APPENDIX 2
Report by NERA on the Frontier Economics Report
National Lottery Licensing and Competition
Introduction
1. This document provides NERA's review of the Frontier
Economics report, National Lottery Licensing and Competition,
which was prepared by Frontier for Camelot and dated December
2003. We understand that this report was submitted to DCMS, and
that the Culture, Media and Sport Select Committee (CMS Committee)
has passed it on for comments to the National Lottery Commission,
who have in turn asked NERA to provide an independent review.
2. The Frontier Economics' National Lottery licensing
and competition study prepared for Camelot is a clearly written
report that covers some of the issues involved with competition
in the lottery market. The report also draws attention to some
issues that merit examination by NLC before the Lottery is rebid.
For example, there may be a case (cf paras 22, 55, 142) for examining
whether a different form of retention schedule might generate
higher revenues than the current "progressive tax" model
(although we note that it is open to bidders to offer different
degrees of progressivity in their proposed payment schedules within
the existing progressive tax model). The suggestion (para 22)
that the government should consider the impact of weak bidding
for the third licence also seems an obvious one - this clearly
needs to be done, but it would seem sensible that this should
include a consideration of how the possibility of multiple licences
would impact on the strength of the overall bidding process. However,
the report exhibits a clear bias in favour of the status quo,
and contains numerous assertions that are not backed up by evidence.
Major concerns
3. NERA has three major concerns with the
Frontier report.
- First, the report is not clear enough in defining
the form of multiple licence model that is being assessed. In
particular, it fails to distinguish between the case where separate
exclusive licenses are offered for different types of lottery
product (Lotto/ Scratchcards/Interactive games), and the case
where each type of product is supplied by more than one licensee.
NERA's work for the NLC has demonstrated that Lotto and Scratchcards
can be regarded as almost completely separate products, since
the introduction of Scratchcards had no significant effects on
sales of the Saturday draw (the only other Lottery product offered
when Scratchcards were introduced). If there is little competitive
interaction between product clusters, as this evidence suggests,
then the problems of cannibalisation, uncoordinated product launches
and free riding highlighted by Frontier are potentially far less
serious than Frontier appears to imply.
- Second, the report fails to consider a potential
advantage of separating the bidding of different groups of Lottery
products. Under the current single licence model, bidders are
required to offer a single retention schedule covering revenues
from all types of product. However, the marginal costs vary between
product groups, and it is possible that the existing retention
schedule may not offer strong incentives for the licence holder
to expand the sales of Scratchcard products, where marginal costs
are relatively high. If different products were separately bid,
retention schedules might better reflect the marginal cost characteristics
of each product group, and so encourage higher sales.
- Third, the report ignores the benefits of dynamic
competition. It argues that competition for licences will inevitably
reduce sales (and hence revenue for good causes) from levels with
a single operator, but it does not make any allowance for the
impact of competition "in the market" on innovation
in game design, in marketing and in cost reduction. Under the
present system there is competition at the time of licence renewal
between a limited number of bidders, but the impacts of competition
are dulled between licence renewals. With multiple licences, each
operator will have an incentive to develop their own market niches,
and while they will not take direct account of cannibalisation
on other operators' sales, they will nevertheless be concerned
that their own product is positioned so as to be relatively immune
to cannibalisation from their rivals.
Unsupported assertions
4. The Frontier report contains a number of assertions
that are not backed up by evidence;
- the "current licensing approach…appears
to have worked well" (para 26). However, sales have been
falling over time despite the introduction of new games, and a
different operator or a number of operators might have been able
to generate greater sales through product innovation and marketing.
Frontier's judgment could only be validated if it could be benchmarked
against the counterfactual of what the sales and revenues could
have been in an alternative system, and possibly one where competition
within the market of the National Lottery had been allowed. Given
the difficulty of doing this, an alternative approach would be
to benchmark against performance of lotteries in other countries.
- ".. the economic value of the Lottery is
likely to be lower in the multiple licence model than in the single
licence model" (para 15). This is at the heart of the whole
argument between single and multiple licence models, and therefore
needs to be analysed in detail - particularly in relation to (1)
the way that the market would be split up between different licences
so as to minimise inter-operator cannibalisation and (2) the dynamic
impacts of competition "in the market" (see above).
- Small bidders would not be attracted in a multiple
licence system (eg para 123). This depends in part on the way
that the system would to be devised.
- The winner in a single licence competition will
be able to assemble all the skills needed (para 96). We do not
think that the winner of the bid would necessarily provide the
optimum combination of skills.
Other points
- The report underlines the risks involved with
changing the present situation but these risks are not weighted
against the costs of not changing the present arrangements, especially
in a context of declining sales.
- We believe that the Frontier Economics report
undervalues the role that NLC regulation can effectively play
to avoid undesirable outcomes (such as unco-ordinated timing of
launches) and its ability to rely on experts' advice for issues
of particular complexity. We believe that the report should not
dismiss the ability of regulators to cope with a market with more
operators and licenses.
- The Frontier report is also dismissive of the
prospects for effective regulation of access to national distribution
networks. This situation is now common in many regulated industries,
including telecoms, electricity distribution, railways and posts.
While there are difficulties in determining conditions for access
and in determining access prices, there is now also substantial
regulatory experience in the United Kingdom in this area upon
which the National Lottery Commission could draw.
- We believe that the discussion of the bidding
process is rather superficial. The report concludes (para
69) that some of the greater difficulties can be avoided by use
of a sealed bid, first price, tender, without noting that this
is in any case the most commonly used form of bidding process.
- Most of the arguments about costs in a
market where there is more than one firm (duplication of functions
like finance and HR; loss of synergies in marketing or market
research, decreased buying power) would apply to any market (para
112), but are not normally used as generic arguments to justify
lack of competition.
- The "illustrative model of competition"
used in the Annex is superficial and does not add anything to
the report's arguments. The Salop model is a variation of the
simple Hotelling location model. It is a static model that also
involves very specific assumptions that are not valid in this
case: namely that all operators' costs are symmetric, that products
are similar enough to allow cannibalisation to take place, that
the whole market can be covered, that demand is fixed and cannot
expand, and that consumers only purchase one unit by picking
a single product in the lottery.
Conclusions
5. This review has highlighted NERA's main concerns
with the Frontier report. These include in particular the way
that the report ignores the dynamic benefits of competition, the
way that the report fails to take account of the role of effective
regulation in licensing new products and their launches and in
devising systems of competition that can minimise the impacts
of cannibalisation between different operators, and the way that
the report fails to make clear the possibility that competition
between some forms of Lottery products (in particular between
weekly draws and Scratchcards) may not lead to losses of market
in any case.
NERA Economic Consulting, January 28th
2004
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