23. Supplementary Memorandum
submitted by the National Lottery Commission
NOTE ON THE RISKS AND BENEFITS ASSOCIATED
WITH A POWER TO GRANT MULTIPLE LICENCES TO OPERATE THE NATIONAL
LOTTERY
PURPOSE OF
THIS NOTE
1. Recent evidence given to the Culture,
Media and Sport Select Committee (the CMS Committee) by Camelot
emphasised the risks associated with the Government's proposal
to empower the National Lottery Commission (NLC) to grant more
than one licence to operate the National Lottery. The NLC first
saw the submissions when they were copied to the NLC by the Committee
on 14 January 2004. This note sets out the NLC's views on the
arguments put forward against the Government's proposal.
THE NATURE
OF THE
PROPOSAL
2. The NLC's starting point is that an effective
competition for a third licence to operate the National Lottery
is likely to be very difficult to generate under the present arrangements.
This view is based on both experience and views expressed by potential
bidders (see paragraphs 9-11 below).
3. The Department of Culture, Media and
Sport (DCMS) consulted on four options for change in June 2002.
The Government proposes to give the NLC the power to grant more
than one licence to operate the National Lottery if it considers
this appropriate. The present arrangement for an operator's licence
and separate licences to promote games would be replaced by "full
capacity" licences. This would remove the limitation under
present legislation that only one operating licence can be granted.
It would also do away with the requirement for individual game
licences, although it is likely that approvals would have to be
given before new games could be launched.
4. The key features of these proposals,
from the NLC's perspective, are that:
— it has greater flexibility to structure
the next competition in a way that it judges likely to make that
competition as effective as possible. This does not preclude the
NLC offering a single licence if it considers this to be the best
option, based on conditions at the time. Nor does it prevent applicants
bidding for all licences if more than one licence is offered;
— a more flexible structure offers
the opportunity to generate greater competition for licences,
so ensuring that the good causes receive a high proportion of
the value of each ticket sold. It also offers the opportunity
to encourage greater innovation and specialisation than may be
offered under a single operator model, bringing the potential
for greater growth to the portfolio;
— it will be able to consult widely
and carry out research in order to assess what licence structure
is most likely to generate effective competition for the relevant
licence(s) and encourage innovation, whilst minimising harmful
competition between licensees during the course of those licences;
and
— the introduction of "full-capacity"
licences will allow the NLC to specify a clearly defined role
for each licensee within the National Lottery as a whole. This
will give each licensee greater freedom to manage their part of
the overall portfolio and should help limit the degree of competition
between operators.
FLEXIBILITY AND
TIMING OF
DETAILED RESEARCH
5. The Government's proposals have been
criticised on the basis that detailed research has not yet been
undertaken to demonstrate how they will operate. To the extent
that critics ascribe a pre-determined view of the structure of
the next competition to the NLC, this is misguided. The NLC has
made clear that it has not taken such a view.
6. Early legislation giving greater flexibility
is essential if that flexibility is to be utilised in the next
competition. The NLC cannot dedicate resources to research and
consultation on powers which have not been given to it by Parliament.
It therefore cannot carry out the detailed design work critics
say is essential before Parliament grants it wider powers.
7. More fundamentally, the NLC believes
that now is not the right time to reach firm conclusions on the
structure of the next licence competition. The extent of the response
to the DCMS consultation, and the NLC's own informal contacts,
suggest that potential bidders have yet to turn their minds to
the next competition. They will look, as must the NLC, at the
state of the market and technology closer to the time of the competition.
It is then that the NLC will be able to engage with potential
bidders and to assess the likelihood of competition and the licence
structure most likely to encourage it. To take a final view now,
two years into the current licence, risks adoption of a scheme
which may prove inappropriate at the time of the next competition.
8. If a mandatory scheme in primary legislation,
based on prior research and consultation undertaken at the present
time, were to be adopted, there is a risk that it would not obtain
Royal Assent in time for it to be used effectively for the next
competition. The legislation might also prescribe a scheme which
would be appropriate for the next competition but inappropriate
for following competitions. The implication that Parliament should
legislate on the scheme for competition before each competition
takes place removes much of the benefit of an independent and
experienced regulator. Rather, the regulator should be given the
flexibility to make a considered judgement at the appropriate
time.
LIKELIHOOD OF
COMPETITION IF
NO CHANGE
IS MADE
9. The NLC believes that the present legislative
requirements greatly reduce the likelihood of competition for
the third licence. This view has not been reached without seeking
the views of others.
10. During the preparation of the competition
for the last licence, the Commission made contact with as many
potential bidders as it could. It actively sought views from bidders
involved in the first competition. Whilst some pointed to issues
of intellectual property and access to retailer data (which have
been addressed in the second licence), concerns were far more
wide ranging. These included:
— nature of the undertaking: running
the National Lottery is a large and specialist undertaking. Some
potential bidders identified that it did not sit well with their
core business; others that it was so large that, although their
core business was in a similar field, it would unbalance their
business and distract management attention;
— likely returns: these were
not considered particularly attractive when the costs of bidding,
risks of handover and pressures of public scrutiny were taken
into account;
— opportunity costs of bidding:
some potential bidders emphasised the effort required and
diversion of focus from other opportunities and from their core
business as reasons for not bidding. Others had the skills to
cope with bidding complexity (which was seen as similar to PFI
deals) but were discouraged by the lack of opportunity to make
use of their investment if unsuccessful. A PFI team can generally
bid for a number of PFI deals. The Lottery is only competed for
every seven years.
— reputational risks: potential
bidders were concerned about the risks associated with handover
from the existing operator and the significant impact that an
unsuccessful handover might have on their reputations. Part of
their concern related to information flows. But they were also
concerned about the incumbent's preparedness and ability to manage
the handover, especially if, for example, key staff left before
the licence ended;
— limited number of gaming system
suppliers: this was seen as a significant constraint.
11. It is very difficult to identify and
engage with potential bidders so far from the next competition.
But the limited contact the NLC has so far had has not reassured
it that the changes made in the second licence are sufficient
to deliver a strong competition for the third licence without
legislative change. Indeed, the NLC notes that the CMS Committee,
the National Audit Office (NAO) and the Public Accounts Committee
have all expressed similar views, and that the People's Lottery
made clear in its evidence to the CMS Committee that it did not
expect the present arrangements to generate competition for a
third licence.
FUTURE DEVELOPMENTS
IN THE
LOTTERY MARKET
12. Much of the criticism of the Government's
proposals is based on the likelihood of competition between multiple
operators to launch new games, the damaging effects this will
have and the need for the NLC to take on the operator's role in
managing such launches. This is based on three assumptions, each
of which is uncertain.
A continued proliferation of games
13. The present operator is focused on a
strategy of diversification, whereby new games are introduced
to offset the decline of existing games. The NLC does not believe
that this strategy is viable indefinitely. Player demand for an
ever widening portfolio of games has not been established. It
seems more likely that the National Lottery will, in time, reach
the point where returns from new games will no longer justify
the cost and effort required to introduce them. Whilst some new,
innovative opportunities will be identified, these will be comparatively
rare. Operator(s) will focus much more on refreshment of existing
games, and replacement of underperforming games with redesigned
versions, which would fall within their "full capacity"
licences. The present operator has already indicated that its
plans for the year following the introduction of EuroMillions
are to focus on new distribution channels rather than new launches,
in part in order to allow the existing portfolio to "settle".
14. The timing at which this point might
be reached is unclear, but may well occur in the second licence
period given the present operator's longer term commitment to
an aggressive schedule of game introductions. The NLC would expect
to assess the position closer to the next competition and to design
the next competition in a manner which best reflects the state
of the market.
Competition between games
15. Critics also appear to assume that all
games compete for similar players and that this will encourage
competition between operators. The NLC accepts that some games
cannibalise others significantly (and that this may reduce the
incentive for licensees to take into account cannibalisation where
it impacts upon other licensees), but notes that the degree of
cannibalisation is not necessarily uniform or high across the
portfolio. For example, work carried out for both the NLC and
the operator by third-party consultants has concluded that there
is very little cannibalisation between scratchcards and draw-based
games. Again, further work will be required closer to the next
competition, but the NLC has already indicated that it will seek
to minimise the risks in this area by letting at most a small
number of licences, packaged to keep games which substitute for
one another (especially jackpot games) within the control of a
single licensee.
Technological limitations
16. Criticism is also based around technological
constraints. The assumption is that technology (especially Lottery
software) can only be updated on a very limited number of occasions
a year. This will cause competition between licensees for their
updates to be given priority. It is also assumed that economic
and security considerations point to the need for a single gaming
system.
17. The NLC doubts that these constraints
will be significant by the time of the next competition. The present
operator runs its main games on a software platform which was
current at the time of the first licence (1994). The NLC's own
experience from discussion with lottery software suppliers suggests
that current systems are written to open standards and are modular
in format. This greatly eases development, reduces constraints
on introduction of updates and allows different systems to interface
much more straightforwardly. Modern terminal design also allows
much greater flexibility. The NLC anticipates that the next licence
will see the introduction of such systems regardless of the basis
of competition, but would expect to assess fully technological
developments and take these into account in the design of the
third competition, to the benefit of the good causes.
THE FRONTIER
ECONOMICS REPORT
18. The NLC believes that the report would
have been better informed if it was based on a wider range of
views. It appears to be based predominantly on information provided
by the present operator. No approach was made to the NLC or, it
appears, to DCMS or to other potential participants in the next
competition. Nonetheless, it provides a starting point for further
consideration of the issues.
19. The NLC has the following comments to
make on the recommendations reached by Frontier Economics.
Undertake a rigorous assessment of risk of weak
bidding for the third licence
20. The NLC agrees that this needs doing.
It has emphasised the need for extensive consultation before the
competition for the third licence term is designed and would welcome
views from potential bidders at as early a stage as possible.
However, the NLC believes that it would be premature to undertake
a final assessment now. Market conditions and technological developments
change and, without an understanding of these, potential bidders
may not be able to take a clear view whether they would wish to
bid. In addition, potential bidders are likely to see the next
competition as a distant event and so will have given it little
thought. Whilst early conversations would be helpful, taking a
firm view based on consultation at the present time is likely
to give undue emphasis to the views of the current operator and
its suppliers.
21. The NLC would expect to undertake the
necessary economic analysis as soon as it has the power to do
so (that is, once the Bill has received Royal Assent or, possibly,
its second reading in the House of Commons) and to commence consultation
soon afterwards.
Consider alternative options to multiple licences
to simulate bids
22. The NLC agrees this work should be done,
but would emphasise that it has already explored a range of options
within the present legislative framework. These inevitably focussed
on how the process is structured rather than the content of the
licence offered. The NAO considered these in its review of the
award of the second licence and concluded that, even with these
in place, there remained a significant risk that there would be
no competition for the third licence. On the evidence presently
available, the NLC is of a similar view. We also note that the
consultation undertaken by DCMS offered interested parties the
opportunity to make suggestions, and that these were taken account
of by the Government in its development of the proposed reforms.
23. The NLC has also sought to explore possible
arrangements for the handover of assets, in particular key contracts
for a limited period, from the incumbent to a future operator.
This would help address concerns about handover arrangements.
Implementation of such changes is dependent on the agreement of
Camelot and its key suppliers. The NLC asked Camelot to open discussions
on how this might be achieved in July 2003. Camelot is presently
considering this request.
24. Camelot and Frontier Economics hint
at other alternatives. It is difficult to assess these when so
little detail is provided, but the NLC would comment as follows:
— oblige the operator to make best
use of competitive tendering and procurement arrangements / permit
the operator to select different suppliers during the course of
the licence: the last competition expressly asked bidders
how they would make use of such arrangements. The present operator
is free to use competitive tendering and has done so, for example
in selection of its advertising consultants. But under the present
licence structure, benefits flow to the operator alone unless
the savings trigger a secondary contribution (where profits exceed
those forecast in its bid). The NLC considered whether to put
different arrangements in place, but considered that these could
lead to an over-complicated structure where it became involved
in specifying tenders and selecting the preferred supplier, as
the NLDF would have a financial interest in the outcome;
— allow gambling and gaming firms
to compete: both competition processes to date have permitted
this, so long as involvement was through a single purpose vehicle.
Organisations such as Rank and Littlewoods have either bid or
considered bidding;
— underwrite bidding costs: this
is under consideration and was discussed in the NAO report, but
is not considered sufficient to offset other disincentives to
bid (see paragraph 10) and carries its own risks;
— require the incumbent to submit
a final binding bid before others are asked to bid: it is
hard to see how this would work, or what benefits it would bring,
without further detail.
Modify retention arrangement
25. The present retention arrangements are
those contained in the present operator's bid. It is not clear
to the NLC why the change which Frontier Economics suggests would
affect the level of returns to good causes favourably. It is arguable
that the greater incentives should be contained earlier in the
licence period, both to allow the licensee to recover its capital
costs and also to secure the benefits of game introduction early
in the licence period, so that returns flow throughout the licence
rather than only for the later years.
Mitigate the risks of multiple licences
26. The NLC agrees that the design of the
next competition should seek to mitigate risks, but emphasises
that these include the risks of no competition associated with
a single licence model. It has made clear it intends to achieve
this through careful design of the next competition, following
thorough research and wide consultation prior to finalising the
design of the competition (see paragraph 7).
Ensure the NLC is properly resourced to address
risks if a multiple licence model is adopted
27. The risks depend on the degree of complexity
introduced, including the number of licences, the degree to which
they can be structured to minimise competition between licensees
and the availability of co-operation provisions within licences
which are enforceable.
28. The NLC believes the Government has
the ability, through the proposed changes to its constitution
(permanent chairman, flexibility of numbers, executive commissioners),
to bring new expertise to the Commission and, through oversight
of its budget, to ensure that it is properly resourced.
29. The NLC is also clear that its role
would change significantly if the present single licence model
were retained and did not generate any significant competition
for the third licence. In such a case, it would probably need
to move towards the models adopted by utilities regulators when
overseeing monopoly providers in order to control the operator's
profits and so maximise returns to good causes.
CAMELOT'S
SUBMISSION
30. Camelot identifies a number of specific
risks which it believes will lead to an over-complex solution
which will inevitably lead to a reduction in returns to good causes.
The NLC offers the following comments on Camelot's arguments.
Game plan
31. Camelot assumes that portfolio growth
will be the key element of the game strategy in the third licence,
and that all games represent substitutes for each other. The weaknesses
in these assumptions are highlighted in paragraphs 13-14. Also
implicit in the argument is that the skills and expertise needed
to develop all elements of the lottery portfolio are similar.
This is not necessarily the case. The expertise required to manage
a draw-based portfolio is not the same as that required for the
management and distribution of a physical product like scratchcards.
Marketing and brand management
32. This argument repeats that put forward
on game plans; that licensees will compete between themselves
through marketing arrangements for each others' players. The same
weaknesses in these assumptions apply. As the NLC has indicated,
it would maintain the existing overarching brand (which it owns)
with game brands beneath it. This is consistent with Camelot's
submission, which suggests that it presently sees different games
as different brands within an overarching framework.
Jackpots
33. The NLC has consistently recognised
the need to maintain the natural monopoly that jackpot games require
and indicated its intention to design licences accordingly. However,
it would note that even under a single operator, more than one
jackpot game may be operated (eg twice weekly Lotto draws, Lotto
Extra and EuroMillions are all designed to be jackpot games),
and the need to refresh these products effectively is important.
Interactive strategy
34. If Camelot is correct that interactive
channels simply represent a different medium by which existing
games may be offered, then the NLC agrees that it is unlikely
to make sense to group these within a separate licence. However,
interactive channels are still in their infancy and their future
is difficult to predict. Both bidders, at the time of the last
licence competition, saw these new media as a means to offer innovative
new products and other lotteries are exploring such options. If
it became clear that such new products could be generated successfully,
then a separate licence for such products might be an option worth
considering.
Retailers
35. The NLC accepts that retailers have
significant concerns about the impact of multiple licensees, but
it does not see any reason why these could not be met. It anticipates
that it will be possible for licensees to share, at the least,
use of a common terminal and local connection. This will address
concerns about multiple terminals. More modern terminals and supporting
systems may also provide gains to retailers, amongst others. The
NLC would expect to consult widely with retailers before making
any final decisions on the third licence structure.
IT
36. The NLC sees no reason to suppose that
lottery IT systems must be placed in their entirety under the
control of a single operator. The banking sector provides an example
of how different operators may provide secure interfaces between
their systems to allow customers access to services through a
variety of operators. The utilities sector provides clear examples
of successful "common carrier" models. As explained
at paragraph 17, technological moves to modular systems architecture
written to open standards should allow each licensee to manage
their own gaming systems, using the modules relevant to their
business, with secure interfaces between operators where necessary.
Support services
37. The NLC believes that a model based
on co-operation is possible, and that it is quite feasible to
generate economic and licence incentives to operators to participate
in such arrangements. In this way, the supervision required by
the regulator in this respect may not be substantially greater
than that required under the present single licence arrangement.
Role of the regulator
38. Given the points made above, the NLC
does not accept the argument that it is inevitable that the regulator
will become the de facto operator. The NLC rejected the option
of a state operated lottery in its original submission to DCMS
and has taken the view that, whilst the regulator's role will
change, it should aim to minimise the degree to which the regulator
controls licensees' commercial decision making.
CONCLUSION
39. The NLC believes it is essential to
take a balanced view of the risks and benefits associated both
with the Government's proposals and with making no change to the
present licensing framework. It is not clear that all the risks
identified by Camelot will materialise, or that they are all of
similar consequence. The ability to mitigate those risks is not
assessed. More fundamentally, the risks of change are not balanced
against the likelihood of, and risks associated with, the potential
lack of effective competition under the existing arrangements.
The NLC believes that the flexibility in the Government's proposals
will allow it to take that balanced view, at the appropriate time
and based on research and consultation, when designing the next
competition.
28 January 2004
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