4.99	$6.02	$6.49	$5.96	$7.56	$6.20
Total	$15.57	$21.98	$26.15	$27.70	$32.09	$24.76
% of Income	10.3%	6.2%	4.4%	3.0%	2.0%	3.4%
% of Disposable Income	10.4%	6.5%	5.1%	3.8%	2.7%	4.2%

OTHER ISSUES ON THE COMPOSITION OF THESE "LUXURY" TAXES

The regressive incidence of these taxes is amplified by different rates in the case of both tobacco and alcohol.  For tobacco, the excise tax is levied by weight.  Accordingly, it falls relatively more heavily on the cheaper tobacco types which are consumed more heavily by poorer people.

The high tax rate on tobacco also tends to have a heavy impact on younger people, as a much larger proportion of people in the age groups over 40 have either never smoked or have ceased smoking.  Tobacco usage presents a risk to longevity, but this is not a risk that any smoker can be unaware of.  It is argued that governments have a duty to deter this activity, and penal taxation rates can certainly have this effect.  But smokers, like other members of the community, are best placed to determine for themselves how or whether they trade off relative preferences for the product and its adverse health effects.  (This is not to say that non-smokers who dislike the environmental impact of smoking should not be able to demand its non-use where it has some impact upon them.)

It is often claimed that the high tobacco tax compensates for the increased health costs its usage entails.  The tax collections, however, vastly over-compensate for any such costs. ⁽¹⁾  Indeed, to the degree that smokers die younger than non-smokers, a cold social cost–benefit approach would indicate that its consumption reduces the costs of maintaining "unproductive" older citizens!

The continued high usage of tobacco in the face of escalated taxation levels is evidence that it is highly preferred by those using it.  Its persistent usage is indicative that it is addictive.  The evidence for this is somewhat challenged by the vast number of people (perhaps the majority of the population over 45) who are former smokers.  In any event, if it is indeed addictive, it is somewhat anomalous that the victim's habit should be punished.

In the case of alcohol, health concerns are also sometimes offered as a rationalisation for high taxes.  These claims are spurious:  very few people consume sufficient quantities of alcohol to harm their health, and taxing it to deter such small proportions of the population would be akin to taxing food because some people over-eat.  For other moderate consumers, alcohol actually has a beneficial health effect by reducing the incidence of heart disease -- this effect is common to all types of alcohol.

As previously alluded to, the tax rates on beer, wine (including cider) and spirits are vastly different.  These differences largely reflect historical and industry pressures.  The wine lobby has successfully resisted taxation rates comparable to those of the other two categories.  Yet beer, with an equivalent wholesale tax rate of over 90 per cent, is overwhelmingly the alcoholic drink of preference for those with lower incomes, while wine, with a rate of 41 per cent, is mainly consumed by the more affluent.

Even in the case of spirits, traditionally the preferred alcoholic drink of higher-income earners, the lower-income earners actually spend a higher proportion of their income on these products than higher income categories.  Nor is there a plausible case for placing higher taxes on spirits because of their higher potency.  Spirits drinkers are aware of the strength of the alcoholic content.  In any event, almost all spirits are consumed in a mixed form and at strength less than that of wine.

The effect of the very high rates of tax on spirits is likely to come under severe pressure as a result of technological change in the industry.  Alcoholic drink manufacturers are increasingly able to imitate the tastes of those products that face very high tax levels with lower-taxed substitutes.  Thus, in Australia there is now a range of synthetic alcoholic products often based on wine and cider (for instance, Two Dogs, Subzero, Father O'Leary's) that pay only a fraction of the tax rate of the products with which they compete.  These products are enjoying an explosive growth in sales at the expense of the more traditional products.

Gambling expenditure may have increased markedly over recent years, though data on this are difficult to assemble as, prior to the legalisation of casinos and the introduction of gaming machines, there may have been a high incidence of illegal and unreported expenditure.

The tax on gaming is subject to a considerable number of distortions, not the least of which is local monopolies on casinos, which represent a regulatory tax on gamblers, a tax which State governments are seeking to collect in the form of specific franchise charges on the right to establish the monopoly.

In addition, some States have severe limitations on the installation of gaming machines.  In Victoria, for instance, there is a limit of 27,500 such machines.  The location of these machines is controlled, and there is an insistence that 50 per cent of them be placed in licensed clubs rather than pubs.  Demand for their installation in clubs is fully satisfied, hence those pub owners fortunate enough to have the scarce supply are able to enjoy high profits whether for the machines themselves or from the products consumed while patrons use them.

Furthermore, there is a discriminatory tax regime between pubs and clubs, with the Government taking 33.3 per cent of the daily take in the former and 25 per cent in the latter.  This is in addition to the income tax-exempt status that clubs enjoy, a distortion that a recent Industry Commission report on tourism has drawn to the attention of the Commissioner of Taxation.

THE SIGNIFICANCE OF "LUXURY" TAXES TO GOVERNMENT REVENUE

THE COMMONWEALTH

Commonwealth revenue from tobacco and alcohol in 1994–95 is estimated at some $4.2 billion.  This comprises $1,128 million in sales tax on alcohol and $3,082 million in excise plus import duty on beer, spirits and tobacco.  The share of the different products is shown in Figure 2 below.

Figure 2:  Share of different products in total "luxury" tax revenues

These goods account for over 15 per cent of Commonwealth indirect tax revenues and 4 per cent of total tax revenues.  Over recent years, their growth has been relatively low -- sluggish growth in consumption (and some shift out of higher-taxed and into lower-taxed alcoholic products) has been offset by continued tax increases on tobacco products.

THE STATES

The "luxury" taxes have grown to comprise one fifth of State revenues over recent years.  They now account for only slightly less than Payroll Taxes, traditionally the mainstay of State finances, and are more important than property taxes (6 per cent), motor vehicle and petrol taxes (16 per cent), stamp duties (16 per cent) and the financial duties on bank and insurance transactions (12 per cent).

Figure 3:  State revenue base

The "luxury" taxes are responsible for over one-quarter of government revenues in Queensland and Tasmania.  Figure 3 above illustrates their importance across the States in general.

These taxes have grown from a share of 15 per cent in 1989–90, largely due to an increase in tobacco taxation levels.  Gambling taxes account for over half the revenues raised on the three product categories.  The relative shares are shown in Figure 4 below.

Figure 4:  Share of different products in total "luxury" tax revenues

CONCLUDING COMMENTS

A range of very high taxes is levied on tobacco, alcohol and gaming, expenditures that are associated with extravagance or harmful activity.  People tend to understate their consumption of these goods and services, possibly out of a sense of guilt about their indulgence in these expenditures.

Expenditure on tobacco, alcohol and gaming is equivalent to some 8 per cent of income in the average household, but 24 per cent for those on lower incomes.  The high taxes on these goods and services have a very heavy impact on lower-income earners, accounting for 10 per cent of the incomes of the lowest quintile compared with only 2 per cent of the incomes of the highest income quintile.

The taxes on these products are highly regressive and a harsh impost on poorer people's leisure and social consumption.

There is a long tradition of citizens taking action against excessive levels of taxation -- the Boston Tea Party being perhaps the most celebrated instance.  One form of this action is being seen in other countries in the evasion of alcohol taxes;  and in Australia there is a clear shift of supply and demand into the more lightly-taxed wine, cider and synthetic alcohol products.

The tax regime in Australia is over-dependent on revenues from alcohol and tobacco.  One factor in this is the successive High Court decisions that have legitimised taxes that are effectively nothing more than State-based sales taxes as "franchise" taxes.  There is increasing urgency to redress the imbalance between the States' abilities to raise revenue and their expenditure requirements.  Allowing the States some scope for more equitably and efficiently levying tax on goods and services would be a good start.  Reviewing the disallowance of State taxation on goods would allow greater scope for widening their taxation net.

At the Commonwealth level, one major necessary step is to bring greater balance to the tax rates for similar products, in particular wine, spirits and beer. ⁽²⁾  Technological changes are already disturbing the fragile equilibrium that has allowed such disparate rates to persist for so long.  Even so, there has been a steady erosion of beer's market share, to the benefit of wine.  Without early action, we will see economically wasteful decisions as suppliers reformulate their products purely to benefit from differential rates.

It is not acceptable for governments to maintain that they should impose high tax rates on these goods and services so as to discourage consumption.  Such a claim would be morally ambiguous in view of governments' own dependence on these revenues.  More importantly, however, it is not the role of governments to encourage or discourage different sorts of expenditures by their citizens.  Rather, it is a fundamental role of government to preserve people's freedom to choose for themselves which goods and services they consume.  The benefits which people obtain from consuming tobacco, alcohol or gaming clearly outweigh the value of the money they spend on them.  In the absence of any adverse "spillovers" affecting others from the consumption of these goods and services -- and almost all the benefits and costs of consumption are borne by those buying them -- the appropriate outcome is that they be taxed no higher than other goods and services.

ENDNOTES

1.  The best and most comprehensive assessment of the costs and benefits of smoking in Australia is by ACIL Economics in Smoking:  Costs and Benefits for Australia, March 1994, which concludes that:

"The principal market imperfections relevant to smoking are tobacco taxation (imposed at a much higher rate than for other products) ($2.5 billion), tariff imposts (which allow higher tobacco product prices to prevail within Australia) ($0.1 billion), partly offset by more intensive use by smokers of subsidised health care ($0.4 billion).  This nets out to an annual transfer of $2.2 billion away from smokers, mainly to consolidated revenue.

Thus, contrary to popular belief, the level of taxation on tobacco products easily exceeds claimed health care costs by smokers on the community."

2.  While a volumetric tax on all alcoholic beverages would redress the distortion between different alcohols, it would still leave the problem of inequity in the tax rates between alcohol and other goods and the effects of this on different income groups.

Cheaper power and the glory

The key question is whether it is appropriate for government-owned firms to embark on high-risk generating ventures either with the taxpayers money or at the expense of energy customers, writes Richard Wood.

Deregulation and competition in electricity supply in Victoria and NSW is providing colossal savings to those customers permitted to break free of the government stipulated price.  It is also resulting in enormous productivity gains, especially in Victoria, where the industry had massive overstaffing and poor plant reliability.

As from February 1997, the two State markets are to be linked.  Electricity cab then be bought from interstate generators and the electricity will flow from the lower priced market to the higher priced market.

In both Victoria and NSW, before recent reforms, the cost of generated power was more than 5c per kWh.  It is being phased down from that level for the customers who are not yet free to negotiate their own prices.  (These account for 60 per cent of usage in Victoria and 85 per cent in NSW, falling to 60 per cent in July of next year).  The "contestable" customers have negotiated prices believed to be about 3c per kWh in both States.

But the competitive electricity supply forces unleashed in bothe States are driving prices much lower than this.  This is compounded by lower demand caused by major users continuing to engineer greater economies into their power demands -- many firms have signed on to the Commonwealth's Greenhouse Challenge and found they can operate with less power even where, as with supermarkets, there is a greater demand for power for refrigeration.

At the heart of the new electricity market is a spot price determined half hourly from the bids of generators wanting to supply power to the system.  Since July of this year, this price has averaged only 2.4c in Victoria (1.6c in September and October) and 2.2c in NSW.  Long-term contracts are on offer at less than 3c in NSW.

There are considerable implications arising from these low prices.

In Victoria, the marginal costs of production for the brown coal-fired generators (supplying 85 per cent of the load) are thought to be less than 1c and profitable operation requires at least 3c.  In NSW, because the coal is available for uses other than power generation, the marginal costs are thought to approach 2c and profitable operations require up to 5c.  Although almost all power is sold under contracts above the spot prices, they will continue to place downward pressure on future contract prices.

This presents major difficulties for the generators' profitability, especially since there is considerable surplus capacity which can readily be brought on stream whenever prices improve.  In Victoria, the largely privatised generation industry will bear the burden of lower prices but there is some respite in the offing once the link with NSW allows Victorian generators to offer their intrinsically cheaper power into that market.  While ratcheting Victorian prices upwards, this will maintain downward pressure on NSW prices.

For the NSW supply industry, the prospect of full competition with Victorian generators is alarming.  Forty per cent of customers will soon be able to negotiate their own prices.  If the prices they negotiate are at the 3c per kWh now on offer for annual contracts, NSW generators' revenues will be nearly halved, bringing a loss of some $400 million.  If Victorian generators were to capture a 4 per cent share of the market, a further loss of $100 million would be incurred.

One concern of privately owned firms is that the NSW Government-owned firms will not act commercially.  This will guarantee huge losses to the NSW taxpayer and grievously distort the entire market.  A more insidious concern would be if NSW tried to keep out Victoria power on spurious greenhouse grounds.

A true market can only be assured if the NSW Government abandons its ideological opposition to privatisation.  The current low electricity prices will doubtless have reduced the market value of the generators, but they remain highly prized assets.  Their sale would allow private capital to operate with commercial disciplines and equilibrate the risks and returns concerned.  Such a position is also the only way the NSW Government can avoid the risk of taking a major hit on its finances.

Yet in NSW, a new gas-fired cogeneration facility is shortly to commence at Smithfield on the back of a contract of 5c per kWh entered into by the Government-owned Integral Energy.  A further plant at Botany is to be partly owned by another Government-owned firm, Energy Australia.  To operate profitably, such a plant requires a power contract of 4c per kWh.  Energy Australia is being asked to guarantee that price.

These are complementary to other industry developments and might turn out to be far sighted if the price of electricity were suddenly to double.  But there seems little prospect of this happening over the next few years.  And, as the lead time for constructing these sorts of plants is only two years, it would seem folly to embark on them now.  Moreover, the new plants can only exert additional pressure for the closure of the more marginal existing NSW coal-based plants.

The key question is whether it is appropriate for government-owned firms to embark on high-risk ventures either with the taxpayers money or at the expense of energy customers.  Voters will not tolerate tax increases, while electricity customers are aggressively seeking better deals.  Capital resources available to State governments for roads, schools and public housing are increasingly limited.

There is no end of such calls on government investment capital for projects that could not attract private capital.  Should State government funding be allocated to the casino that characterises the present electricity market rather than on public goods that cannot attract private funding?

ADVERTISEMENT

Prescription for inefficiency

Although a task force has been set up to ensure fair competition in gas service provision with minimal government intrusion, the process the group has proposed is fraught with bureaucratic intervention and control, writes Richard Wood.

In discussions on national energy markets, gas has been the poor relation of electricity.  Yet while coal-based electricity provides the bulk of Australia's non-transport energy market, gas accounts for 31 per cent.

At present there is little rivalry in gas provision to Australian markets of either an intra or inter-basin nature.  A national framework for free and fair trade in gas featured strongly in the Hilmer report and is one of the pillars of the national competition policy agreed to at meetings of the Council of Australian Governments.

The settled principles include requirements that all monopolies are removed or controlled, no impediments to competition remain and government entities are placed on a commercial footing.

In the past year, a gas reform task force of government officials assisted by industry representatives has been nutting out the precise terms for fair competition.

Although ostensibly about minimal intrusion into private sector arrangements, the outcome is a process that is indelibly tattooed with bureaucratic intervention and government controls.

The task force's proposals will discourage companies from building new pipelines or pipeline capacity not a guaranteed commercial success.

The proposals contain no scope for an entrepreneur to take a punt on an uncertain pipeline venture with the hope of high profits should its demand prove to be high.  This is because a regulator will ultimately determine the price of carriage -- and that price will be based on costs.

So the best the risk-taking entrepreneur can expect on a successful investment is the regulator's notion of a fair profit.  This caps the profit from a successful new enterprise but, as no customer pays for a facility that has been ill conceived, there is no offsetting compensation.

This must lead to a sharp fall in new pipeline development.  Taking out the most risky ventures will diminish the growth of rival pipelines and retard the competitive conditions the task force was set up to expedite.

Most pipelines are largely built on firm bankable commitments of major users and retailers for the capacity of the pipes.  However, capacity can be developed so it is flexible and can be expanded at a modest cost increase -- the volume being related to the square of the surface of the pipe.

But pipeliners will only install surplus or capacity that can be easily developed if they can see a reasomable chance of profiting from it.  And under the proposed regime, such scope for augmented capacity may be absent or even a liability.

Where the extra capacity must be on-sold to third parties at prices judged reasonable by a regulator, there is a risk the prices paid by those parties committing to contracts will be undermined.

The outcome is a perverse incentive.  Pipeliners will be forced to design the pipes so only the committed gas can be carried.

The task force also shows no sign of restricting the control of government to these pipelines that are essential facilities.

Where, as will soon be the case with Sydney, gas can be transported by more than one pipeline system, in the absence of collusion (which would be dealt with under separate provisions of the Trade Practices Act) there should be no need for government oversight.

Yet the task force assumes all pipes will be essential facilities and subject to governmental control.  In this respect it has been guided by US regulations.

But it has badly misread the US developments where the residual controls are irrelevant to the efficiency that has developed in the gas market, an efficiency created by the growth of rival pipelines, not price controls.

The task force faces up to the possibility its controls may bring an imbalance between the demand for capacity and its supply -- an imbalance likely to be made worse where, as is possible, the price may even be based on historical rather than replacement costs.

But it addresses these in ways that only compound the basic shortcoming.

For example it acknowledges the regulator's arithmetically determined tariff may sometimes bring a scramble by users for available capacity, where the calculated price is too low.

However, there is no way in the face of this recognition that the task force will retreat from its rejection of the normal market solution which allows price to allocate demand for firm capacity to those who value it most.  Instead, the task force prefers a queuing approach.

Queuing is, of course, totally alien to the efficiency brought about by market-determined prices.  Queues in fact epitomise the failures seen in centrally planned economies.

As if queuing were not bad enough, the task force proposes that those at the head of the queue be forbidden to sell their position to others behind them.

This means the users who value the capacity most cannot obtain it from others who place a lower value on it.

The proposals of the gas task force suffer from an inadequate understanding of market processes, of how government intervention can all too readily emasculate these, and of a cheerful optimism about the ability of regulators to establish prices which fully mirror those revealed in the interplay between demand and supply.

Like the constructs of so many other brave new worlds, its prescriptions would be a severe impediment to achieving the efficiency it seeks.

ADVERTISEMENT