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SELECT COMMITTEE ON THE NATIONAL BROADBAND NETWORK
Implications of the proposed National Broadband Network
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SELECT COMMITTEE ON THE NATIONAL BROADBAND NETWORK
CHAIR (Senator Ian Macdonald)
Implications of the proposed National Broadband Network
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SELECT COMMITTEE ON THE NATIONAL BROADBAND NETWORK
(Senate-Friday, 4 June 2010)
ERGAS, Professor Henry
HARRISON, Dr Mark Douglas
CHAIR (Senator Ian Macdonald)
COUTTS, Professor Reginald Paul
KERIN, Professor Paul
PEARSON, Mr Mark
RIORDAN, Mr Sean
STANTON, Mr John Leslie
WAGG, Dr Michael
SHERIDAN, Mr Andrew
- ERGAS, Professor Henry
Content WindowSELECT COMMITTEE ON THE NATIONAL BROADBAND NETWORK - 04/06/2010 - Implications of the proposed National Broadband Network
CHAIR (Senator Ian Macdonald) —I declare open this public hearing of the Senate Select Committee on the National Broadband Network. The committee’s proceedings follow the program that has been circulated and these are public proceedings. The committee hearings are covered by parliamentary privilege. There are other rules and regulations, but I know Professor Ergas has appeared before a number of committee hearings and is fairly familiar with them, without me having to go through them.
I have confirmed with my committee members that we are happy for Dr Harrison to be here as well, and I assume that, where questions or approaches come to your area of expertise, which we will find out about shortly, you will interpose with Professor Ergas and you will work together. Is that how you intended to do it?
Prof. Ergas —Yes.
CHAIR —The committee is happy with that approach. Dr Harrison, have you been before Senate committees before?
Dr Harrison —No, this is my first time.
CHAIR —Perhaps I should say to you that these hearings are protected by parliamentary privilege. If there is anything that you want to say that you think might be better said privately in camera, you can make that request of the committee. The committee will consider the request and determine whether we can do that.
I thank Professor Ergas for coming back. We have had the benefit of your expertise before. You will also note that in our fourth interim report we quoted some things that you had said publicly, and as I have mentioned to you privately, we gave the department and NBN Co. selected excerpts of things that were in public comments that you and a number of other analysts and experts had said and asked the department and NBN Co., as the case may be, to respond, which they have. I have provided you with a copy of those responses this morning and in the course of your presentation perhaps you might like to respond to their response, if you feel so inclined. Alternatively, some of the committee members may question you in relation to your comments, the department’s response and what you might say to it, but we will deal with that as we move along.
Unfortunately at the end of Senate estimates week all senators are committeed out. We are a bit slow in starting, and I apologise for that as well. Senator Fisher will be here very shortly to complete the committee, but we are a quorum.
With that, I might ask if you have some opening comments. This particular hearing of the NBN select committee was more or less engaged with respect to the implementation study. We are very keen to get evidence on the implementation study. That is what we are principally interested in. Do you have some opening comments?
Prof. Ergas —Thank you for asking me to appear in front of you. I should say at the outset that I have, over the years, provided advice on a consulting basis to a number of entities that are affected, one way or the other, by the proposed National Broadband Network. However, I am appearing here in a strictly personal capacity and any views I may express are entirely my own and should not be imputed to any current or former clients.
I am joined today by Dr Mark Harrison who, like me, is an economic consultant. Dr Harrison is also appearing strictly in a personal capacity today. I thought it would be useful for Dr Harrison to be present at today’s proceedings because Dr Harrison is an authority on the issue of discount rates and the cost of capital to the public sector and is the author of the Productivity Commission study that looks at the issue of the appropriate selection of a discount rate for public sector projects, the NBN obviously being such a public sector project.
With those preliminaries, I will make a few brief introductory remarks. My first remark goes to the implementation study, itself. As I have said in my published material, some of which you have been kind enough to cite, I believe that the implementation study is a useful piece of work and in many respects a very careful piece of work. That does not mean that I agree with everything in it, and there is a great deal that one could discuss and argue about. Taking that as given, I think the implementation study team has obviously done a very careful piece of work in trying to look at the issues involved in implementing the NBN proposal.
The first point of substance I would make is that I believe it would be highly desirable for the detailed workings that underpin the results that are presented in the implementation study to be public. It is often very difficult in reading the report to understand precisely what has been done and why it has been done that way. I cannot imagine that there are significant issues of commercial confidentiality and, to the extent to which there are such issues, they could be dealt with by requiring those having access to confidential information to fill in the appropriate undertakings or to commit to the appropriate confidentiality undertakings. Having access to the underlying material would be helpful in both assessing the implementation study and coming to a more well-founded assessment of its strengths and weaknesses, but also in terms of informing the broader public debate. As a result, I would urge the committee to do all it can to ensure that the detailed workings that underpin this study are made public in a timely and comprehensive way.
Turning now to the substance of the study, as I have said in my published commentary, the study makes a number of assumptions that seem to me optimistic. It is very difficult to test those assumptions without access to the detailed workings, but as best as one can tell from the summary that is given in the report, there are a number of areas where the study team’s approach is rather optimistic in terms of the prospects for NBN Co. One area that I have signalled in that respect, and it is not the only one, is the assumptions with respect to price trends over time. The study, as you know, assumes that prices that are received by NBN Co. for its services increase steadily and continuously over time. That, of course, is in complete contrast to the experience of Australian telecommunications over the period from the 1980s to the present and is also in contrast to the experience internationally, as well as to current trends.
I note that the response that you have received to those comments about price assumptions from the department and NBN Co. points out that the assumption of increasing prices over time reflects a mix of factors, in particular there is an assumption that over time NBN Co. will be selling a progressively higher speed or otherwise higher price range of services, so there is some change in the composition of the services it sells, but also that prices across the board will be increasing. That is entirely correct, but the study itself is very cautious in terms of the prospects for the composition of NBN Co. services to change to higher priced services over time. It cautions against assuming that such upgrading will occur or that it will occur at any point early in the deployment and operation of the new network. As a result, in terms of the factors that affect the commercial and broader economic liability of the new network, one has to assume that the bulk of the work, in terms of the per-unit revenue change, comes from this pure increase in prices over time. Again, it would be highly desirable for NBN Co. or the department to disclose the detailed workings that underpin those price projections so that analysts can look at whether those projections are in fact reasonable.
Even with all of those assumptions the study concludes that the internal rate of return for NBN Co. will be about equal to the government bond rate. There are a number of issues that one can raise in that respect. There are some technical problems with the way the study proceeds and I believe this is, indeed, a flaw or an error that the study has made, that it uses essentially the bond rate as the cost of funds or it seems to suggest that the bond rate is the cost of funds and then it uses a nine per cent discount factor in evaluating choices of technologies. No explanation is given, either in the study itself or in the response, of that apparent inconsistency and the response does not seem to understand that that is a problematic aspect of the study. But, even putting that aside, the response then says in defence of this result that the internal rate of return on NBN Co. will be barely equal to the bond rate. It says in defence of that result that the bond rate is the cost of funds that is relevant to the government.
CHAIR —Just so that we are all on the same page, where are you?
Prof. Ergas —In the response at page 11.
CHAIR —Under which heading?
Prof. Ergas —Under the heading ‘Commercial Viability’. The study notes the projected return is about the government’s costs of funds. The response then goes on to say that the government considers the additional benefits et cetera are sufficient to justify taxpayers not receiving a premium for project risk.
In the statement there are at least two significant errors. The first is the assumption that the projected return—that is, the bond rate—is the government’s cost of funds. They cite no rationale for that, and Dr Harrison may want to comment on that. Second, the response seems confused in that it appears to assume that additional benefits alter the required cost of capital to a project, not its overall commercial viability or economic viability more broadly. In other words what they seem to be saying here is that, because there are these additional benefits, it is appropriate to use a low discount rate. That is a confusion between the discount rate and what it is you are discounting. The benefits go to what it is you are discounting. The discount rate is not affected by those benefits, or only very indirectly affected by those benefits.
The bottom line on that is that the bond rate does not reflect the opportunity cost of capital to the public sector. I do not believe there is any substantial dispute, even academic dispute, as the response suggests in that respect. That raises the question of whether this project is worth proceeding with.
In the comments that I and others have published in respect of the implementation study we note that using the bond rate as the cost of capital breaches the competitive neutrality guidelines and breaches the guidelines for government business enterprises. It is clear that the response paper does not in any way address those comments. It does not dispute that fact, which I believe is recognised also by the implementation study.
The first point that comes out of this is that the implementation study, even on the basis of optimistic assumptions, finds a rate of return that is well below the cost of funds. That suggests that the project is, simply put, not commercially viable. That has implications for the budgetary treatment of this project. In particular I would contend that the project fails the criteria that are set out at page 381 of the study for a project to be regarded as market operator and hence be classed as a public non-financial corporation for ABS and budgetary reporting purposes.
There is a subsidy element that is very substantial in this project and that subsidy element should be transparently disclosed in the budget as and when it is incurred. Let me make a final point which is this: when I first appeared in front of this committee it was on the issue of cost-benefit appraisal of this project. At the time the government’s approach and the response that I know you had in evidence from departmental officials was that it was not possible to carry out a cost-benefit appraisal because such cost-benefit appraisal would require making a number of assumptions about costs, demand and revenue. We now have the results. The government has spent $25 million, or its claimed $27 million, doing a very detailed study that provides exactly the information required for a cost-benefit appraisal. Given access to that information, it would be a matter of days to complete the cost-benefit appraisal of the project. That cost-benefit appraisal could be done strictly on the basis of the assumptions that underpin this implementation study.
I would therefore suggest that, if the government is willing to disclose the information and the detailed workings that underpin this study, I would be happy to use those in the model that we already have in place to generate a cost-benefit appraisal at no cost to the taxpayer. All that is required is that we be given access to the underlying workings. If, for whatever reasons, the government does not want to do that, there are many people in government and in the major departments who are capable of taking these results and transforming them into a cost-benefit appraisal of the project. I see no reason whatsoever why Treasury or Finance could not undertake such a cost-benefit appraisal now that the information required is fully available and indeed has been paid for by the taxpayer.
CHAIR —That is a very interesting and, might I say, generous offer. You said that, given the information that the information study found or the assumptions on costing, it would take a matter of days—I think you said—to do a proper cost-benefit analysis using a model which you have. I always struggle when talking about models. What model are you talking about? Is it a model that is recognised by others as being the right model? Can you just elaborate a bit more on that?
Prof. Ergas —As you know, in a paper with a colleague prepared for the Productivity Commission symposium I undertook a cost-benefit appraisal of the NBN going on the basis of the information that was available then and a number of estimates that we developed and that paper has now been published by the Productivity Commission. We already have the modelling framework in place and what would be involved is to populate that framework with the results that come out of the implementation study. We would obviously be happy to make our own workings available publicly for others to assess and, if they find difficulties with them, to critique.
We have that modelling framework and that is the absolutely conventional modelling framework that is used for a cost-benefit appraisal and that is consistent with the department of finance’s guidelines on cost-benefit appraisal.
CHAIR —Suggesting that the ACCC has published it does not necessarily mean the ACCC agrees with it.
Prof. Ergas —No, I am sorry; it is the Productivity Commission. There is certainly no inference that the Productivity Commissioner has endorsed it.
CHAIR —But clearly the Productivity Commission would not be publishing any work based on modelling that was clearly not acceptable. This is a question most of us this side of the table struggle with when it comes to modelling. I should not, perhaps, speak for Senator Lundy, but I do. How would critics of your work assess your model?
Prof. Ergas —The only commentary, really, that we have had in respect of our model is that there is some disagreement about the underlying assumptions—in particular about take-up of the service—but not really about the structure of the modelling as such.
CHAIR —But you are saying that using the assumptions in the implementation study would correct that criticism.
Prof. Ergas —Absolutely.
CHAIR —Are you serious about a matter of days?
Prof. Ergas —Yes. Obviously for that to be the case it requires that the information is provided in a form that is understandable, readily documented and easily usable as long as—
CHAIR —It must be there if the implementation study has used it.
Prof. Ergas —Well, it did.
CHAIR —You also said that if your, I will say, generous offer is not taken up by the government—and I would be interested to hear why they would not take it up as it is not going to cost anyone anything except you for your time and expertise—Treasury or Finance or anyone else could also do a cost-benefit analysis relatively quickly using the assumptions that are clearly available because they have been used in the implementation study. Is that what you are saying?
Prof. Ergas —Yes. You would have to make some additional assumptions but most of those could be based on the more detailed workings in the implementation study. There is obviously room to argue about exactly where those detailed assumptions would come out, but again one would normally do sensitivity tests that would allow one to encompass a range around those assumptions and to look at the sensitivity of the results to those assumptions. But there is no doubt, to my mind, that the departments of Treasury and finance would have the in-house capability to undertake such a study on the basis of the very detailed material that has been produced for the implementation report.
CHAIR —Would McKinsey-KPMG be capable of doing that, bearing in mind that they made it quite clear in their implementation study that—dot point—‘This is not a cost-benefit analysis because we have been asked not to do it, or we have not been asked to do it.’ I am not sure which, but they made it clear this was not a cost-benefit analysis. Are McKinsey-KPMG the sort of people who could do a cost-benefit analysis within—quoting you again—a matter of days?
Prof. Ergas —I am afraid I would not know really for a fact what McKinsey’s capabilities are in that respect, but there is no doubt that KPMG undertake a wide range of cost-benefit appraisals in many different areas, so they too would have the internal expertise required to undertake such a cost-benefit study.
CHAIR —Dr Harrison, could you just start. Senator Ludlam has joined us. You might, just for his benefit, explain who and what you are.
Dr Harrison —I am an economist.
CHAIR —Please, when you are talking about discount rates and internal rates of return, can you assume—in my case quite correctly—that we really do not know a lot about it, so you might have to sort of go back to Economics 101 just to, in a one-liner, tell us exactly what you mean by discount rates and so on. Over to you, Dr Harrison.
Dr Harrison —I emphasise that I am appearing as a private individual and an economist. I have been an academic, a public servant and a consultant, but most relevantly, from May 2007 to May 2009, I was visiting researcher at the Productivity Commission, where among the things I did was to write the comprehensive paper on the social discount rate in cost-benefit analysis—in other words, What discount rate should the government be using to evaluate its projects?’ What the study does is calculate an internal rate of return of six to seven per cent and then compares that with the government bond rate and calls that the government’s cost of funds. The problem with that is that the government bond rate is not the cost to the taxpayer or to society. Really, how you finance a project does not affect the project risk. The project has certain risks; they are there, they have a cost and someone has to bear them. Financing is about who bears those risks and so when the government finances it, basically, the risk is thrown onto the taxpayer. If the project makes a loss, it is going to be the taxpayer that has to step in and make up the difference.
The government bond rate takes no account of that risk that is imposed on taxpayers. The government can sell bonds at a rate of five per cent because payment is guaranteed by the taxpayer but, when they finance this project, who picks up the cost of losses on the project? It is the taxpayer. The private risk premium indicates the cost of risk—what people have to be paid to bear it—and that is why the private return is above the government bond rate, because it includes a premium which accounts for the cost of the risks imposed on investors in the project.
As for the social cost, that is really about opportunity cost and the point is that when we finance these projects we are crowding out private investment that has a higher return. In Australia, a conservative estimate of the return to the average private investment is nine per cent real—so about 12 per cent nominal, or more—and certainly over the last decade it has been much more; it has been about 11 or 12 per cent real. That is the average private investment and the point is that with this money, if we invested it in the private sector in a project with the same risk, we would earn that higher return. For a project of average risk we would earn 11 or 12 per cent real over the past decade, but on an average, say, nine per cent would be a conservative estimate. For more risky projects you get a higher return to compensate you for that extra risk; for less risky projects, a lower return.
The opportunity cost of investing in the NBN is that we are forgoing private investments with a much higher return. The cost of capital should reflect that and the bond rate does not reflect the foregone investments, the investments we are giving up in order to invest in this project.
CHAIR —Sorry, can I just interpose there. If someone were lending money at the bond rate but knowing that the government—that is, the taxpayer—was going to guarantee it and you would be absolutely certain you would get your six per cent, for an investor is that not sufficient—that there is really no risk? I mean, even if the whole thing falls over and collapses in a heap of dust, they will still get their money back plus six per cent.
Dr Harrison —Yes, because the person who is buying the bonds, yes, gets a government guarantee and that is why they are willing to lend at five per cent. My point is that that has nothing to do with the project risk. The project is very risky and someone has to bear it and it is the taxpayers—the owners of the project—that bear that risk. It is completely independent. The financing of it, which is just the buying and selling of bonds; has nothing to do with the real risk imposed by the project. So taking the bond rate ignores this risk that is borne by someone, and it is borne by the taxpayer.
CHAIR —You are saying that, if the government were not involved in this, the cost of money would be 11 per cent, 12 per cent or perhaps 20 per cent?
Dr Harrison —Then the investors in the project would bear that risk and they would require a premium to compensate them for it. If we finance this project privately, it would cost much more than five per cent and that would reflect all the costs of the project to the owners, including the risk cost, and they have to take account of what they could get with their money in alternative opportunities.
CHAIR —And you are saying that competitive neutrality principles and the government’s own public sector funding require them to be borrowing at the real rate?
Dr Harrison —Because the taxpayers guarantee these things, they borrow at whatever rate—you know, five per cent—but when they are evaluating their projects they should evaluate them with all the costs that are imposed on society.
CHAIR —Yes. All right. Did I interrupt you?
Dr Harrison —I was just going to talk about the Department of Finance and Deregulation response, which says:
The government considers the additional benefits to the economy and society accruing from the NBN are sufficient to justify taxpayers not receiving a premium for project risk.
CHAIR —Can you just—
Dr Harrison —That is on page 11 of the response.
CHAIR —Under ‘Commercial Viability’?
Dr Harrison —Yes, that is right. It is the second paragraph. The great thing about cost-benefit analysis is that it makes the methodology and the assumptions all clear and explicit and then you can argue about them—you know, Professor Ergas assumed this; someone else assumed something different. You can argue about which is a more realistic assumption and it makes it all very transparent. Also, the assumptions you make along the way are very transparent. That response is very confused. It is saying that we can get some unmeasured, unproven benefits to the economy and somehow use them to reduce the discount rate, whereas, if you did it properly, you would take account of all the costs and benefits, you would try to measure those benefits to society, you would also try to measure the cost of the risk that the project is imposing on society and then you would compare them. You know, the cost-benefit analysis is about weighing up those costs and benefits.
Perhaps it is true that these external benefits would justify the project, but you would not do it by lowering the discount rate. That is about valuing dollars in the future compared to dollars now—nothing to do with the external effects of the project. We should measure these external effects and then, when they accrue in the future, discount them at the appropriate discount rate. There is no way you should adjust the discount rate as some sort of ad hoc way of taking account of these external benefits, because that is a very particular way of doing that. The lower the discount rate, the higher the value of future dollars, and there is no reason why that trade-off is relevant for the external benefits that come from this project.
CHAIR —In reality, clearly the government is saying: ‘Well, we mightn’t have the funds right, but it is going to be such a great thing for Australia and everyone will have 100 megabits per second right around Australia, no matter where you live, except if you happen to live in the seven per cent, and that is such a good thing for Australia and it has so many benefits otherwise; forget about the cost. This is a good thing for Australia, so let’s go ahead.’
Dr Harrison —That is exactly what should be tested in the cost-benefit study. That is the point; you can say that, but showing it is another thing. The question is: let us try to get estimates of these benefits and see whether they do justify the cost. The cost should be properly measured, which includes the cost of capital and which includes the cost of risks imposed on taxpayers; then you can weigh them up. In essence they claim they know the results of the cost-benefit study without ever doing it.
CHAIR —Okay, but in effect, would the government not argue, ‘Look, this might be all okay in academia and with economists arguing about this, but the mere fact of the matter is we are getting this great asset for Australia, we are going to pay for it by borrowing’—these are my terminologies, but you know—‘at six per cent and people will lend to us because they know we are the government and we are going to pay them back’? There is all this talk about forgone risks, forgone costs or costs that should have been; so what? What is the relevance of all that?
Dr Harrison —Usually, when you undertake a project in the private or the public sector, you want to know: is there a net benefit? Do the benefits exceed the cost? If it is so obvious, that should be very easy to show in a cost-benefit analysis. I am saying they have presumed the results of the analysis that has not been done.
CHAIR —Going back to Professor Ergas’s generous offer, within three days—or perhaps a little longer—once you have got the material you would know whether the concerns—
Dr Harrison —I have a feeling I am going to be doing this.
CHAIR —So it is your generous offer, not Professor Ergas’s.
Prof. Ergas —It merely makes my offer all the more generous.
CHAIR —It very much does. We could know all this and put it to bed. I mean, if the government is right, in three days they could prove to the world that all of the critics are all wrong and that they are right; is that right?
Dr Harrison —You could produce a cost-benefit study and its value would depend on the assumptions that went into it, but they would be very clear, you know, and then we could say—
CHAIR —But Professor Ergas has said that the assumptions are already in the implementation study.
Prof. Ergas —You could take the results of the implementation study. It seems to me that it is important to distinguish two things: what the implementation study tried to do and then the broader question of the wider desirability, or otherwise, of this project. As I understood what the implementation study tried to do, it sought to look at the commercial viability of NBN Co. To look at the commercial viability of NBN Co., it is obviously important to value risk at the rate at which risk would need to be remunerated where there is a commercial project. The study is mindful of that and at pages that begin at about page 410 of the report it looks at what a required rate of return would be for the project were it undertaken in the private sector. It finds that that required rate of return is far higher than the bond rate—probably double the bond rate. So, if you are focused on commercial viability, the project does not seem to meet that test, at least on the basis of the analysis that has been done by the McKinsey-KPMG team.
A project may not be commercially viable but may still be socially worthwhile. It may be desirable because of its broader implications for the wellbeing and welfare of Australians. That is a perfectly legitimate motive for governments to undertake projects and is a motive that may apply, at least conceivably, in this case. We also recognise that we live in a world of scarce resources and that government cannot undertake every conceivable project that it might wish to undertake. When government funds are used for one purpose rather than another, that has an opportunity cost, because government itself is constrained and because when government borrows or takes resources, and when government spends those resources, they are not available for use elsewhere in the economy; that itself has a very significant opportunity cost.
Over the years, we have had a universal acceptance by successive governments in this country that the proper way to assess whether a project will indeed merit the use of scarce government resources is by undertaking a proper cost-benefit appraisal. That is not what the implementation team was asked to do; it is not what they have done, but it would certainly be possible—indeed, readily possible—on the basis of the very detailed information that they have clearly generated to undertake such a study and to thus come to a more robustly based and transparently contestable view as to whether the benefits from this proposed National Broadband Network exceed its opportunity costs.
Senator LUNDY —I heard the Business Council of Australia the other morning on radio raise this issue of why it was important, in their view, that the NBN project be assessed on purely commercial terms. Dr Harrison, have you taken any inspiration or are you familiar with the Business Council’s exhortations in relation to this over the last few days?
Dr Harrison —No, I have not.
Senator LUNDY —I am interested in the purity of the argument, given that the government was able to test the market with an expressions of interest process and, with the market failing to respond and a range of other factors, it is determined to press ahead with what the government sees as a very important economic infrastructure. The government certainly believes, as Professor Ergas points out, that it is socially worthwhile. Why do you contend that the test needs to be rigidly associated with what could be deemed a commercial viability test, in pressing forward, if there is a very strong political view that there are externalities, social and economic benefits, that were incapable of being serviced by that higher rate of return demanded by the commercial markets?
Dr Harrison —You are misinterpreting what I said. I never said that you had to have commercial viability. We were pointing out that on its own report it apparently does not have commercial viability. If there are social benefits that still justify, more than offset, the commercial losses that we expect on this then it would be worth going ahead, but asserting them is not proving them. I think it would be prudent to check whether it really is worth going ahead. It is a very costly policy. Would the money be better spent elsewhere? There are lots of things you can do.
Senator LUNDY —I will come back to the money being spent elsewhere. In saying that you should prove it first, how can you prove it in the absence of a high-bandwidth network and activity taking place?
Dr Harrison —To the best of our ability we estimate what the costs and benefits of this project will be to assess whether it is worth going ahead. With your best-practice regulation, guidelines and so on, all throughout government policy making it is considered a good idea, for a relatively low cost, to assess these things in advance to see if they are worth going ahead with, rather than just asserting that there are social benefits from them. There are social benefits, but the question is: are they big enough to offset the cost of doing this?
Senator LUNDY —Do you think they are?
Dr Harrison —I do not know. I have not done the cost-benefit analysis.
CHAIR —But you could in three days.
Dr Harrison —They would have to be very large to offset the substantial cost of doing it. Maybe it does not sound plausible that they are that large.
Senator LUNDY —I am familiar with a range of reports over many years that show that the economies that have been investing in information and communications technologies tend to be the fastest growth economies—certainly prior to the GFC. Does that count?
Dr Harrison —When you do the cost-benefit study, you have to have your best estimate of the kinds of benefits it results in, and that would be a benefit. There is some question as to what the causation is and whether the richer economies buy more IT equipment—
Senator LUNDY —Let us talk about multifactor productivity associated with the higher use of ICTs. Would that be something, given that there is plenty of evidence of that? There are plenty of reports published about the association with multifactor productivity and the extensive use of ICTs. That evidence is out there.
Dr Harrison —Good cost-benefits would take account of all of this evidence and weigh it up. As I said, the advantage is that it is not just hand waving. It is saying, ‘We are assuming X and Y and these are the benefits we expect.’
Senator LUNDY —Where I am at a bit of a loss is in response to the opposition’s claims that somehow, in the absence of this formal cost-benefit analysis, it is flawed. I have been reading these reports and international research studies showing the economic and social benefits of investment in that, so there is a reasonable base level of knowledge and understanding that I think informs the policy overall and why, at one point at least in the not-too-distant past, there was universal agreement that a universal high-bandwidth network for Australia was a positive thing. That has changed. We now have an opposition saying that they are not going to support it and economists like you and Professor Ergas coming out and saying, ‘We shouldn’t make the investment on the basis that there isn’t a cost-benefit analysis available for perusal, because there might just be another infrastructure investment that might return more benefit to the Australian people.’ That seems to be the substance of your presentation.
Dr Harrison —No, that is not it. No doubt there are benefits, but how big are they? You say it raises multifactor productivity. Is it by 0.1 per cent or 0.2 per cent? What does it have to be to justify this project? The key thing in the cost-benefit study is: what are the counterfactuals? Basically we are predicting the future; that is why it is so hard. To work out the costs and benefits of the project we would need to say what would happen without the project and what would happen with the project, and the difference is the cost and benefits of the project. That is very difficult to do because you need to predict the future. At least, with the cost-benefit study, we can have our predictions about the future. Your prediction might be that, if we do not do this, we are never going to have the investment in broadband technology that you think the economy needs. That is one assumption.
Senator LUNDY —We know that because we tested the market. We already know that one.
Dr Harrison —I do not think that anyone thinks that it will stay at the current levels forever. There is wireless technology developing and all sorts of other things. Predicting the future is hard, but the good thing about a formal analysis is that we can make those predictions explicit and determine how much you want to rely on them, how reliable they are and what the risks of entering this project are and so on. It is good-practice policy making to try to weigh up the cost and benefits of things before you do them.
CHAIR —With the assumptions that you have got from the implementation study, three days of work and a generous offer by you, you could have the cost-benefit analysis done.
Dr Harrison —They obviously have some prediction about the future in there to come up with their numbers.
CHAIR —If the government is so certain about the benefits, why would they not jump at your very generous offer?
Senator LUNDY —Why not just do it for the public good?
CHAIR —They need the assumptions from the implementation study.
Prof. Ergas —The detailed results.
CHAIR —That is the first point.
Dr Harrison —Professor Ergas did one as a public good. As I said, it is hard to predict the future. This study has one prediction and it would be useful to get the details on what they are.
CHAIR —To feed that into the cost-benefits?
Dr Harrison —Yes.
Senator LUNDY —Just going to the spectre of an alternative investment, given that we are talking about peak capital funding of around $26 billion estimated in the implementation study, and for that debt to be serviced by the subsequent profitability of NBN Co., what, under that model of financing infrastructure, can you point to as alternative worthy investments that ought to be considered?
Dr Harrison —When you draw this money from the capital market you crowd out private investment. Who knows where it comes from? But we know that, on average, it has a very high rate of return. Nine per cent real would be a very conservative estimate of what we are giving up when we crowd out private investment to have more government investment. That is the cost of the government project and the benefits from it should exceed that cost.
Senator LUNDY —Given that the market failed to respond—the market had an opportunity to respond to the government’s needs with respect to the policy to build a national broadband network—the implementation study shows that the rate of return, as you say, is around the bond rate. I am not clear as to why you contend that it is some kind of reasonable test for government that this project return the commercial rate of investment. It may have been what Professor Ergas, rather than you, was pointing out, but I am at a loss as to why NBN Co. would need to sit that test, given that the policy is on the back of market failure and the incapacity of telecommunications companies around the world to determine that they could make this investment.
Dr Harrison —Market failure is a necessary condition for the government to be involved, but it is not sufficient. It shows that there is a potential gain from government involvement, but the question is: is there an actual gain? What exactly are the benefits from doing this? You can say that it is not commercially viable then the private sector will not do it, but then the question is: should the government step in, and do the benefits outweigh the costs of doing this?
Senator LUNDY —You are ignoring a really important fact, and that is that private companies who expressed an interest and participated, albeit in varying degrees of effectiveness, in the expressions of interest request for information process demanded things like access holidays in the regulatory environment to justify their investment. Again, that signals from the market that, yes, they would make the investment if they were provided with the sort of access holidays that allowed them to, firstly, manipulate market structure and, secondly, guarantee a rate of return. That implies that in a commercial environment, if there were regulatory distortion in the market, there would be a private investment. The government is uncompromising in the purity of the market structure model under NBN Co. Does that not account for something and start to impact on the preconditions as to why the long bond rate return of investment is entirely reasonable in the context of this policy going forward? Would you as an economist, and perhaps Professor Ergas as well, ever argue that we ought to compromise on the open access nature and the separation of the wholesale and retail aspects of the broadband market in exchange for private investment over public investment? You would not argue that, would you?
Dr Harrison —I would say that you would weigh up the costs and benefits of doing that.
Senator LUNDY —You would not argue that. Professor Ergas, you would not argue that, would you? You would not compromise market structure and having an appropriately framed competitive regime in the telecommunications market just to boost the return of whoever the investor was, would you?
Prof. Ergas —The issue is still whether the benefits from this project, whatever those benefits may be and however widely they might be cast, exceed its costs.
Senator LUNDY —No. We know the market would invest if they could get a commercial rate of return. They cannot, because to get that they would have demanded a manipulation of the regulatory environment and get some kind of access holiday. We have a government, through public policy, saying, ‘We think this is a good thing,’ and we have talked about some of the measures that you would want to bring into that. You have the market saying, ‘We would invest in this if we can get a guaranteed commercial rate of return.’ Surely a long bond rate of return and purity of market structure to guarantee competitive tension in the market, which plays out on a whole raft of other economic measures and features of telecommunications in this country, is a reasonable place to set your public policy.
Dr Harrison —The whole point of what I was saying is that the government bond rate is not relevant for assessing the costs of this project. It is not the cost of capital to the taxpayers or to society. I come back to the point that it is a cost that you have to take account of. There are benefits. You say they are big, but are they big enough to outweigh the costs? That is the issue.
Prof. Ergas —You seem to assume that there is a need for a major national project of this kind—
Senator LUNDY —Absolutely. I am working from that assumption.
Prof. Ergas —and then, given that need, you go on to assume that the optimal form of that project is this particular project. Even if you accepted your initial assumption, which may or may not be correct—
Senator LUNDY —We can discuss that.
Prof. Ergas —the point would still be that what you would need to do is to look at the benefits and costs of the alternative options in a systematic and transparent way. You go on to assume that one of the particular benefits of this option is that this option allows you to have a more procompetitive market structure than might otherwise occur. Even if you accepted that assumption—and it is merely an assumption, and the implementation report has the detailed discussion of a number of the problems associated with the assumption you made—you would still have to say to yourself: ‘Assuming that what I want is to have the open, competitive environment with whatever regulatory arrangements that in turn requires, and assuming also that if I tried to have an alternative network built on a purely commercial basis, such as some kind of fibre-to-the-node network as against this fibre-to-the-premises network, the only way it could be commercially viable would be if I compromised on that objective.’ You would still need to say to yourself, ‘How much would it cost to get an alternative environment—say, this fibre-to-the-node project—undertaken in a way that was consistent with that open, competitive framework, compared to how much it will cost taxpayers to get that open, competitive environment in this FTTP, or fibre-to-the-premises, project that is the National Broadband Network?’
In other words, if your objective is to have an open, competitive environment, you need to do two things. First, you need to assess the costs and benefits of having such an environment, and it may well be that the benefits of such an environment outweigh its costs. Second, you need to find the least net socially costly way of achieving that objective. It is by no means obvious that that least net socially costly way is this particular project. Until you have done that work, everything else would unfortunately not really be much more than mere assertion.
Senator LUNDY —I want to go back to Professor Ergas, with the point that he makes about making assumptions that the nature of the investment comes after a decade’s worth of commentary, critique and analysis of the failings of the existing environment in telecommunications. What you appear to be contending now is that it is not just a cost-benefit analysis of the fibre-to-the-premise network; you are challenging the very assumption, or you are raising the spectre of challenging the assumption, that we need a universal high-bandwidth network for Australia. Can I just clarify for the purpose of your evidence whether or not you believe it is the right public policy direction to be pursuing a universal high-bandwidth fibre—specifically fibre-to-the-premises—network or not. Do you think that there is a better model, or are you not convinced that that is the best public policy at the moment?
Prof. Ergas —Let me merely echo a number of points that are made—and I think well made—in the implementation study. The implementation study notes that in fact the current environment has deliberate, relatively high-speed service to a very wide range of both business and residential consumers. It goes to some length to emphasise that the prices associated with those services have been reasonable, and it notes that there are a number of developments underway that would lead to the quality, range and affordability of those services continuing to improve over time. The implementation study itself is very far from suggesting that there is any comprehensive failure in the current telecommunications environment. That said, my own view—
Senator LUNDY —Can I say that that is the most optimistic interpretation of the implementation study’s assessment of the current telecommunications regime I have heard. It is very selective.
Prof. Ergas —That may be, but I am happy to provide the direct quotes from—
Senator LUNDY —If they are there, I think I need to make this point: the overall context of the implementation study’s assessment is that important fact that we do pay one of the highest costs for the bandwidth that we currently get, particularly through ADSL services, in the world.
Prof. Ergas —I am happy to trade citations from the implementation study, but my point is—
Senator LUNDY —Well, you started it.
Prof. Ergas —that the implementation study is, I think, relatively clear in its assessment of the current telecommunications environment, but that does not mean that there are no problems with that environment. My own longstanding view has been that there are such problems and that those problems do then translate into adverse implications for investment and for the upgrading of that network over time. What I am not convinced of is that the appropriate solution to those problems is to effectively have the government build an entirely new, very high-cost network without testing that through proper appraisal both commercially and in cost-benefit terms. Insofar as I can tell on the basis of the work that I have done, if you subject the proposal to that type of analysis then it does not withstand the analysis because the costs of the proposal seem to greatly outweigh its benefits. It may be that the more detailed work that has been done by the implementation study would lead me and others to change our minds, but it is impossible to tell that without access to those detailed workings.
CHAIR —And that is where you started.
Senator LUDLAM —I have only one question. I suppose it is a variant of what I asked you last time you were with one of these committees. It is relatively easy to estimate the costs of such a project, particularly now that we have a bit more of the detail of the implementation study, but how on earth do you estimate the benefits of a network such as this, particularly when the benefits are non-monetary? My understanding of the cost-benefit analysis is that you need to imagine or predict the future, as you put it, benefits of the network to be used for things that do not exist yet because the network does not exist and then come up with a monetary value for those things and balance that against the costs. There is a whole range of quite complicated assumptions that need to be put in there for that kind of model to work. From everything I have seen, you end up with another range of assertions that happen to be backed up by a complex set of assumptions that are actually quite difficult to interrogate. What would the value actually be of such an analysis? What would it tell us?
Prof. Ergas —As Dr Harrison said, all cost-benefit analysis is an exercise in projecting and attempting to evaluate the future. All cost-benefit appraisal requires the comparison of future options—that is, the world with the project compared to the world without the project. As you rightly point out, in undertaking that assessment it is important to have a metric in terms of which to evaluate the benefits and a set of projections as to what those benefits might be. The way we, as economists, approach that is essentially through the willingness of the community to pay for the benefits that the project will create. That willingness to pay in some cases may be the monetary willingness of individuals to pay to buy services from the project, or in other cases valuations that society places on indirect or wider benefits a project will create.
What is helpful about the implementation study is that it has apparently, as best one could tell from the summary, looked in very considerable detail at what the likely use of the network may be over time and how that use translates also into willingness to pay for its services and hence in the underlying valuation of those services. Because it does that right across the board for residential and business use and also public sector use of the project, that should provide a firm basis on which to undertake that evaluation of benefits.
That is not to say that you will not require some additional assumptions to do that or that the valuation that you come up with of those benefits will be by any means a certainty. There are a wide range of uncertainties that are involved and I think the study is quite frank in its recognition of those uncertainties. But they have put an enormous amount of effort into trying to get that right. It seems to me that it would be an enormous shame and a departure from good public policy for all of that work to be excluded from informing a proper cost-benefit appraisal. It would be an enormous waste of the $25 million or $27 million that taxpayers have paid for this study.
Dr Harrison —Could I just add that as a practitioner I am a big believer that good public policy evaluates the costs and benefits of various options, but the values are greatest when this sort of thing is done before the decision is made. I agree that an element of what you are saying is very true, but just for the study coming on after to ex-post justify some of the budget assumptions is probably not of much value. As someone who does these things, I think it is a good discipline to try to put numbers on these. They are very hard to estimate, but when you start thinking, ‘How am I actually going to put a number on it?’ you start to think about the things that affect the costs and benefits. It actually helps with the development of policy. Really it should be done within the department at an early stage. It does not have to be formal, but just thinking in terms of what the costs and benefits are, and how we can tweak the policy to increase the benefits. We find out that the benefits really depend on penetration, for example, so then we might want to encourage that. Also, just comparing different policy options is important. I said before not only that it is good discipline but that it makes things explicit. Then people can look at your assumptions and say, ‘Oh well, that is ridiculous.’ You might say that you are underestimating the benefits of this and be open to criticism. But implicitly you have to do this whenever you make a policy. You have to think about the costs and benefits. I am saying it is a good idea to explicitly write them down, because it is a good discipline and it makes things transparent and open to evaluation and criticism.
Senator LUDLAM —I guess that is not quite the point I was making about when it happens. I apologise for having been out of the room; I was a bit late. Professor Ergas said that this could be done in three days if somebody put their minds to it, or whatever that may be—
CHAIR —Perhaps I am verballing you on the three days. A few days, I think you said.
Senator LUDLAM —And I am not sure that that was to be taken as a commitment that you are going to go away and do it—
CHAIR —I think it was a serious offer; wasn’t it?
Senator LUDLAM —By monetising things that actually probably should not or cannot be monetised, you are forcing yourselves, to my mind, into a rather artificial framework. You can calculate the costs of digging the trench and that has a monetary impact that you can stick on a balance sheet. What is the value of providing fast broadband to a remote Aboriginal community in the Pilbara where they are downloading their administrative documents on a PDF? You are going have to invent a number and then you are going to present the parliament with a—
Dr Harrison —Monetising just makes them comparable. Monetising just makes them comparable to put them in the same dollars terms—
Senator LUDLAM —Yes, but they are imaginary numbers. The core costs are physical. As to the benefits, you have to make numbers up and then you—
Dr Harrison —But if you assert—
Senator LUDLAM —Sorry, just let me finish. Professor Ergas, to his credit, did undertake a cost-benefit analysis, I guess, last year, or quite some time ago now—it was the first time it was attempted—and you come up with a number beyond which, according to sound public policy, we are better off without the NBN. If it costs more than this, we are better off without it. I do not dispute the estimated costs, because it is infrastructure and that is people’s time that we can estimate, but I do dispute that you can come up with an imaginary number that says, ‘Beyond this it is not worth bothering.’ That is a political question. It is a question of social and public benefit. I am not sure it is an appropriate thing where you can just stick a dollar figure to it and say, ‘If it costs you more than that, don’t bother.’
Dr Harrison —But you must implicitly do that when you make a decision about the project.
Senator LUDLAM —I do not think so. I think it is a political—
Dr Harrison —When you say, ‘Go ahead’, you are assuming that the benefits exceed the costs and the question is: what basis do you have for that assumption? You have to try to think, ‘Well, you know, do they?’ and determine the benefits. How much are they worth? Some of these things—
Senator LUDLAM —I just do not think it is an economist’s question. I think it is a political question. The pricing model that was done in the implementation study is extremely important. Is this thing going to run at a profit or a loss? Those are good questions for economists and technologists and those are good questions to ask and it is important that we have that, but I think asking economists to invent a monetary number for the benefit of bringing broadband to a remote Aboriginal community is a bit imaginary.
Dr Harrison —The way I do these things is—
Prof. Ergas —Senator, can I just—
Senator LUDLAM —I am sorry; I know that is an assertion, not a question.
Prof. Ergas —Can I just respond to that for one moment.
Senator LUDLAM —Of course.
Prof. Ergas —This is an issue which arises in many areas where you have to do project appraisal, and they can be areas that range from social policy issues through to education policy. Here it arises in the context of infrastructure policy. I agree with you that there are a number of project impacts and that in reality it is probably not merely difficult to monetise but impossible to adequately or sensibly monetise. That is an issue on which, within economics, there is a debate as to whether there exists such incommensurable evaluations, but my own personal view is that at times there are project impacts that really cannot be sensibly monetised.
So what does that mean in terms of the proper conduct of cost-benefit appraisal? What I think it means is that in the cost-benefit appraisal what you try to do is to sensibly measure what you can measure. You try to be as clear as possible about what it is you have measured and how it is that you have measured it. It is then up to government—and in that sense I agree with you that it is a political decision at the end of the day—to say, ‘This study suggests that on the most careful cost-benefit appraisal this project will lose a billion dollars’—or it may be for a so-small social project and it will lose $10 million—‘but we believe that these benefits exceed that loss.’ That is a quite proper decision for government to make, but it is a decision that government needs to make informed by the best appraisal on which it can rely. Having that appraisal then also assists the community in having confidence in, and being able to transparently hold government accountable for, the decisions it takes.
Senator LUDLAM —I completely understand.
CHAIR —I am sorry to do this, because there is a lot of interaction. Before Senator Ludlam arrived, your point was that a lot of those assumptions are there in the implementation study that we paid $25 million for; if they were publicly released, people could do it. That is not quite Senator Ludlam’s point, I appreciate, but it is there.
Senator LUDLAM —Not so much.
CHAIR —Gentlemen, thank you very much. As I say, we could have—
Senator FISHER —I have a question.
CHAIR —A very quick one.
Senator FISHER —Perhaps on notice?
Senator FISHER —Is the cost-benefit analysis the same as, ‘Is the National Broadband Network in the national interest?’ I think that is part of the discussion you have just had with Senator Ludlam. I suspect it is not. I suspect that whether the National Broadband Network is in the national interest is a broader question of how you would define a cost-benefit analysis in wonderful economic terms. So is it the same question? If not, is the additional one an appropriate question: ‘Is the National Broadband Network in the national interest?’ If so, how do you answer that question?
Secondly, the department indicated that even if the government were to have done a cost-benefit analysis it would have been very challenging because of the lack of international comparators. Again, this builds on, I think, your discussion with Senator Ludlam. I do not think you have answered how you would actually do that cost-benefit analysis, if you accept that there is a lack of independent comparators. Finally, even if it be concluded that you cannot do a cost-benefit analysis, how does that stop you wanting one?
CHAIR —I was going to say if you could answer that in 30 seconds I would allow you to answer, but I do not think—
Dr Harrison —I would say it is a useful input into decision making and it is always useful to know the costs. The main point that I was making was that the bond rate is not the cost of capital for this project.
CHAIR —Perhaps you could have a look at Senator Fisher’s more detailed three questions when the Hansard comes out in a couple of days, and perhaps you would not mind just giving us a response in writing. I am sorry not to allow you, but we do have other witnesses who have time constraints and we have to move on, bearing in mind that the committee itself was very late in starting. Gentlemen, thank you very much for coming. Thank you very much, Dr Harrison, for your generous offer that Professor Ergas made on your behalf.
Dr Harrison —I presumed that.
Prof. Ergas —It is an assumption.
CHAIR —It is an assumption.
Senator FISHER —At least it is public.
CHAIR —I shall make sure the government is aware of that very generous offer in the next day or so and I am sure Senator Lundy will pass it on as well, and perhaps you will get a phone call, but do not hold your breath. Thank you very much, gentlemen.