Promoting productivity gains in regulated industries

1. Promoting productivity gains in regulated industries Presented by Sarina FisherSenior EconomistCentre for International Economics

2. Summary • PART 1: Why are regulators concerned about productivity • What is productivity? • Why regulators are required to consider productivity • The contribution of productivity to Australia’s strong economic performance • PART 2: Ways regulators can promote productivity • Consider efficient costs • Making productivity adjustments • PART 3: Which type of productivity should be used for the adjustment? • PART 4: Measurement issues: how much to adjust?

3. PART 1 Why are regulators concerned about productivity

4. Inputs Productivity Output % per annum % per annum % per annum 1964-65 to 1973-74 3.4 (71) 1.4 (29) 4.8 (100) 1973-74 to 1990-91 1.9 (76) 0.6 (23) 2.4 (100) 1990-91 to 1998-99 2.0 (57) 1.5 (43) 3.6 (100) Firstly, what is productivity exactly? • The ratio of input to output • Getting more from the same or less inputs • Getting the same from less inputs • Specifically, the difference between changes in inputs and changes in outputs is productivity (table) • Not about producing more or working harder, but combining resources efficiently to get more from less Outputs, inputs and productivity Source: PC estimates based on ABS data sourced from Productivity Commission (2000).

5. Competitive markets drive productivity gains - So too should overseers of regulated industries • In a competitive market firms search out productivity gains to lower prices/increase market share • Monopolies and other regulated industries face no effective rivals and weaker incentives to improve productivity • Regulators need to step in to emulate the market • Encourage productivity gains • Ensure they are efficiently shared between businesses and their customers

6. What can regulators do to encourage productivity growth? • “Economic regulation” to encourage productivity growth in regulated industries, via: • simulating the effects of competition • encouraging efficiency and prudent investment • E.g. incorporating efficient costs into building block analysis • Incentive regulation: Using rewards/penalties to emulate ‘survival pressures’ of a competitive market to help induce productivity improvements • E.g. making productivity adjustments and allowing additional gains to be captured by the business

7. Ignoring productivity foregoes gains to businesses and customers • If inputs costs are only inflated by their cost in regulated prices without consideration of productivity gains: • gains will be lower and/or • not shared with transport users • Providing efficient services is important to demand and therefore the prospects for cost recovery

8. Productivity has been pivotal to strong economic performance • Australia’s economic miracle since the 1990s • Average GDP of 3.5% p.a. over the past decade • Fears of catching the “Asian flu” during the 1997 financial crisis proved unfounded and proved the economy robust • Productivity growth has been remarkable by world standards • Productivity has been a key driver of income gains • Worth 56% of average annual income growth (1.4 pp to the 2.5% annual average) • Up from 43% contribution in the 1970s and 1980s (0.6 pp to the 1.4% annual average)

9. Source: OECD (2006). Australian GDP per capitaIndex, OECD Average = 100

10. Australia outperformed other leading economies throughout the 1990s • GDP and productivity growth in Australia stronger than elsewhere throughout the 1990s • GDP stronger than the US and a third greater than the OECD as a whole • Productivity growth around 20-60% higher than the US and other OECD economies • Labour productivity gains stronger in the 5 years to 1998/99 than previous 30 years • Back to levels not seen since the 1960s when they were a worldwide phenomenon • Now Australian gains ‘stand out’

11. Communication services Electricity, gas & water Mining Agriculture Manufacturing Transport and storage Finance and insurance Market sector Construction Wholesale trade Retail trade Accommodation, cafes & restaurants Cultural & recreational services -2 0 2 4 6 8 10 % per year Productivity gains have occurred in all regulated industries Labour productivity growth: Average p.a. 1974-75 to 1998-99 • Communication services lead the surge • Electricity, gas and water industry a strong performer • Transport and storage, outperform the market average Source: Productivity Commission (2000).

12. Productivity growth in transport • Labour productivity growth doubled in the 1990s • On average (all industries), annual labour productivity growth has eased from 3.2% annual growth to 2.2% per annum (historical average) • Yet transport and storage industries defy the trend with labour productivity continuing to rise • growth was 1.2 percentage points stronger in the 5 years to 2004/05 than the previous 5 years • Put another way, it is up 16% over the 5 years or 3% average annual growth

13. Productivity gains expected to continue in future years • Every expectation of continued productivity gains in the future • Commonwealth Government forecasts 2% annual productivity growth for the next few years • Reforms in regulated industries will deliver gains • More room for improvement with productivity growth up but the level still below other developed countries • In 2001, the relative level of productivity in Australia was below the US, Canada and France, despite outperforming these countries in annual productivity growth since the 1990s

14. So what exactly is changing? • Labour productivity: not about how much or intensely we work, but how efficiently we work • Such as how much technology and other capital is invested per worker (sometimes referred to as “capital deepening”) • Such as work and management practices and the allocation of resources (combining labour and capital to produce more output, also called “multifactor productivity”)

15. Other improvements • Productivity gains are be made, even if they cannot be specifically attributed to labour or capital • Sometimes referred to as “total factor productivity”, which is a residual after changes to the inputs to labour and capital are taken into account • Usually based on an efficient benchmark firm • Not specific to a particular business

16. PART 2 Ways that regulators promote productivity

17. Productivity has always been a consideration for regulators • All regulated industries have been encouraged to promote productivity for some time • Eg. In gas, capital and operating expenditure are required to be prudent/efficient or else costs are not ‘allowable’ for the purpose of recovery through prices • In transport, the focus has tended to be on cost recovery • Encouraging productivity is important to make sustainable inroads to cost recovery • Productivity gains need to be achieved • Productivity gains need to be shared with transport businesses (for profitability) and passengers (for demand)

18. Techniques used to encourage productivity gains • Consider only ‘efficient’ costs in determining recoverable revenue from fares • E.g. level of efficient costs considered for multi-year price paths or access agreements • Make productivity adjustments to changes in input costs to recognise actual/potential productivity gains • Private buses (2005) • Taxis (2006) • Combine these approaches in pricing decisions

19. Advantages of productivity adjustments • Shares the gains (and possibly losses) that have been experienced between transport businesses and users • Additional productivity gains beyond the benchmark allowance can be captured by the firm to encourage firms to outperform the benchmark

20. PART 3 Which type of productivity should be used for the adjustment?

21. Partial or total productivity adjustments? • Identifying appropriate productivity indicators depends whether gains can be attributed to certain factors and/or measured most accurately • Have the gains come from labour? • Have the gains come from the combination of labour and capital? • Have the gains come from things other than labour and capital • Either way, positive and negative changes should be reflected, resulting in a ‘net’ change

22. Need to know the source of gains to make adjustments more effective • Have investments been made in capital equipment that improves operations • from a technical perspective and/or • from a labour efficiency perspective? • Is the use of more efficient capital and/or labour practices new or longstanding? • Are further reforms required to improve organisational and operational efficiency? Are businesses able to affect these reforms or are they external to the business? • These questions can be addressed in your submission to help IPART understand your industry

23. A conservative approach Maybe because evidence suggests the gains have related to changes in work and management practices Referred to as multi factor productivity, such productivity gains have more than doubled in growth terms over the previous productivity cycle However, capital changes can also benefit labour productivity (referred to as ‘capital deepening’) Eg. ICT investment per worker has also had a positive impact on labour productivity IPART has adjusted only labour cost components to date

24. PART 4 Measurement issues

25. How much to adjust? • Measuring productivity is usually controversial • However this doesn’t mean measures are imprecise • Challenges in making growth estimates include: • How to account for changes in quality. Changes in quality could themselves be a productivity indicator such as on time running • What if the benchmark firm is not ‘efficient’ and costs reflect overstaffing or inefficient capital use. Regulators must consider efficient costs. • Measuring labour inputs is difficult in businesses with flexible working hours and varying skill levels • Need to define the outputs of the business. Passenger kilometres, an index of timeliness and other quality indicators, or some other measure or combination?

26. How much to adjust? (continued) • Need to take account of + and - productivity factors in assessing revenue adjustments and cost pass through • Changes in productivity (positive or negative) need to be incremental • For instance, has congestion become worse on average across the networked business? This needs to be demonstrated • Default is measured and verified industry-wide productivity performance • Any deviation from the default requires evidence of difference in productivity • May need to benchmark the firm against itself, look at the distribution of productivity and the mean.

27. What does IPART do? • Not a long history of productivity adjustments for transport businesses • Recent productivity adjustments have been made for private buses (2005) and taxis (2006) • Adjusted only those components of costs that were likely to have experienced productivity gains (e.g. labour costs) • Adjusted by a lesser amount than economy wide productivity gains to be conservative • Other cost components fully inflated by expected cost driver (such as CPI, actual costs, other) • IPART also commissions studies to estimate efficient costs for transport businesses

28. Ensuring that adjustments are robust and transparent • Use the verifiable industry-wide averages as the benchmark productivity adjustment • Examine the unique circumstances of each transport business or industry through a public consultation process to ‘adjust’ the industry wide result • Consider industry and public views about how and why the business should be expected to do better or worse than the measurable industry-wide performance