Public Policy: Using Market-Based Approaches - Department for ...

DTI ECONOMICS PAPER NO.14 

Public Policy: 

Using Market-Based Approaches 

SEPTEMBER 2005

The DTI drives our ambition of 

‘prosperity for all’ by working to create 

the best environment for business 

success in the UK. We help people 

and companies become more productive 

by promoting enterprise, innovation 

and creativity. 

We champion UK business at home and 

abroad. We invest heavily in world-class 

science and technology. We protect the 

rights of working people and consumers. 

And we stand up for fair and open 

markets in the UK, Europe and the world.

DTI ECONOMICS PAPER NO.14 

Public Policy: Using 

Market-Based Approaches 

Robert Hahn 

Justin Coombs 

Ciara Kalmus 

Carlos Razo 

Katherine Curry 

LECG 

SEPTEMBER 2005

DTI Economics Papers 

The reviews of the DTI in Autumn 2001 placed analysis at the heart of policymaking. 

As part of this process the Department has decided to make its analysis 

and evidence base more publicly available through the publication of a series of 

DTI Economics Papers that will set out the thinking underpinning policy 

development. Previous titles include: 

1 Bundling, Tying and Portfolio Effects, Professor Barry Nalebuff (Yale 

University), February 2003 

2 A Comparative Study of the British and Italian Clothing and Textile 

Industries, Nicholas Owen (DTI), Alan Canon Jones (London College of 

Fashion), April 2003 

3 UK Competitiveness: Moving to the next stage, Professor Michael Porter and 

Christian H M Ketels (Institute of Strategy and Competitiveness, Harvard 

Business School), May 2003 

4 Options for a Low Carbon Future, June 2003 

5 DTI Strategy – The Analysis, November 2003 

6 UK Productivity and Competitiveness Indicators 2003, November 2003 

7 Competing in the Global Economy – The Innovation Challenge, 

November 2003 

8 Raising UK Productivity – Developing the Evidence Base for Policy, 

March 2004 

9 The Benefits from Competition – some Illustrative UK Cases, Professor 

Stephen Davies, Heather Coles, Matthew Olczak, Christopher Pike and 

Christopher Wilson (Centre for Competition Policy, University of East Anglia), 

July 2004 

10 Liberalisation and Globalisation: Maximising the Benefits of International 

Trade and Investment, July 2004 

11 R&D Intensive Businesses in the UK, March 2005 

12 The Empirical Economics of Standards, May 2005 

13 Corporate Governance, Human Resource Management and Firm 

Performance, August 2005 

The views expressed within DTI Economics Papers are those of the authors and 

should not be treated as Government policy. We welcome feedback on the 

issues raised by the DTI Economics Papers, and comments should be sent to 

dti.economics@dti.gsi.gov.uk 

ii

Contents 

Acknowledgements vi 

Foreword 1 

PART I INTRODUCTION AND SUMMARY 3 

Section 1 

Introduction and summary 4 

Introduction 4 

How we carried out this study 4 

Key lessons 5 

Case studies 6 

Structure of the report 12 

PART II LESSONS AND GUIDANCE FOR POLICY MAKERS 13 

Section 2 

Using market mechanisms 14 

Continuing role for the public sector 

Market-based mechanisms produce benefits compared to 

14 

traditional policy designs 18 

Market-based mechanisms require creative thinking 19 

Importance of design and implementation 19 

Section 3 

Lessons for the design and implementation of specific mechanisms 22 

Competitive tendering 22 

User choice 25 

Tradable permits 27 

Conclusion 29 

PART III LITERATURE REVIEW 31 

Section 4 


Section 5 

Market failures and the role of the public sector 33 

Markets and market failures 34 

Social objectives and inequality 37 

Section 6 

Government Failure 39 

iii

Public Policy: Using Market-Based Approaches 

Section 7 

Market Mechanisms 42 

Competitive tendering of service provision 43 


Marketable permits 56 

Taxes and subsidies 62 

Opening-up access to natural monopolies 66 

Limitations on the use of market mechanisms 69 

Section 8 

Framework for assessing market mechanisms 70 

The choice of market-based mechanism 70 

Implementation issues 71 

Summary 71 

PART IV CASE STUDIES 73 

Section 9 

Competitive Tendering of Prisons 74 


Market Background 75 

Policy history and timetable 76 

Introduction of a market mechanism 79 

Potential problems 87 

Controlling Service Quality 95 

Outcome of market mechanism 103 

Overall Assessment 108 

Section 10 

Choice-Based Letting in Social Housing 112 


Market Background 113 

Introduction of market mechanism 117 




iv

Contents 

Section 11 

Emissions Trading 147 


Background 147 

Introduction of a market mechanism 148 




PART V ANNEX 169 

Section 12 

Issues in the implementation of market mechanisms 170 

Competitive tendering of service provision 170 


Marketable permits (‘Cap and Trade’) 188 

Taxes and subsidies 191 

Opening access to natural monopolies 193 

References 195 

v

Authors 

vi 

Robert Hahn 

Justin Coombs 

Ciara Kalmus 

Carlos Razo 

Katherine Curry 

LECG 

Acknowledgements 

We are grateful for comments and suggestions from Elaine Bailey, Richard 

Beaton, Myriam Borgi, Fazleen Ismail, Alina Jardine, Adam Land, Andrea Lee, 

Sasha Maguire, Christopher Moir, Amy Newland, Siobhan Pointer, Sheetal 

Radia, Andrew Rees, and Frances Walker. We are also grateful for the cooperation 

and assistance of the various organisations and companies 

interviewed during this research: Camden Council, the Department for 

Environment, Food and Rural Affairs, Harborough District Council, Kirklees 

Metropolitan Council, the Home Office, the National Offender Management 

Service, the Office of the Deputy Prime Minister, Premier-Serco, SGS United 

Kingdom Ltd and Twin Valley Homes. This research was supported by funding 

from the DTI and the Office of Fair Trading.

Foreword 

There is increasing interest in how market based approaches can be used to 

meet public policy goals. Economic theory suggests that more market-based 

mechanisms can have advantages over more traditional policy designs. This 

report, commissioned by the DTI and OFT and completed by a team at LECG, 

examines how competition and market forces can be used to improve the way 

that public policy is implemented. It develops the evidence, base surrounding 

the benefits and pitfalls of using competition and market-based approaches and 

draws out practical lessons that will help policy makers in future policy 

development. 

The analysis presented here is relevant to a wide audience. It draws upon 

economic research and the experiences of officials, from the Home Office, ODPM, 

DTI and DEFRA and other stakeholders, such as local government officials and 

representatives of business. I am particularly grateful for the co-operation of all 

those who contributed their experiences, insights and funding to this study. I am 

also grateful to the Competition Forum, which provided the motivation for this 

work and has, since its establishment in 2004, helped bring together Government 

Departments and the independent Competition Authorities to promote a shared 

understanding of UK and EU competition issues. 

This report contains several important messages. Significant benefits can be 

realised from the use of market mechanisms, even in apparently unpromising 

policy areas. But the scale of these benefits depends on how the mechanism is 

implemented. For this reason, it is important that the lessons of this study are 

used in order to capture these benefits. 

Vicky Pryce 

Chief Economic Adviser and Director General, 

Economics Department of Trade and Industry 

1

Part I 

Introduction and Summary 

3

SECTION 1 

Introduction and summary 

Introduction 

This report, commissioned by the Department of Trade and Industry, examines 

how competition and market forces can be used to improve the way that public 

policy is implemented. 

Public policy often involves either the direct provision of services by the public 

sector, or the public sector regulating how the private sector behaves. For some 

services, this has involved replacing the market with administration by the 

public sector, so that public-sector officials ultimately decide how much of a 

service is provided. However, public policy interventions can instead be 

designed in ways that: 

● introduce competition between service providers; 

● allow individuals a degree of choice over the services they receive and who 

provides them; or 

● create markets where rights and obligations can be traded. 

We call these policy designs ‘market-based mechanisms’. 

Economic theory suggests that market-based mechanisms can have advantages 

over more traditional policy designs. In this report we draw out the main 

conclusions from economic theory and examine whether the expected benefits 

from using market-based mechanisms have been realised in practice. We also 

examine the practical problems that can arise when implementing market-based 

mechanisms, and suggest how these issues can be addressed to maximise the 

benefits from using a market-based mechanism. 

How we carried out this study 

This study has involved reviewing previous research and conducting a series of 

case studies of the use of market-based mechanisms in the UK. We have 

reviewed research on the theory of market-based mechanisms, and also 

previous studies on the use of market-based mechanisms in the UK and other 

countries. We then examined three examples of the use of market-based 

mechanisms in the UK to assess whether the outcomes in these cases matched 

the expectations we would draw from economic theory and previous 

experience. 

For each case study we interviewed Government officials involved in the design 

and implementation of each mechanism. We also interviewed private-sector 

firms and organisations that were affected by the mechanism. In addition, we 

4

eviewed previous reports and studies on the effects of the market mechanism. 

We believe that the combination of these different viewpoints has enabled us to 

take a balanced view of the overall effects of each mechanism. 

The three case studies involved three types of market-based mechanisms, which 

are typical of the mechanisms used in the UK and other countries. 

● Competitive tendering: where private-sector providers are invited to compete 

to become the provider of a particular public service. We examine the 

competitive tendering of prison services in England and Wales. 

● User choice: rather than providers competing to become the monopoly 

suppliers of a particular public service, the users of the service are allowed to 

choose among the rival suppliers of the service. We examine a novel example 

of this mechanism, where potential tenants of social housing have been given 

the opportunity to bid for vacant properties. This scheme is known as ‘choicebased 

lettings’ in the UK; and 

● Tradable permits: firms subject to regulation are given certain rights that they 

can trade amongst themselves. This mechanism has been used in some 

cases to control pollution. Firms are given tradable permits that allow them 

to produce a given level of pollution. Firms that can control their emissions 

more cheaply can profit from doing so by selling their excess permits to other 

firms. We examine the UK emissions trading scheme, which involves the 

trading of permits to emit greenhouse gases. 

In each case, we examine: 

● the underlying rationale for public policy intervention; 

● how the mechanism was implemented; 

● practical implementation issues and how these were resolved; 

● benefits from the use of a market-based mechanism; and 

● lessons for the future use of similar mechanisms. 

Key lessons 

Section 1 – Introduction and summary 

Using a market-based mechanism in place of traditional policy designs can 

create significant benefits, in the form of lower costs and better services. These 

benefits come from greater competition among suppliers and greater choice for 

consumers. 

5


● Benefits of competition among suppliers: introducing competition among 

suppliers can lead to lower costs and better quality services. For example, 

competitive tendering of UK prison services has led to cost savings of around 

10 to 22 per cent. These benefits can arise even when provision of the service 

remains in the public sector, provided it is subject to the discipline of 

competition. We also found that when competition is introduced in one area, 

it can lead to cost savings in other areas where competition has not been 

introduced through the transfer of best practice. 

In emissions trading, the choice of how emissions are to be reduced is decided 

by competition among suppliers, rather than by government decree as in a 

conventional administrative scheme. It is estimated that this had led to costs 

savings of up to $800 million per year in the US. 

● Benefits of greater consumer choice: the ability of firms and individuals to 

make choices can lead to a better allocation of goods and services. The use 

of choice-based lettings in UK social housing has led to a better allocation of 

properties, reducing the time that properties remain vacant by 37 per cent for 

a sample we examined. 

Market-based mechanisms can also create other benefits such as increasing 

transparency and accountability. For example, a tradable permit scheme makes 

the cost of reducing emissions more transparent. 

Introducing these mechanisms still leaves an important role for the state 

because market mechanisms will typically need to be designed and managed in 

some way. For example, when a competitive tender is introduced, the public 

sector still needs to manage the contract with the private-sector supplier. 

While market mechanisms can lead to significant benefits, the scale of these 

benefits depends crucially on how the mechanism is implemented. We found 

that the competitive tendering of prisons has been more successful in the UK 

than it has been in the US as a result of differences in implementation. There 

may also be a need for creative thinking in order to adapt a market mechanism 

to the particular public-policy issue being tackled. 

In Part II we offer specific lessons for the implementation of each mechanism we 

have considered. These lessons are drawn in large part from the three case 

studies we carried out, which we briefly summarise below. 

Case studies 

COMPETITIVE TENDERING OF PRISONS 

Prison services in England and Wales have been subject to competitive 

tendering in one of two ways: 

6


● management-only contracts: which involve tendering the management of an 

existing prison; and 

● design, construction, management and finance contracts: which involve 

tendering the construction and subsequent operation of a new prison in a 

single contract. 

The first management-only contract started in 1992 and the first full design, 

construction, management and finance contract in 1995. 

Competitive tendering was introduced in order to improve efficiency and 

innovation in the provision of prison services. It coincided with a need to replace 

and expand the existing stock of prisons in the UK and it was expected that the 

private sector would be able to achieve this expansion more efficiently than the 

public sector. Initial contracts were open only to private-sector bidders but 

subsequent tenders have been open to in-house public-sector suppliers. 

Tenders have attracted enough bidders to generate competition, with four or 

more bidders in most cases. Different contracts have been won both by privatesector 

and by public-sector bidders. There are currently four different private 

firms managing prisons in England and Wales. The contracting process appears 

to have worked well. We found no evidence either of collusion or of incumbents 

having an unfair advantage in subsequent tenders. 

One of the main concerns regarding competitive tendering is the impact it can 

have on the quality of service provided. Quality of service can be difficult to 

specify and write into a contract with a private-sector supplier. When services 

are subject to a competitive tender the public sector can find itself locked into a 

contract which makes it difficult to address unanticipated problems regarding 

quality of services. This issue has been important in the provision of prison 

services given that experience in the US has involved a number of significant 

failures. 

The UK has avoided many of the problems seen in the US. There are a number 

of reasons for this improvement. First, quality has been an important part of the 

process for assessing tenders. Tenders are not automatically won by the lowest 

bidder. Instead price is only one factor in the decision process. Second, 

significant effort has been devoted to setting explicit performance measures, 

which are monitored and enforced through financial penalties for poor 

performance. More recently, contracts have also allowed for financial rewards to 

encourage improvements in quality above the stated performance target. Third, 

the UK Government has learned from experience, both experience in other 

countries and experience gained from operating competitive tenders in the UK. 

For example, the number of performance measures has been rationalised over 

time, with more focus on outputs (e.g., the skills that prisoners have learned) 

rather than inputs (e.g., the amount of time prisoners spend in classes). 

7


There is some evidence that private-sector prisons may in fact achieve better 

quality of service in some areas than publicly-run prisons. There is evidence, for 

example, that private-sector prisons have better relations between staff and 

prisoners than publicly-run prisons. However, staff in public-sector prisons tend 

to have much more experience and are better paid than those in private prisons 

and inexperience has occasionally been cited as a problem with private prisons. 

Competitive tendering of prisons has been successful in improving cost 

efficiency. Two independent studies have estimated cost savings of between 10 

and 15 per cent and between 13 and 22 per cent. These estimates are based on 

comparisons between the costs of privately-run prisons and the costs of 

comparable publicly-run prisons. They are likely to under-estimate overall cost 

savings because evidence suggests that competitive tendering has led to cost 

reductions in those prisons that remain under public-sector management, and 

even those that are not subject to competitive tendering, due to the diffusion of 

best practice. 

CHOICE-BASED LETTING IN SOCIAL HOUSING 

Choice-based lettings has been used to introduce user choice in the provision of 

social housing – housing which is made available by ‘not for profit’ bodies at 

below market rents. 

The common feature of all schemes is that applicants can indicate which 

properties they would like to be considered for, rather than waiting to be 

allocated a property that they might not want. 

The traditional method for allocating social housing has been as follows. 

Applicants for social housing join a waiting list administered by the local 

authority, or other social landlord. They will then be allocated points based on 

their assessed housing need (for example, whether they are homeless or living in 

overcrowded or unsatisfactory housing conditions) and the time they have been 

waiting on the list. When an applicant reaches the top of the list, in terms of the 

points they hold, the social landlord will offer them one of its vacant properties. 

The applicant will normally be allowed a limited number of opportunities to reject 

a property before they lose their place at the top of this list. 

Choice-based lettings introduces a limited market in social housing, analogous 

to the private housing market. Typically all vacant properties on a social 

landlord’s books are advertised to all applicants who have registered with it. 

These applicants then bid for individual properties. Where more than one 

applicant bids for the same property, it is allocated in one of a number of 

different ways, depending on the design of the scheme. The two most common 

approaches are points or a banding system. 

● In a points-based scheme, applicants are allocated points based on assessed 

housing need and the time they have been waiting for a property. The 

property is then allocated to the applicant with the most points. 

8


● In a banding system, applicants are allocated to certain bands based on their 

assessed housing need and other relevant circumstances. The property is 

then allocated to the applicant in the highest-priority band, and within that 

band to the applicant who has been waiting longest for a property. 

Choice-based letting schemes in the UK were inspired by the use of similar 

schemes in the Delft region of the Netherlands. In the UK, Market Harborough 

District Council introduced a district-wide scheme in April 2000, and Mansfield 

District Council introduced a more limited scheme at around the same time. 

Subsequently, the Office of the Deputy Prime Minister introduced a pilot scheme 

involving 27 authorities which ran from April 2001 until March 2003. A number 

of other authorities have subsequently adopted choice-based lettings, and by 

April 2004, 20 per cent of local authorities had adopted the approach. The 

Government has a target for all local authorities to adopt choice-based letting 

schemes by 2010. 

In introducing choice-based lettings, local authorities have had to address a 

number of implementation issues. First, they had to make significant 

investments in systems to advertise properties to potential tenants and provide 

them with enough information to make an informed choice. Second, positive 

action was taken to ensure that all applicants had reasonable access to this 

information and were equally well equipped to make a choice. The local 

authority provided information in different languages and provided support and 

advice. Consequently, the total resources needed to administer the schemes are 

similar to previous allocation schemes. Indeed, the administrative staff 

previously needed to allocate properties are now tackling these issues of 

information and equality of access. 

Choice-based lettings appear to have addressed a number of perceived 

problems with traditional allocation methods: 

● Allocation lacked transparency: in traditional schemes, applicants did not 

know which properties were vacant and on what basis they were allocated to 

potential tenants. Choice-based lettings allows all applicants to see which 

properties are available, and to bid for those properties. Information is also 

produced on successful bidders for previous properties (how many points 

they had or how long they had been waiting). 

● Perceptions of unfairness: in traditional schemes, allocation appeared to 

applicants to be at the discretion of local authority housing officers. Choicebased 

lettings introduced a transparent and objective allocation mechanism. 

● Lack of empowerment: in traditional schemes, applicants had no influence 

over the process, whereas choice-based lettings allows them to take the 

initiative in selecting and bidding for properties. 

● Undesirable incentives: in traditional schemes, applicants had an incentive to 

lobby local authority officers to move up the waiting list. The use of a more 

objective points scheme and the potential to obtain a property earlier by 

9


choosing a less desirable property may have reduced some of the potential 

to engage in lobbying activity. 

Choice-based lettings has not, so far, involved introducing competition between 

different social landlords – although this is an option which might be considered 

in the future. Its benefits have therefore arisen mostly on the ‘demand’ side, in 

terms of improving the allocation of properties. One factor which indicates 

greater efficiency, however, has been a reduction in vacancy rates, as properties 

are re-let more quickly. 

The main benefit of choice-based lettings has been that potential tenants are 

more likely to occupy a property that meets their needs. Surveys of users have 

shown a high degree of satisfaction with the outcome of the process relative to 

the previous administrative system. It was also suggested to us that when 

tenants choose their own property they are more likely to take greater care of the 

property and will be more committed to their community. 

THE UK EMISSIONS TRADING SCHEME 

The UK, along with many other countries, has committed itself to reduce 

emissions of greenhouse gases. These gases are believed to be contributing to 

climate change, which is a threat to human health and sustainable development. 

The UK climate change programme involves a number of measures designed to 

reduce greenhouse gas emissions. We examined one of these: the UK emissions 

trading scheme. 

This scheme created a market in permits to emit greenhouse gases. Participation 

is voluntary, and firms could choose to enter the scheme and obtain permits in 

one of four ways. 

● First, the Government held an auction where firms offered emission 

reductions relative to current levels in return for Government funding. Firms 

that were successful in this auction (known as ‘direct participants’) could use 

the market to sell permits generated from an over achievement relative to this 

target or buy permits to cover any under-achievement. 

● Second, firms could enter into a ‘climate change agreement’. This involved 

agreeing to an emission reduction target with the Government which reduced 

the level of the climate change levy they were liable to pay. (The climate 

change levy is a tax on greenhouse gas emissions that is a separate 

instrument under the climate change programme). These firms could 

similarly use the market to sell permits generated from an over achievement 

relative to this target or buy permits to cover any under-achievement. 

● Third, other firms emitting greenhouse gases could enter into separate 

arrangements to obtain permits in return for emission reductions. In practice, 

this option was never fully developed because of the then forthcoming EU 

Emissions Trading Scheme, so this option has not been available for 

organisations to use. 

10


● Lastly, firms or individuals could participate as traders in permits, buying and 

selling in the market. 

In summary, participating firms agree to emission reduction targets with the 

Government. They receive allowances in return for exceeding these targets or 

can buy permits from other participants to make up any shortfall. If participants 

go beyond their targets they can sell allowances on the market. In effect this 

involved what is known as ‘grandfathering’, where firms receive an allowance 

based on their historic emission levels, and have to buy permits only if their 

emissions exceed these levels. While other tradable permit schemes involve 

firms buying permits from the Government, so they have to pay to maintain 

existing emission levels, the UK ETS involved direct participants offering 

emission reductions to the Government in the initial auction, and receiving 

allowances if they met these targets. This runs counter to some economic theory 

that suggests firms should have to pay to pollute. However, the ETS was a 

voluntary scheme and it was therefore felt necessary to provide an incentive for 

firms to participate. 

It appears that the initial auction was not as efficient as it might have been, since 

it led to the Government purchasing emission reductions for £18 per tonne of 

carbon dioxide when permits were later trading in the market for only £2-£4 per 

tonne of carbon dioxide. The Government argues that the high prices paid were 

not due to the auction design but to the fixed costs associated with participation 

in the scheme. The commitment that was undertaken by the voluntary participants 

included significant fixed costs, e.g. baseline monitoring and verification 

agreements, and the cost of instituting a new approach to carbon management. 

These costs suggest that the level of incentive would probably need to be 

significantly above the price at which permits traded in the secondary market. 

Overall, the scheme has been successful in terms of reducing emissions at low 

cost. It has created a liquid market in emission permits, and has provided UK 

firms with experience which will be valuable, for example, when they participate 

in the EU emissions trading scheme. The cost of reducing emissions under this 

scheme has been found by the UK National Audit Office to compare favourably 

with other Government schemes aimed at reducing emissions such as the 

‘renewables obligation’. 1 It has also established a centre of expertise in emission 

trading schemes in the UK which will be well placed to exploit this expertise in 

the EU scheme and elsewhere. 

Participating firms have significantly exceeded their targets in the initial years of 

the scheme. The scheme has stimulated many firms to become more aware of 

their total energy consumption and opportunities to improve their energy 

efficiency which are economically viable, as well as beneficial to the 

environment. 

1 The ‘renewables obligation’ requires electricity supply companies to purchase a specified quantity of their 

electricity from government approved renewable sources. 

11


Structure of the report 

In Part II below we identify the main lessons for policy makers drawn from our 

research. It includes lessons from economic theory, from previous empirical 

studies and from our three case studies. We divide these lessons into those 

which are applicable to the use of market-based mechanisms in general and 

implementation issues which are specific to individual mechanisms. 

In Part III we review the economic literature on the use of market-based 

instruments. This includes both the theory of market-based mechanisms and 

studies of their performance in a variety of situations. 

In Part IV we set out the findings from each of our three case studies. 

Annex A contains a more detailed assessment of the economic literature on the 

use of market-based mechanisms and Annex B contains a bibliography of 

references used in this report. 

12

Part II 

Lessons and guidance 

for policy makers 

13

SECTION 2 

Using market mechanisms 


create significant benefits, in the form of lower costs and better services, but 

only if sufficient care is given to their design and implementation. 

This part of our report identifies the main lessons from our analysis. Through the 

case studies, in particular, we have gleaned practical insights as to how marketbased 

mechanisms can be best designed and made to work successfully. These 

lessons provide valuable insights for policy-makers across government as to 

how competition-based policies can achieve a range of policy objectives more 

effectively. 

This part of our report is structured as follows: we first describe our generic 

conclusions on applying such mechanisms; we then discuss specific lessons for 

the three particular mechanisms studied: competitive tendering, user choice and 

tradable permits. 

Continuing role for the public sector 

Our first lesson may seem paradoxical. Market-based mechanisms – even where 

a service is contracted out to private sector providers – do not remove the role 

of the public sector in managing or regulating how services are provided. 

Instead, they involve a different kind of government intervention. When a service 

is transferred to the private sector through a competitive tender, for example, the 

public sector still has to manage the contract with the external supplier. Total 

public-sector resource requirements may be more, less or the same as before, 

but they are likely to be of a different kind. 

There is often a sound rationale for government intervention in a market. 

Without government, certain goods may not exist at all. Others may be provided 

only to a minority of users, in an undesirable quantity or at an excessive price. 

Without compulsory taxation, for example, prisons may not exist. While all (lawabiding) 

citizens benefit from the protection provided by their existence, 

individual citizens benefit whether or not they pay for them. In economic jargon, 

prisons are a public good as the service they provide to society is non-rival 2 (my 

neighbour’s consumption does not affect my consumption) and non-excludable 

(all benefit whether they contribute or not). Conversely, although the free market 

may provide education without government, this may be only for those able to 

pay for it. This might be considered unacceptable in a fair society and may 

conflict with the government’s social objectives. 

2 The same is not true of prisons themselves, which do display rivalry characteristics: one detained prisoner 

occupies a prisoner place that could have been used by another offender. 

14

Section 2 – Using market mechanisms 

Although a pure free-market may lead to too little education, it can lead to too 

much production of other products. Without government controls and 

restrictions, pollution would rise to unacceptable levels. In the absence of 

government intervention, for example, a factory owner will not bear the costs 

that pollution emitted from his factory imposes on others. As a result the factory 

may find it cheaper to use a technology that produces higher levels of pollution, 

despite the fact this leads to a higher cost for society. In economics, the impact 

of the factory’s decision on the rest of society is known as a negative externality. 3 

Other goods may again be provided by the market, but at excessive prices. 

Economies of scale in production may make it inefficient to have more than one 

national electricity grid. Without government intervention, the monopoly 

producer could take advantage of its market power by charging very high prices 

to consumers. 

These examples of market failure suggest there can be a legitimate role for 

government in many sectors of the economy. 4 Market failure alone is a 

necessary but not sufficient condition for government intervention. In some 

cases government intervention may lead to other problems, such as inefficiency 

and corruption, that could outweigh the original market failure. If there is a 

government intervention that can reduce the market failure without giving rise 

to additional problems, then government intervention can be positively 

beneficial. 

However, state intervention can take many forms. An administrative system can 

lead to services being provided at an excessively high cost or poor quality if the 

incentives to minimise costs and improve quality are weak. Services may also be 

provided in the wrong quantities if there is no signal to tell providers which 

goods are most popular and so should be produced in greater quantities. In the 

private sector rising demand encourages firms to produce more but under a 

pure ‘administrative’ system, it can just lead to longer queues. 

Careful use of market mechanisms by government can reduce or eliminate these 

problems. We emphasise “careful” since such mechanisms require the public 

sector to devote significant resources to their design, implementation and 

operation in order to achieve the desired result. In Table 1 we list a number of 

market-based mechanisms which can be used to address the problems with 

pure private provision identified above, while avoiding some of the inefficiencies 

of an administrative system. The choice regarding which market-based 

mechanism to use will depend on a number of factors. However, a useful 

starting point is the nature of the market failure that provides the rationale for 

3 Externalities arise when the cost of a good to society is different from the cost to the individual. Pollution is a 

negative externality as the cost to society is greater than the private cost, education is a positive externality as the 

benefit to society can be greater than the private benefit. 

4 An additional rationale relates to the cost of obtaining relevant information. For example, if consumers lack 

information on the quality of different products they may inadvertently purchase a poor-value product, or the risk 

of making such a mistake could mean that they do not make any purchase at all. Governments can alleviate this 

issue by trying to disclose information. This is not dealt with at length in our report. 

15


government intervention in the first place. In Table 1 we link market failures to 

possible market-based mechanisms. 

Table 1: 

Market failures and market-based mechanisms 

Market failure Potential market-based mechanisms 

Market power Competitive tendering 

Removing entry barriers 

Public goods Competitive tendering 

User choice 

Externalities Marketable permits 

Taxes and subsidies 

Social objectives Competitive tendering 

User choice 

The common feature of these market mechanisms is that they involve a different 

role for the public sector than before. This need not always be a reduced role. 

One of our case studies examined the experience of local authorities switching 

from an administrative system for allocating social housing to a more marketbased 

system of user choice. This new scheme removed the need to employ 

local authority officers to make decisions on which property to allocate to which 

potential tenant. However, it introduced new demands on local authorities’ 

resources, which meant there was no reduction in the overall resources required 

to administer the provision of social housing. The scheme delivered other 

benefits instead: the new system was found to be more efficient in terms of the 

speed of response and also to be more popular with users. 

16

MAIN MECHANISMS REVIEWED 

Our case studies explored the practical application of three different marketbased 

mechanisms. These mechanisms are summarised below. 

Competitive tendering 

Where the public sector takes responsibility for providing a service – either 

because it is a public good, or to avoid problems arising from provision by a 

private sector monopolist – it may be possible to hold a competitive tender to 

choose the supplier of the service. This tender might allow both public-sector 

and private-sector suppliers to compete to become the chosen supplier. 

Competitive tendering allows the benefits of competition (such as improved 

efficiency and innovation) to be introduced to situations where there is a single 

supplier of the service. Competitive tendering can introduce competition for 

the market where competition in the market might not be possible or 

desirable. We examined the competitive tendering of prison services. 

User choice 

In other situations it may be possible to introduce competition in the 

provision of public services by having competing suppliers of the public 

service. This competition can be between public service providers, privatesector 

suppliers, or both. In each case the individual users of the service are 

given the right to choose a service provider. The most popular providers 

gain users and the less popular lose them, creating incentives for providers 

to be more responsive to customer needs. User choice often provides users 

with a “voucher” or entitlement that can be exchanged for a specified 

service, although our case study on choice-based lettings involved a 

different approach. 

Tradable permits 


The examples above involve using market-based mechanisms in the 

provision of services by the public sector. Tradable permits are a means of 

introducing a market discipline to the regulation of private-sector activities. 

Regulation is often used to address problems of externalities, for example, 

by placing a control on the quantity of a pollutant that can be emitted, by 

individual firms. Tradable permits are often used in this context. They 

involve setting an overall limit on the total level of emissions by all firms, 

and issuing permits up to this limit. Firms can then trade these permits 

amongst themselves. Those firms with a high cost of cutting emissions will 

buy permits from firms with a low cost of cutting emissions. Trading permits 

in this way allows emission reductions to be focused on those firms who can 

reduce emissions most easily. These firms will also be rewarded financially 

for doing so by those firms that find it more expensive to cut emissions. Our 

case study examined the impact of the UK emissions trading scheme to 

control greenhouse gas emissions. 

17


Market-based mechanisms produce benefits compared to 

traditional policy designs 

Evidence, both from our case studies and from previous studies of the use of 

market-based mechanisms, shows that significant benefits can be achieved 

when traditional policy designs are replaced with a market-based mechanism. 

These benefits arise from two main sources. 

● Benefits of competition on the supply side: market-based mechanisms can be 

used to create competition between suppliers of public services. Introducing 

competition creates incentives for providers of public services to operate more 

efficiently and innovate in the way they provide services. This sharpening of 

incentives can lead to significant cost reductions. It can also encourage service 

providers to improve the quality of the services they provide, particularly when 

the end users of the service are given a direct choice over which service 

provider to use. 

– These benefits of competition can be achieved both when provision is 

transferred to the private sector and when provision stays within the 

public sector. 

– When competition is introduced in one area it can create benefits 

elsewhere. The techniques that are used to reduce costs or improve 

quality can be copied and applied even where competition has not been 

introduced. 

● Benefits of choice on the demand side: benefits can be achieved when 

individuals or firms are allowed to make informed choices. For example, the 

recipients of public services can benefit from the ability to choose who 

provides them with a public service, such as which school or hospital they 

use. The mere fact that the user can make a choice will increase the likelihood 

that they receive the service they need in the way that is most convenient for 

them. The exercise of user choice can also provide better information for the 

public sector on which services are needed in which area. 

Market-based mechanisms can also create “softer” benefits that are difficult to 

measure but can be just as important as those listed above. Market-based 

mechanisms can introduce transparency and provide both policy makers and 

the public with greater information. A tradable permit scheme can reveal the cost 

of reducing emissions, while a system of user choice can provide better 

information on the type of services users prefer and, if implemented correctly, 

provides users with information on differences between service providers. This 

increase in transparency can improve the accountability of public-sector service 

providers and, by increasing efficiency, it can help make public policy objectives 

easier to achieve. 

18

Market-based mechanisms require creative thinking 

The allocation of social housing would at first glance appear to be a situation 

where market mechanisms could not be used. Social housing is provided 

entirely by ‘not-for-profit’ organisations, with supply fixed by the available social 

housing stock. Demand for social housing vastly exceeds supply in most parts 

of the UK. The price mechanism cannot be used to allocate this scarce resource 

because the government wishes to make social housing available to those in 

most need at below-market rents. These are not auspicious conditions for 

introducing a market. 

However, creative thinking allows the more effective allocation of such housing. 

Traditionally, applicants for social housing had to wait until they reached the top 

of the waiting list, and were then told that they had been allocated a particular 

property selected by a public-sector official. Under the new arrangements, 

known as ‘choice-based lettings’, all vacant properties are advertised and 

marketed to all eligible applicants. These applicants view the properties and 

register their interest. The property is then allocated to the most eligible 

applicant, which is normally the applicant highest up the waiting list, although 

they could be far down the waiting list if the property has not attracted many 

other applicants. In practice, applicants can choose whether they wish to wait 

until a more desirable property becomes available or take a less desirable 

property in order to reduce their waiting time. 

Although the introduction of choice based lettings may seem a minor change, it 

has resulted in a more transparent system, a faster allocation of properties and 

greater satisfaction among users. There is anecdotal evidence that tenants 

allocated properties under this scheme keep them in better condition, which 

may be because they have ‘chosen’ their property themselves rather than 

someone else choosing it for them. 

Importance of design and implementation 


The benefits achieved by a market-based mechanism depend on how the 

mechanism is designed and implemented. A badly designed market mechanism 

can be worse than traditional alternatives. The importance of implementation is 

perhaps best illustrated by the contrast between the UK and US experience of 

competitive tendering of prison services. Several studies have pointed to 

failures in competitive tendering of prison services in the US. In contrast we 

found that competitive tendering of prison services in the UK has, on balance, 

been a success. The difference here seems to be due to differences in policy 

design and implementation rather than any inherent differences between the UK 

and US. In particular, UK policy makers have learned from the US experience 

and taken measures to address problems found there. Differences in UK and US 

experiences are explained in more detail in section 3. 

19


Below we identify some lessons for policy design and implementation which are 

relevant to all, or most, market-based mechanisms. In section 3, we identify 

some lessons that are relevant to the specific market-based mechanisms we 

focus on in this report. 

EXPECTED COSTS AND BENEFITS OF A MARKET-BASED MECHANISM 

When a market-based mechanism is used, there should be a clear view on the 

net benefits that this is expected to deliver relative to a more traditional policy 

design. The benefits produced by market-based mechanisms were described 

above. The extent to which these will be realised depends on whether certain 

features are present: the benefits of competition will only be realised if there are 

sufficient competing providers to guarantee a competitive process; the benefits 

of choice will only be realised if users are able to exercise choice. Clarity on the 

expected benefits and costs will help policy makers to assess whether the 

conditions for achieving these benefits exist or, where they are not, how this 

problem can be addressed. 

Clarity on the expected benefits and costs will also make it easier to evaluate the 

performance of the mechanism once it is in place. As with all public policy 

initiatives, the outcome of the market mechanism should be evaluated once 

information on its performance is available. Comparing actual performance 

against expectations helps to identify any potential areas for improvement and 

lessons for future programmes. 

THE RIGHT PEOPLE NEED TO BE INVOLVED IN THE DESIGN 

When designing a market-based mechanism, it is essential that the design team 

includes people with an appropriate balance of skills. An inappropriately 

balanced team can lead to a process that does not take into account all the 

different skills and perspectives required for a successful solution. For example, 

the design team for a competitive tender process might need to include 

procurement specialists. Such specialists can bring experience from 

procurement in other areas in order to get the lowest price and best quality 

service for the public sector. 

The importance of quality makes it desirable for a design team to include people 

with experience in the day-to-day operation of the service. Such people can 

anticipate specific problems with the use of a market-based mechanism in that 

particular area that may not be apparent to outsiders. Moreover, even where 

problems can be easily identified, operational people can propose the most 

appropriate ways to overcome those problems. One of the lessons we drew 

from our case study on competitive tendering in prisons is the importance of 

maintaining service quality. The overall conclusion from our case study was that 

the large number of quality measures used by the Prison Service have been 

successful in keeping service quality at an appropriate level. However, not all 

service quality targets have been equally effective. One target required all 

20


broken items in the prison be replaced within 24 hours, and suppliers failing to 

meet the target incurred penalties. This target nearly undermined an initiative by 

one prison operator to provide toasters for prisoners, because a broken toaster 

accrued the same penalty as a more serous broken item. 

Similarly, the inclusion of operational staff in the design of performance targets 

can help to ensure that they are designed appropriately. Some of the benefits of 

competitive tendering come from new suppliers introducing fresh ideas into the 

provision of public services. Performance targets should safeguard quality while 

at the same time providing opportunities for innovation. In prisons, there has 

been a change in the type of performance target over time from targets that 

controlled virtually every aspect of prison life, to those that allow some room for 

innovation while safeguarding quality. A target that measures the success of 

education in prison by exam results arguably provides better scope for 

safeguarding quality and innovation than one that requires a set number of 

hours in the classroom. 

Policy-makers and economists should also be an integral part of design teams. 

Policy-makers can help ensure that the scheme is consistent with overall 

government policy. Policy-makers should seek to see that the rationale for the 

policy is clear, define the expected benefits and costs, set out how they will be 

achieved and ensure that the scheme is part of a coherent approach to dealing 

with an identified problem. 

Economists also have a valuable role to play. Economists can ensure that the 

mechanism and its implementation reflect the underlying market failure. 

Economists can also assist in predicting the likely effects of the mechanism and 

in evaluating the evidence on its performance. 

21

SECTION 3 

Lessons for the design and 

implementation of specific 

mechanisms 

This section summarises some of the main lessons drawn from our review of the 

theoretical and empirical literature and the three case studies we conducted. We 

focus on the three mechanisms covered by our case studies. More detail on 

these, and other mechanisms, can be found in Parts III and IV of our report. 

Competitive tendering 

Competitive tendering has been widely used in many countries in different areas 

of the public sector. The wide-ranging application of this mechanism means 

there is much experience to draw on in designing a system of competitive 

tendering. This experience suggests that two main issues are likely to arise: 

● market power of suppliers; and 

● maintaining the quality of the services provided. 

Some actions that reduce one of these problems may exacerbate the other. 

Policy makers may therefore need to take a view on the relative risks of these 

problems and decide which one takes priority. 

MARKET POWER 

Two market power issues can arise. 

The first market power issue is when an incumbent supplier has a significant 

advantage over potential competitors for a contract and, as a result, none of 

these potential competitors are willing to go to the trouble of bidding against it. 

This situation typically arises when the incumbent possesses information that 

competitors lack, or owns assets that can be used to fulfil the tender that 

competitors do not possess. 

A number of actions can be taken to reduce incumbency advantages, some of 

which should be taken into account when the contract is initially let in order to 

avoid creating an incumbency advantage in the first place: 

22

Section 3 – Lessons for the design and implementation of specific mechanisms 

● ensuring that information held by the incumbent is shared with potential 

bidders (this has been the case for prisons, where the incumbent has to share 

information on the costs of running a prison with rival bidders) and 

maintaining public ownership, or third-party ownership, of specific assets, 

will help to reduce the advantage possessed by an incumbent; 

● breaking up the contract into a series of smaller contracts, which are not all 

let to the same supplier, will ensure that there are a number of incumbents 

who will be potential competitors for each other’s existing contracts; 

● a longer contract period may encourage more firms to bid, since they are 

more likely to recover the fixed costs of bidding – although this may have 

implications for quality of service, as discussed below; and 

● it is generally desirable to transfer as much risk as possible to the supplier 

since this increases the incentive faced by the supplier to operate efficiently. 

Risk transfer could be achieved through contractual design, for example by 

ensuring that the supplier rather than the public sector bears the risk of cost 

overruns. However, where it is clear that the supplier cannot control some 

risks (where some input costs are beyond its control, for example) it may be 

beneficial for the public sector to bear, or share some of, these risks in order 

to encourage more suppliers to compete in the tender. 

The second market power issue is when there are a number of potential bidders 

but a high risk of collusion between them. Collusion is most likely to occur when: 

● there are a relatively small number of bidders, so that it is easy to organise a 

cartel, and there are barriers to entry that prevent new suppliers, outside of 

the cartel, from bidding; 

● there are a number of very similar contracts so that potential suppliers can 

share the contracts between each other in the expectation that each will 

generate similar profits; and 

● there is a transparent tendering process that allows the bidders to monitor 

each other and ensure that all are complying with the collusive agreement. 

Given these factors, the following actions might reduce the risk of collusion: 

● removing any unnecessary entry barriers, such as excessive or 

disproportionate pre-qualification criteria; 

● avoiding the creation of a series of identical contracts and instead creating 

contracts that vary in size; and 

● avoiding an auction design that is too transparent – a system of sealed-bid 

auctions may be preferable to an open auction if the risk of collusion is high, 

although this may also deter potential bidders in some circumstances. In 

general, auction design is a subject on which expert economic advice should 

be sought. 

23


COLLUSION IN FLORIDA AND TEXAS MILK CONTRACTS 

We did not find any suggestions that collusion had occurred in our case 

study of prison services in the UK. However, the tendering of school milk 

contracts in Florida and Texas provides an illustration of how a poorly 

designed public procurement process can create the ideal conditions for 

collusion. A large number of very similar small contracts were created (in 

total several hundred a year between the two states). In each school district 

contracts were awarded independently of one another and at different dates. 

Each school district also published details of all bidders for the contract and 

the price bid by each. The transparency created by this system made it easy 

for bidders to collude (either on price or by sharing out contracts) and to 

detect when any firm cheated on a contract. The frequency of contracts 

deterred firms from breaking ranks and undercutting the cartel, both 

because the gains from doing so on any individual contract were likely to be 

small and because any such attempt could quickly be punished by the other 

cartel members undercutting on the next contract. 5 

QUALITY 

When services are contracted-out to a private-sector supplier, the supplier will 

normally have strong incentives to reduce costs. The introduction of incentives 

to minimise costs can raise concerns that costs will be reduced at the expense 

of quality of service. In principle, this concern can be addressed by specifying 

appropriate quality standards in the contract between the public sector and the 

supplier. However, experience suggests that this can be difficult to do: quality 

can be difficult to define and measure, and suppliers may have an incentive to 

focus on improving dimensions of quality that can be measured while ignoring 

other dimensions that may be more important. 

These problems are not unique to competitive tendering. Where there is no 

competitive tender it can still be difficult to measure quality and set appropriate 

targets for public-sector service providers, such as schools and hospitals. The 

difference is that when services remain wholly in the public sector, and there is 

therefore no legally-binding contract with the supplier, it can be easier to adjust 

measures and targets in the light of experience than it is to renegotiate a 

contract with a private-sector supplier. 

In practice, this problem is most likely to arise during the first round of tendered 

contracts. In subsequent tenders it should be possible to learn from experience 

in order to improve how quality is defined, measured and monitored as has been 

the case with the competitive tendering of prison services in the UK, which is 

discussed below. This problem suggests that in the first round of tenders it may 

be necessary to include some flexibility, allowing for quality measures to be 

5 Pesendorfer (2000) as quoted in Motta (2004), Competition Policy: Theory and Practice, Cambridge University 

Press. 

24

eviewed and improved, for example. Flexibility may, however, create 

uncertainty and costs for suppliers and deter investment if there is a risk that 

changes to the contract will make this investment unprofitable. It may therefore 

be desirable to have some element of flexibility in the first round of tenders, but 

phase this out as the public sector becomes more experienced at writing 

contracts. 

Even where it is not possible to fully define all aspects of quality, service 

providers will have an incentive to maintain or improve quality if they know that 

this aspect of their performance will be taken into account when the contract is 

re-tendered. This incentive, and the need to allow for contracts to be reviewed, 

suggests that tender lengths should not be too long, at least in the first round of 

tenders, if concerns regarding quality of service are high. 

User choice 


PRISON SERVICES IN THE UK 

In the US, the private-sector provision of prison services has been associated 

with poor quality provision of services, which has led some commentators to 

suggest that prisons are not a suitable candidate for competitive tendering. In 

contrast, the UK experience has been successful, with few instances of the 

quality problems found in the US. A number of factors may have led to these 

different outcomes, but the following appear to be likely to have been 

important reasons for the relative success in the UK: 

● Problems in the US have often been associated with speculatively built 

prisons. In the UK, providers of prison services are selected by the public 

sector, and selection involves a strong emphasis on quality as well as cost. 

● Sophisticated measures of quality have been developed in the UK which 

have been closely monitored. These measures have developed over time, 

learning from experience. 

● Contract lengths in the UK were initially relatively short (five years). 

This approach allowed for contracts to be revised and improved although 

it may have had negative consequences for investment. Contracts are 

now longer but allow for some degree of renegotiation. 

● Contracts in the UK now include both penalties for poor performance and 

rewards for good performance. 

Experience in the application of user choice suggests the following issues may 

arise: 

● designing an allocation mechanism; 

● providing sufficient information; and 

● risks of inequality of access. 

25


ALLOCATION MECHANISM 

Introducing user choice will not necessarily mean that all users will be able to 

exercise their first choice on all occasions. Capacity is likely to be limited. For 

example, it would be inefficient for every school to have the capacity to offer a 

place to every child in its education authority area. As a result school places are 

likely to be limited at the most popular schools and not every parent will be able 

to send their children to these schools. 

Given these capacity constraints, some mechanism is needed to ration the 

capacity of popular service providers between competing users. In private-sector 

markets this role is performed by the price mechanism: those who are willing 

and able to pay more bid up the price until demand matches available supply. 

Since allocating places on the basis of willingness to pay may conflict with 

public policy objectives, it may be necessary to find an alternative allocation 

mechanism for public services. Users will need to understand that their ability to 

choose will be constrained by available capacity and they may have to accept 

something less than their first choice, which may still be preferable to no choice 

at all. 

CHOICE-BASED LETTINGS 

In the case of choice-based lettings a number of different mechanisms have 

been used to allocate properties between rival potential tenants. Some 

involve awarding points based on a number of objective factors (such as 

length of time waiting for a property and whether the person is disabled etc). 

Others simply rank applicants based on the length of time they have been 

waiting, but allow certain applicants priority for certain properties. In all 

cases applicants are awarded some form of ‘currency’, such as points or a 

position on a waiting list. Properties are then let to the applicant possessing 

the most currency. A key difference with the traditional administrative 

system is that all eligible applicants can view the available properties. As the 

properties are advertised weekly in local media, applicants can choose 

properties that they prefer, rather than having a choice made for them. It also 

means that those lower down the waiting list are able to choose the less 

popular properties, which may be rejected by those at the top of the list, so 

that unpopular vacant properties can be re-let more quickly. 

Although capacity is likely to be fixed in the short run, it may be possible to alter 

it over the long run-by deciding whether or not to close one school and expand 

capacity at another, for example. User choice will provide information on user 

preferences that we would expect to be used to influence these decisions. 

Incorporating information from actual user choices may work best when users 

have the option of using private-sector providers. Private-sector providers are 

likely to have more freedom than public sector providers to raise the capital 

needed to finance an expansion in capacity. So involving private-sector 

providers may make supply more responsive to user preferences. 

26

INFORMATION 

Users can exercise an informed choice only if they possess sufficient relevant 

information. A system of user choice therefore requires that the public sector 

devote resources to communicating information on available choices to 

potential recipients. 

Care needs to be taken to provide information that is easily understood and 

allows for comparisons between providers, without over simplifying complex 

differences in quality. For example, consider the problem of assessing school 

quality. Exam league-tables may to some extent reflect the quality of education 

provided by different schools, but exam results might not be a complete 

measure of the quality of education provided. Good results may simply reflect a 

school’s ability to attract bright pupils and users may therefore need guidance 

on how to interpret and use the information provided. 

ENSURING EQUALITY OF ACCESS 

A related issue is that some users will find it easier than others to interpret 

information and exercise their right to choose. Those less able to exercise their 

right to choose might include users with less education, those for whom English 

is a second language and those who find it more difficult to access information 

because they live in a rural location with poor transport links, for example. 

Inequalities in the ability to choose may lead to inequality in the allocation of 

services, with the more advantaged participants receiving better services than 

those who are less able to exercise their right to choice. 

The experience of choice-based lettings shows that if these issues are 

recognised at the outset, then measures can be taken to assist any 

disadvantaged groups of participants. These measures include providing 

information in different languages, ensuring that information reaches all 

potential users and employing staff to provide guidance and advice to users, for 

example. 

TRADABLE PERMITS 

Tradable permit schemes have now been employed in a number of countries, 

mainly to control pollution emissions. Key implementation issues include: 

● allocating permits; 


● differences in environmental impacts; and 

● the liquidity of permit markets. 

27


INITIAL ALLOCATION OF PERMITS 

Permits need to be allocated to firms or individuals. This allocation might be 

achieved through “grandfathering”, where permits to pollute are issued on the 

basis of existing levels of pollution or industrial output. Grandfathering has the 

merit that firms who previously had the right to produce pollution maintain that 

right without any direct cost, but now face an opportunity cost from continuing 

to pollute (this opportunity cost is the income they could receive from selling 

their permits). This system also tends to be easier to introduce. 

However, grandfathering may create perverse incentives, since it can, in effect, 

reward firms for past pollution and penalise those firms who have already 

reduced emissions. Grandfathering can also, in some circumstances, stifle 

competition if it creates market power by disadvantaging new entrants who will 

have to buy permits from incumbent firms. 

These problems are avoided if, at the outset of the scheme, permits are sold in 

some form of auction. The auction allocates permits to those who value them 

most, but forces them to pay for the right to pollute. However, care needs to be 

taken in the design of the auction to ensure that it produces a fair and efficient 

market price, and does not create any of the problems discussed below. Auction 

design is a complex subject, and the correct auction design is likely to vary from 

case to case. This is a subject on which expert advice should be sought. 

THE UK EMISSIONS TRADING SCHEME 

The UK emissions trading scheme involved an auction in which firms bid to 

obtain funding in exchange for offering to make greenhouse gas emission 

reductions. The auction was designed by independent auction experts and 

subject to review by stakeholders before implementation. This initial auction 

resulted in the government purchasing emissions reductions at a price of 

£18 per tonne of carbon dioxide per year, which subsequent experience has 

shown is significantly above the market price for allowances (which were 

later trading in the range £2–£4 per tonne). A subsequent analysis by 

economists, commissioned by the National Audit Office, suggested an 

alternative auction design that might have reduced the initial payments 

made by the UK government. 

LIQUIDITY 

A successful tradable permits scheme requires that there is a liquid market in 

permits: by this we mean that it must be possible for buyers and sellers to trade 

permits at a price close to the underlying market price without significant delay. 

They should not need to wait for other traders to appear or pay a high penalty 

for trading quickly. Liquidity is likely to be highest if: 

28

● there are a large number of buyers and sellers, which suggests that tradable 

permit schemes should generally be large – one large scheme is likely to be 

more liquid than a number of smaller schemes; 

● a trading infrastructure exists, such as an exchange where buyers and sellers 

can meet; and 

● rules allow for trading by proprietary or arbitrage traders-traders who do not 

need permits for their own purposes, but buy and sell for profit. These traders 

can be an important source of liquidity. 

DIFFERENCES IN ENVIRONMENTAL IMPACTS 

Some pollutants have different impacts depending on where they are released. 

For example, emissions of effluents into rivers may have different impacts 

depending on the river where emissions take place or the location along the 

same river. For some other pollutants, such as greenhouse gases, location is not 

an issue, but some greenhouse gases have a more intensive effect on climate 

change than others. 

Where different impacts exist, they might suggest that separate schemes are 

needed to reflect these differences. However, as explained above, larger schemes 

are generally desirable because they increase liquidity. There is a trade-off here 

between environmental quality and efficiency objectives. It may be possible to 

resolve this tension and include emissions with different impacts within the same 

scheme if the differences in impact are predictable. This is the case with different 

greenhouse gasses, for example. The UK ETS therefore includes all types of 

greenhouses gases with set “exchange rates” to determine how permits can be 

used to meet obligations regarding different greenhouse gases. 

Conclusion 



create significant benefits, in the form of lower costs and better services. 

However, the extent of these benefits will depend on how the mechanism is 

implemented. We have set out above a number lessons, drawn both from the 

theory of market-based mechanisms and the significant body of experience that 

now exists in many countries, which suggest how these benefits can be 

maximised. 

29


30

Part III 

Literature Review 

31

SECTION 4 

Introduction 

This part of the report reviews the economic literature on market mechanisms, 

and is organised as follows. We begin by describing the principal rationales for 

government intervention in Section 5. We then outline the situations in which 

government intervention can create its own problems (‘government failure’) 

which may undermine, or at least reduce, the effectiveness of government 

intervention in Section 6. In section 7 we describe the market mechanisms that 

have been proposed as methods for reducing this government failure and issues 

that need to be considered when implementing these mechanisms. Lastly, in 

section 8 we present a framework for assessing the performance of these 

mechanisms. 

Additional information and evidence drawn from our review of the literature is 

contained in Part V of the report. 

32

SECTION 5 

Market failures and the role 

of the public sector 

In this study we examine different ways in which the public sector can achieve 

its policy objectives. Public policy, for our purposes, includes: 

● the public sector providing services to the public (health care, education and 

the criminal justice system are examples of this in the UK); and 

● the public sector regulating, influencing or dictating how others provide services 

to the public (health and safety policy and environmental policy, for example). 

As a starting point, it is important to understand why we use the public sector, 

rather than private firms or individuals, to provide services to the public; and 

why the public sector regulates the behaviour of the private sector in some 

circumstances. Economists analyse this question by considering how an 

intervention affects the ‘welfare’ of society. Broadly speaking, welfare is 

measured as the difference between the value that consumers place on the 

goods and services they receive and the cost to society of producing those 

goods and services. Using this approach, it is possible to measure the welfare of 

individuals or the welfare of society as a whole. 6 

We distinguish below between two broad reasons for using the public sector to 

provide services, or regulate how others provide them: 

● because there is a market failure which, in some situations, means that the 

public sector would be better than the private sector at providing certain 

services, or that some regulation of private sector provision could increase 

the welfare of society; or 

● because leaving provision to an unregulated private sector would lead to 

outcomes which society would find undesirable because they conflict with 

wider social objectives, such as avoiding inequality in wealth, incomes or 

opportunities. In this situation an unregulated private sector might maximise 

the welfare of society as a whole but the resulting inequalities between 

different members of society might be considered unacceptable. 7 

6 Total welfare is the difference between the total value consumers place on a good and the physical cost of 

producing it. Consumer welfare is the difference between consumer’s valulation and the price they pay. Either of 

these measures can be used to inform policy analysis. They are not without problems, primarily because of the 

need to make comparisons between the welfare of different individuals. For a seminal treatment, see Kenneth 

Arrow (1963) Social Choice and Individual Values, Yale University Press. 

7 Note that this situation could be viewed as a form of market failure if, in calculating the welfare of society, higher 

weight were given to some individuals (the less wealthy) than to others. 

33


Below we consider each of these two rationales in turn. We focus mainly on the 

first, which includes a number of distinct situations. 

Markets and market failures 

An important question that economics attempts to address is whether and when 

goods and services should be provided by the public sector or the private sector. 

A further related question is the extent to which provision by the private sector 

should be left to unregulated markets, or be subject to some degree of control 

or regulation by the public sector. 

If certain conditions are met, the private provision of goods and services in a 

competitive market will maximise social welfare. A market in which these 

conditions hold is called a perfectly competitive market. 

When the conditions for perfect competition do not hold, this is called a ‘market 

failure’. It means that private provision through a competitive market could fail 

to maximise social welfare. In these circumstances it may be that intervention by 

the public sector would improve the welfare of society. 

Economists have identified the following market failures, which are explained in 

more detail below: 

● market power; 

● public goods; 

● externalities; and 

● imperfect information. 

MARKET POWER 8 

For a market to be perfectly competitive there must be a large number of 

competing buyers and sellers trading an identical product or service. In 

particular, no market participant should be so large that they possess ‘market 

power’, or the ability to influence the market price. When this condition is 

violated, a profit maximising firm will restrict output and charge a higher price 

than would prevail in a perfectly competitive market. This reduces consumer 

welfare because consumers pay a higher price to receive the same good. Social 

welfare is also reduced because the value placed on lost units of output exceeds 

the cost of producing them. 

There are many reasons why the condition that there are a large number of 

competing buyers and sellers does not hold in some markets, three of which are 

outlined below. 

8 The following discussion draws on Stiglitz, J.E. (2000) Economics of the Public Sector, Third Edition, W.W.Norton 

and Company, New York/London. 

34

Section 5 – Market failures and the role of the public sector 

First, firms may engage in behaviour that stifles competition. Examples of 

this include firms merging to reduce the number of competitors in the market 

or suppliers forming cartels by agreeing a price to charge or which customers 

to serve. Firms might also engage in strategic behaviour to force their 

competitors from the market, 9 for example, by setting prices below cost with the 

intention of raising them above competitive levels once rivals have exited. 10 This 

problem is normally addressed through laws that prohibit such behaviour 

(competition laws). 

Second, the goods or services traded might not be identical. For example, 

consumers may have different tastes and therefore choose to buy slightly 

different products. This allows some producers to charge higher prices if their 

products are preferred by consumers. While such markets are not perfectly 

competitive, they do not generally provide a rationale for government 

intervention. The fact that some firms can charge higher prices by differentiating 

their products provides an incentive for firms to innovate and develop products 

better suited to consumers’ needs. The greater variety of products available 

enhances customer choice and tends to increase consumer welfare. Even if 

prices rise, the benefits of increased choice may outweigh the increase in price 

so that consumers are better off. 

Third, the cost structure of the industry may mean that it would not be efficient 

to have a large number of competing firms. In some industries, known as 

‘natural monopolies’, firms incur very large fixed costs (costs which do not vary 

as output expands) and very low variable costs (the costs which increase as 

output increases). 11 In this situation, having two firms in the industry incurring 

two sets of fixed costs may be more expensive than if there is only one firm in 

the industry. Examples of these natural monopolies include utilities such as 

natural gas pipeline networks, as well as some public transport networks, such 

as a railway system. Natural monopoly is an extreme case but there exist many 

other sectors where fixed costs are large in relation to variable costs, making a 

smaller number of suppliers the more efficient outcome. 

Where a natural monopoly exists, an unregulated profit-maximising provider 

will set prices at a higher level than would prevail in a perfectly competitive 

market, restricting output and reducing social welfare. Governments can 

overcome this problem in a number of ways. For example, they could become 

the monopoly supplier and attempt to charge the perfectly competitive price; 

they could regulate the price charged by the private sector monopolist to 

9 Such strategic behaviour is normally sustainable only in markets where there are significant entry barriers, 

otherwise any attempt to raise prices above competitive levels would attract new entrants who would compete 

the price back down to its competitive level. 

10 Similarly customers might form cartels in order to drive prices down or undertake mergers which reduce 

competition on the buyers’ side of the market. 

11 Formally speaking, a natural monopoly is an industry where average total costs are declining at the level of 

output where the market clears. See Baumol, W., J. Panzar and D. Willig (1982) Contestable Markets and the 

Theory of Industry Structure, Harcourt Brace Jovanovich: New York. 

35


attempt to achieve the same outcome; 12 or they could sell the right to become 

the monopolist and capture any monopoly profits for the public purse. 13 

PUBLIC GOODS 

Public goods have two characteristics which differentiate them from other goods 

and services: non-rivalry and non-excludability. 

● Non-rival goods or services have a zero marginal cost: the cost of supplying 

the good or service does not increase when the number of consumers or the 

volume of output they consume increases. An example of a non-rival good is 

a terrestrially broadcast television or radio service. 

● Non-excludable goods are goods or services where it is not possible to limit 

the number of consumers. In particular, suppliers are not able to provide 

services only to those who pay for them: other consumers can ‘free-ride’ 

using the same service even though they have not paid to receive it. 

Examples of non-excludable goods include national defence and street 

lighting. 

A good which is both non-rival and non-excludable might not be provided by the 

private sector, or might be provided at a lower quantity than would maximise 

social welfare. If the supplier cannot exclude free-riders there is no incentive for 

consumers to pay for the service, so the supplier might not be able to earn 

sufficient revenues to cover its costs, even when society would value its 

provision. The public sector may therefore need to intervene to ensure that such 

goods and services are provided in sufficient quantities. 

EXTERNALITIES 

The consumption of a good or service by one set of individuals can in some 

circumstances affect the welfare of others. This effect is called an externality. 

Externalities can be positive or negative. An example of a negative externality is 

the pollution created from the use of fossil fuels; an example of a positive 

externality is the benefit that a homeowner with a carefully tended garden 

confers on his neighbours. 14 

In the presence of an externality, the welfare society gains from the consumption 

of a product is different (higher or lower) than the welfare received by the 

suppliers and direct consumers of the product. As a result, the amount that 

direct consumers chose to use will not be the same as the level of consumption 

12 For a useful introduction to the issues of regulating natural monopolies see Armstrong, M., S. Cowan and J. 

Vickers. (1999) Regulatory Reform: Economic Analysis and British Experience, The MIT Press: Cambridge, MA; 

and Newbery, D. (1999) Privatisation, Restructuring and Regulation of Network Industries, The MIT Press: 

Cambridge, MA. 

13 See Demsetz, H. (1968) ‘Why Regulate Utilities?’, Journal of Law and Economics, for the first paper suggesting 

that competition for a market with natural monopoly characteristics could result in an efficient outcome. 

14 This concept is related to that of public goods in that non-excludable public goods (e.g. street lighting and 

policing) create positive externalities. 

36

that would maximise social welfare. In these circumstances the government 

may wish to require or encourage greater or less use in order to maximise social 

welfare. 

INFORMATION FAILURES 

Consumers may lack adequate information about the products and services they 

are buying. For example, consumers of financial products may be unaware of 

the risks of the investments they are making, a purchaser of a car might not 

know how reliable the car is. These information failures may lead consumers to 

make decisions they would not have made in the presence of better information, 

such as making an investment that is too risky, or buying an unreliable car. These 

decisions will reduce their welfare. 

Markets can also fail when there is asymmetric information, a situation in which 

one party to a transaction is better informed than the other. If the more informed 

party has an incentive to use his superior information to act opportunistically, 

then this can lead to what are known as ‘moral hazard’ problems. For example, 

complete insurance on a rental car may lead to the driver driving more carelessly 

than they would do if they were liable to pay for any damage. 

Governments may wish to avoid this problem by regulating which products can 

and cannot be sold or requiring the disclosure of certain information. 

In some situations information failures can mean that markets fail to function 

and trades which would enhance welfare do not take place. 15 For example, if 

consumers are not able to judge whether or not an investment is risky they may 

assume that all financial products are risky and choose not to buy any of them. 

This behaviour may encourage the sort of government intervention described 

above. Another example is that firms may be unwilling to invest in research and 

development if they expect that competitors will be able to copy their 

innovations. This may lead governments to introduce patents and laws to 

protect intellectual property. 16 

Social objectives and inequality 

Section 5 – Market failures and the role of the public sector 

Where markets do not display the failures described above, society might still 

decide that the outcome of an unregulated market would not be desirable 

because it conflicts with wider social objectives. For example, society may be 

concerned to avoid significant levels of inequality in income, wealth or 

15 Seminal papers describing how informational failures may give rise to incomplete markets include: 

Akerloff, G. (1970) ‘The Market for Lemons: Quality Uncertainty and the Market Mechanism’, The Quarterly 

Journal of Economics 84; Greenwald and J. Stiglitz (1986) ‘Externalities in Economies with Imperfect Information 

and Incomplete Markets’, The Quarterly Journal of Economics; and Rothschild, M. and J.E. Stiglitz (1976) 

‘Equilibrium in Competitive Insurance Markets: An Essay on the Economics of Incomplete Information’, The 

Quarterly Journal of Economics 90. 

16 Lastly, markets may fail if they fail to reach a stable equilibrium. This can occur in periods of high inflation, for 

example, which provides a rationale for macro-economic policies designed to maintain price stability. This area of 

government intervention is beyond the scope of this report. 

37


opportunities between different members or groups within society. This might 

mean that outcomes which maximise social welfare are undesirable because of 

the inequality between different members of society that they create. 17 This 

could, for example, lead to government intervention in the provision of 

unemployment benefits or pensions if it is felt that purely private-sector 

provision would fail to achieve the desired level of equality. 

17 Arguably, this can be seen as a form of market failure if ‘equality’ is seen as a public good. 

38

SECTION 6 

Government Failure 

The previous section explained why unregulated markets may fail to maximise 

social welfare, or lead to undesirable outcomes. In some cases the market itself 

may produce solutions to these failures. For example, in order to avoid problems 

of incomplete information, firms may invest in developing a reputation for 

quality. In other cases, such solutions may not emerge and this might lead to 

intervention by the government to correct the market failure. However, 

intervention by government can itself have consequences for social welfare. 

Government intervention might fail to completely solve the problem it is 

attempting to address. In some situations this ‘government failure’ could be 

worse than the problem the intervention was designed to correct, so that 

government intervention reduces rather than improves social welfare and/or 

equality. 

We set out below a number of reasons why government failures may arise. 

INFORMATION PROBLEMS 

In unregulated markets, the price mechanism can help producers to know 

whether or not they should be producing a certain good or service. If the price 

is higher than their marginal cost of production they know that the value 

consumers place on the product (as revealed by the price they are willing to pay) 

is greater than the cost of supplying more output. It is worthwhile expanding 

output. Similarly, if the market price is below their marginal cost of production 

then customers do not value the products they are producing enough to 

continue maintaining current output levels. This information helps suppliers to 

know whether or not to expand or contract output (and helps potential suppliers 

know whether they should enter the market). The decisions they take are both 

privately profitable for those suppliers and also help maximise social welfare by 

ensuring that products are produced when, and only when, their value to 

consumers exceeds the cost of producing them. 

When services are provided directly to users by the government, rather than 

through a market, this price mechanism will not be present. Hence information 

on whether or not it is worthwhile (from society’s point of view) to increase or 

reduce output is lost. The public sector, acting outside of a market, is likely to 

produce either too much or too little, and would only by an unlikely coincidence 

produce the socially optimal level of output. 

INEFFICIENCY 

As well as determining how much is produced, markets also help select the most 

efficient suppliers. Suppose there are two firms supplying a market with an 

identical product and one has higher costs than the other. As explained above, the 

39


market mechanism ensures that output is produced up to the point where price 

equals marginal cost. If price equals the marginal cost of the expensive producer, 

the other supplier will be able to expand its output which will lead to a fall in the 

market price. This means that price is below cost for the more expensive producer 

who will therefore cut back output, and perhaps exit the market altogether. In this 

way firms with lower costs win business from those with higher costs. 

The market will also provide consumers with an opportunity to chose between 

firms producing higher or lower quality output. In general, unless there is a big 

enough difference in price, consumers will choose producers of high quality 

output over producers of low quality output. The market mechanism thus directs 

business towards producers with lower costs and/or higher quality output. 

Direct provision by the government removes this process and can lead to 

inefficient or poor quality services being provided. 

PRINCIPAL-AGENT PROBLEMS 

The government’s policy goals may not be perfectly aligned with the interests of 

the managers that are implementing its policies. 18 Individual departments may 

expand their size, activities and budgets beyond that which is efficient in order 

to increase their own importance. 19 The interests of principal and agent can also 

diverge when an individual official has the scope to pursue his own political 

agenda. Principal agent problems are found in both the public and the private 

sector, but designing an appropriate incentive contract to re-align interests can 

be more difficult in the public sector. 20 The public sector is limited in how it 

compensates employees and cannot fire workers or award bonuses to the same 

extent as the private sector. Furthermore, the pursuit of social welfare rather 

than profit maximisation gives rise to a complex set of objectives, some of which 

may be difficult to measure. An incentive contract in this case could lead to the 

agent focussing his efforts on the measurable output to the detriment of the 

other non-measurable objectives. 21 

CAPTURE 

Government officials may be ‘captured’ by special interest groups and act in 

ways that are in the interests of these groups, rather than society as a whole. 22 

For example, an official could be persuaded by domestic producers to impose an 

18 Although this problem may arise equally for principals and agents in the private sector, designing an appropriate 

incentive contract to re-align the interests of principal and agent may be more difficult in the public sector. This 

issue is addressed in Tirole, J. (1994) ‘The Internal Organisation of Government’, Oxford Economic Papers 46. 

19 The classic literature relating to bureaucratic behaviour and agency size is contained in: 

Niskanen, W.A. (1977), Bureaucracy and Representative Government, Aldine-Atherton: Chicago and Tullock, G. 

(1965), The Politics of Bureaucracy, Public Affairs Press: Washington DC. 

20 This issue is addressed in Tirole, J. (1994) ‘The Internal Organisation of Government’, Oxford Economic Papers 

46. 

21 See Holmstrom, B. and Milgrom, P. (1991) ‘Multi-Task Principal-Agent Analyses: Incentive Contracts, Asset 

Ownership and Job Design’, Journal of Law, Economics and Organisation 7. 

22 See Stigler, G. (1971) ‘The Theory of Economic Regulation’, The Bell Journal of Economics and Management 

Science 2(1). 

40

Section 6 – Government Failure 

import quota that would harm consumers, or to continue an inefficient subsidy 

scheme by those receiving the transfers. Because government intervention is a 

potential resource to such groups there is an incentive for them to organise and 

lobby the official to act in their collective interest. This will cause social welfare 

to suffer when the benefit accruing to the interest group falls short of the cost 

imposed on society. The adversely affected party will not lobby against the 

regulation if the incentives to do so are too weak. For example, consumers may 

object to paying the higher prices resulting from an import quota but may find it 

difficult to organise themselves. Any benefits from lobbying must be shared 

with a large number of individuals, and the temptation to ‘free-ride’ on the 

activities of others is strong. 

Regulatory capture may also arise as a result of asymmetric information. For 

example, an official regulating prices in an industry may be reliant upon firms in 

the industry to provide cost information. If reported costs are not easily 

verifiable, this provides an incentive for firms to over-state their costs in order to 

obtain a higher regulated price. 

41

SECTION 7 

Market-Based Mechanisms 

We have seen in the previous sections that market failures and social objectives 

lead to government involvement in sectors of the economy. We have also seen 

that government intervention can bring its own problems. 

One reaction to this problem is to ask whether, even when a market failure 

exists, an unregulated private sector may be more desirable than government 

intervention. Government failure might outweigh the market failure it is trying to 

correct. However, a third option may be to change the mechanism the publicsector 

uses. 

Government failure results from the loss of certain advantages of free-market 

provision: such as incentives for efficiency and the role of the price mechanism 

in allocating resources. One approach, therefore, is to try to introduce these 

disciplines into the mechanism the public-sector uses. We refer to such 

mechanisms as ‘market-based mechanisms’, which we define as mechanisms 

that attempt to use market forces to reduce the problem of government failure. 

The use of market-based mechanisms is unlikely to completely eliminate the 

impact of government failure. Nor is it guaranteed that their use will reduce this 

problem; that depends on how well they are designed and implemented. 

However, the careful use of market-based mechanisms can help to overcome 

some government failures. For example, in many cases it is possible for 

governments to achieve their objectives by setting obligations that private firms 

have to meet or, where it is decided to keep service provision entirely in the 

public sector, by introducing customer choice to give a more efficient allocation 

of resources. 

For our purposes we divide market mechanisms into five broad categories. 

However, any particular application may involve a combination of more than 

one of these categories. In this section we describe each of these mechanisms in 

turn, before noting the problems that need to be taken into account when 

considering the use of these mechanisms. The mechanisms we consider are: 

● competitive tendering of service provision; 

● introducing user choice; 

● marketable permits (‘cap and trade’;) 

● taxes and subsidies; 

● regulating access. 

In addition, we consider the use of auctions as a means to value scarce resources. 

42

Competitive tendering of service provision 

Some areas of public policy involve the public sector directly providing services 

to the public. For example, the criminal justice system has traditionally involved 

the public sector directly providing a number of services: a police force, courts 

and prisons. 

As noted in section 6, pure government provision of a service can lead to 

inefficiencies due to the absence of the discipline the profit motivation provides, 

and conflicts between the incentives of those working in the public sector and 

the overall goal of policy makers. In some cases, these problems can be resolved 

by tendering for the supply of the particular service. This is similar to the use of 

franchises in the private sector, where, although overall control may rest with a 

single firm, the operation of a particular activity is delegated to other firms or 

individuals. 

Competitive tendering of service provision is often possible as in many cases a 

government obligation to supply a particular service need not involve 

government delivery of the service. In many cases, governments can meet their 

objectives by using the private sector to undertake all or part of the actual 

delivery of the service. For example, even though the government has a 

commitment to provide prisons, this commitment can be met by using private 

sector firms to run these prisons. 

By placing the provision out to competitive tender, governments can introduce 

competition into areas of the economy that may previously have been insulated 

from this process. Moreover, this tender process need not only involve private 

sector firms. Research suggests that it is the introduction of competition, 

regardless of whether the winner is in the private or the public sector, which 

delivers the main benefit in improving the efficiency of service provision. 23 

BENEFITS OF THIS SYSTEM 

The benefits of competitive tendering can be divided into two main types: 

● the reduction of costs through incentives to increase efficiency; and 

● the introduction of ex ante competition for the market. 

The reduction of costs through incentives to increase efficiency 

Section 7 – Market-Based Mechanisms 

It was noted in section 6 that government delivery of services can suffer from a 

lack of efficiency as the incentives of individuals carrying out the delivery of the 

service may differ from the government’s overall objective. For example, if there 

is prestige attached to having a large department size, then this can directly 

conflict with the objective to provide a service on the most efficient basis. Even 

23 Domberger et al. (1995) ‘The determinants of price and quality in competitively tendered contracts’, Economic 

Journal; and Domberger, Meadowcroft and Thompson (1986) ‘Competitive tendering and efficiency: the case of 

refuse collection’, Fiscal Studies 8. 

43


when individual incentives are aligned with the attainment of social objectives, 

public sector provision may be less effective than private sector provision. 

Markets provide sharper incentives for cost efficiency through the profit motive 

and are better able to disperse information through the price mechanism. 

In contrast, placing the right to provide a service out to competitive tender 

provides a direct incentive to increase the efficiency of service provision. 

Provided that there is sufficient competition and that the requirements can be 

appropriately specified, then competitive tendering can give strong incentives to 

improve efficiency. There are many studies that have found that outsourcing 

reduces government expenditure, with savings typically estimated in the region 

of 20 per cent. 24 Examples of these reductions include: 

● savings of around 20 per cent after contracting out refuse collection in UK 

local government; 25 

● savings of around 34 per cent in hospital domestic service provision based on 

a sample of over 3,000 hospitals in the UK; 26 

● savings of between 11 and 19 per cent in refuse collection by municipalities 

in Sweden. 27 

A key question is whether these cost reductions are due to the introduction of 

competition or to the switch to using a private sector firm. Privatisation, the 

transfer of the service provider from public to private ownership, can be achieved 

without introducing competition. For example, the existing operation could be 

sold to the private sector without any provision for tendering of the contract for 

provision of services. On the other hand, the use of a competitive tendering 

process might leave provision under public sector ownership, if the existing 

public sector operation wins the competitive tender. In order to identify the 

benefits of competition it is necessary to separate out the effect of privatisation 

from the effect of competitive tendering. 

Distinguishing between these two effects is not straightforward. It can be 

difficult to isolate changes in costs due to changes in specifications and there 

may be problems with controlling for any changes in quality. 28 However, despite 

these qualifications, on balance, studies suggest that it is the introduction of 

competition rather than a change from public to private ownership that matters. 

24 See Edwards and Stevens (1978); Domberger, Meadowcroft and Thomspon (1986); Reeves and Barrow (2000); 

Nash, 1993; Reca and Zieg (1995); Ahlbrandt (1973); Edwards (1996) and Blom-Hansen (2003). 

25 Szymanski, S. and Wilkins, S. (1993) ‘Cheap rubbish? Competitive tendering and contracting out in refuse 

collection- 1981-88’, Fiscal Studies 14(3). 

26 Domberger, Meadowcroft and Thompson(1987) ‘The impact of competitive tendering on the costs of hospital 

domestic services’ Fiscal Studies 8(4). This estimate has been confirmed with more recent data by Milne and 

McGee (1992) ‘Compulsory Competitive Tendering in the NHS: a new look at some old estimates’, Fiscal Studies 

13(3). 

27 Ohlsson, H. (1998) ‘Ownership and production costs: Choosing between public production and contracting out’, 

Uppsala University, Working paper No.1998-6, Sweden. 

28 Jensen, P.H. and R.E. Stonecash, (2004) ‘The efficiency of public sector outsourcing contracts: a literature review’, 

Melbourne Institute Working Paper Series wp2004n29, Melbourne Institute of Applied Economic and Social 

Research, The University of Melbourne. 

44

As Stonecash and Jensen (2004) observe, if the private sector were inherently 

more efficient than the public sector, outsourcing to private firms should result 

in larger savings than services outsourced to an in-house team. However, the 

balance of evidence shows that observed outsourcing savings are achieved 

whether the service provider winning the contract is public or private. 29 These 

savings come both from better management of resources and higher 

productivity of inputs, and in some cases also from lower wages for staff. 30 

Moreover, other studies have shown that simply changing from public to private 

ownership may yield little efficiency benefits if competition is not introduced at 

the same time. 31 Together this all suggests that it is the introduction of 

competition that leads to greater efficiency. 

The introduction of ex ante competition for the market 

Some services can be characterised as natural monopolies as the characteristics 

of demand and supply mean that they may be most efficiently supplied by one 

supplier. For example, on rural bus routes there may be insufficient demand to 

support more than one provider, or indeed in some circumstances the route may 

only be profitable at all with a subsidy. In such cases, where it is not possible to 

have competition ‘in’ the market, the use of tendering may make it possible to 

have competition ‘for’ the market where rival firms bid for the right to run the 

monopoly service. 32 Although this ex-ante competition is not a total substitute 

for competition ‘in’ the market, in circumstances where competition in the 

market is not possible it can yield many of its benefits. For example, it may not 

be economic to have two competing bus operators on a local bus route. 

However, by allowing competing companies to compete for the right to provide 

the monopoly service, some of the monopoly profits can be recouped ex-ante. 

In addition, this could be combined with limits on fares to prevent the 

exploitation of monopoly power. 

APPLICATIONS 


Competitive tendering can be used in situations where a government obligation 

to provide a particular service can be separated from the actual delivery of the 

service. This has been used in a number of applications ranging from cleaning 

29 Domberger et al. (1995) ‘The determinants of price and quality in competitively tendered contracts’, Economic 

Journal. This study looks at contracts for cleaning services awarded through competitive tender, comparing those 

tendered with those not tendered, and those contracted out with those won by the in-house team. Domberger et 

al find it is the tendering of the contract for competition that leads to observed reductions in price, and conclude 

that contracting out rather than awarding contracts to an in-house team has a negligible impact on both price and 

quality; Domberger, Meadowcroft and Thompson (1986) ‘Competitive tendering and efficiency: the case of refuse 

collection’ Fiscal Studies 8. This paper reports similar conclusions with respect to refuse collection, as savings 

from introducing competition through the tender process are of a similar order whether the contract is awarded 

to a private contractor or the in-house team. 

30 Cubbin, J. Domberger, S. and Meadowcroft, S. (1986) ‘Competitive tendering and refuse collection: identifying the 

sources of efficiency gains’, Fiscal Studies 8. 

31 Pollitt performs a social cost benefit analysis of the Scottish electricity generating companies and finds negligible 

benefits. He suggests that this is due to the lack of restructuring as remaining vertically integrated may have 

impeded entry by competitors into the home market. Pollitt, M. (1999) ‘The restructuring and privatisation of the 

electricity supply industry in Scotland’, Mimeo. 

32 Demsetz, H. (1968) ‘Why regulate utilities?’, Journal of Law and Economics. 

45


services and refuse collection to private prisons. Private prisons is one of the 

case studies considered in Part IV of this report. 

In addition, competitive tendering has proved successful as a means of 

allocating the right to provide a monopoly service. In the UK, the right to operate 

bus and train routes have all been allocated by competitive tender. Given the 

lack of financial viability of several of these routes, this has often been on the 

basis of which operator will accept the lowest subsidy. 

IMPLEMENTATION ISSUES 

Economic theory and studies of past experience suggest that the following 

implementation issues can affect the success of competitive tendering: 

● market power; 

● incomplete contracts; and 

● asymmetric information. 

The evidence on these issues which we have examined is set out in Part V. Below 

we summarise the main conclusions we have drawn from this evidence 

Market power 

Market power problems can occur for two reasons. First, there may be only one 

firm which is able to bid for the contract, in which case the benefits of 

competition would not be realised. This problem is most likely to arise where 

there is an incumbent supplier and potential competitors perceive that this 

incumbent has such an advantage that there is no point in bidding. If there 

genuinely is only one potential bidder then this might suggest that competitive 

tendering is not a desirable approach; but in practice it may be possible to 

redesign the contract put out to tender in order to encourage more firms to bid. 

We list below some ways to achieve this. 

● Breaking up the contract into a series of smaller contracts that are awarded to 

different bidders may avoid creating a dominant incumbent supplier. This 

might involve a restriction on the number of contracts that can be awarded to 

one firm. While this may create some costs in the short run (because 

economies of scale across contracts are lost, or because the most 

economically advantageous bid cannot be accepted for some contracts) these 

may be offset by the increase in competition for tenders over the longer run 

and the potential for yardstick competition in the interim. 

46


● Increasing the length of the contract term reduces the number of times the 

contract is re-tendered and competition takes place. If this means that 

opportunities to win a contract are rare, it could force unsuccessful firms to 

exit, reducing competition for future tenders. On the other hand, a longer 

contract term may in fact increase competition for each tender because it 

makes each contract potentially more profitable and therefore may 

encourage more firms to bid. 

● The terms of the contract can also affect the incentives to bid. A fixed-price 

contract will be desirable in one sense, because it transfers risk (the risk that 

costs might increase, for example) to the service provider who then has an 

incentive to manage and minimise these risks (keep costs under control, for 

example). However, transferring this risk to the provider also reduces their 

incentive to participate. Therefore, if there is concern over a lack of competition, 

it may be desirable to reduce the extent to which risk is transferred to the 

service provider (by the use of some element of cost-plus pricing). 

● One factor that might favour an incumbent is the switching costs that would 

be incurred by the public sector when switching providers. If the public sector 

commits to ignore these switching costs this might encourage other firms to 

bid. This would be sensible if the gains from encouraging competition are 

expected to outweigh the additional switching costs that might be incurred. 

Second, problems of market power can occur if there is collusion between 

potential bidders. This might involve an agreement over which tenders will be 

won by which firms, with other firms not bidding or bidding at high prices in 

order to avoid winning the tender. The nature of public procurement means that 

it is often susceptible to such collusive behaviour. For example, potential bidders 

will often have to meet certain criteria which limit the number of potential 

bidders and create barriers to entry for new participants. There is also likely to 

be transparency over the contracts that are available and who has won each 

contract, which helps firms to monitor whether competitors are complying with 

their collusive agreement. 

It may be possible to reduce the risks of collusion by addressing these factors: 

reducing any qualifying criteria for participants and reducing transparency over 

tender outcomes. However, this might not be possible: qualifying criteria may be 

important to maintain service quality, for example. 

It may also be possible to reduce the risks of collusion through the choice of 

auction design. For example, a sealed-bid auction (where participants submit 

their bids simultaneously in one round of bidding) will reduce transparency 

compared to an open auction (where participants are invited to make bids at a 

specified price which is then raised or lowered, depending on the type of 

auction). A sealed-bid auction may reduce efficiency but this might be 

considered acceptable where the risk of collusion would otherwise be high. Part 

V contains information on how open auction design can be tailored to minimise 

the risks of collusion. 

47


Incomplete contracts 

Ideally, when a service is contracted out to the private sector, the contract should 

specify not just the price but also the quality of service to be provided. In 

practice, however, it may be difficult to specify quality criteria that are 

comprehensive and capable of measurement. This can lead providers to 

sacrifice quality in order to minimise costs, or to focus only on measures of 

quality that can easily be measured. In general, contracting out will work best 

where the opportunities to reduce costs through reducing quality are small or 

the effect on quality can be easily measured. 

Partly this issue can be addressed by ensuring that contracts have well specified 

measures of quality, which are effectively monitored and enforced, although it 

may not always be possible to devise and implement such measures. This can 

be reinforced, however, if firms know that the quality of the service they provide 

(broadly defined) will affect whether they are successful in future tenders. This 

can create incentives to maintain quality standards even where they are not 

specified in the contract. 

Hold-up problem 

A related issue is the ‘hold-up’ problem. This problem occurs in contracts when 

an initial commitment by one party exposes it to ex post opportunism by the 

other. For example, when a contractor considers whether to undertake a large 

investment in a specific asset, it will take into account the incentives for the 

official managing the contract to renegotiate prices down once the investment 

has been undertaken. If the investment is irreversible and has no alternative use 

outside the public sector, the government could theoretically ‘hold-up’ the 

contractor and capture the entire benefits of the investment for itself without 

paying an appropriate transfer fee. This is a problem arising from incomplete 

contracts because, if the government could credibly commit to not acting in this 

manner, the contractor would face the correct incentives when making his 

investment decisions. However, where such commitment is not possible, the 

contractor will be aware of the potential for hold-up and consequently invest 

less. 

Asymmetric information 

There may be circumstances where the public sector has less information than 

potential service providers, or some service providers possess less information 

than others. Both of these cases can raise implementation issues. 

The first situation, which is related to incomplete contracts, arises when the 

public sector is not able to monitor the efficiency of the service provider. For 

example, if costs rise it may be difficult to know whether this is due to 

inefficiency on the part of the service provider or factors outside its control. To 

address this problem it may be desirable to transfer risk to the service provider 

(through a fixed-fee contract, for example) in order to increase its incentives to 

minimise costs – although this approach could increase short-run costs and may 

48

educe the level of participation, and therefore competition, in the tendering 

process. Where lack of competition is not a concern, the incentive benefits of 

transferring risk to the private sector are more likely to outweigh any short-run 

increase in costs. 

The second situation, where some potential service providers have less 

information than others, can give rise to a ‘winner’s curse’ problem. This arises 

when bidders do not know the true costs of providing the service and make 

different forecasts. The bidder that wins the contract will be the one with the 

lowest forecast, which is most likely to be below the true cost of providing the 

service. It might be expected that this will be a good result for the public sector, 

but it can result in firms feeling under pressure to cut quality, raising their 

bidding price in order to compensate for this risk or deciding not to participate 

since they expect the contract to prove unprofitable for the successful bidder. 

In general, the winner’s curse problem can be minimised by providing bidders 

with more information so that they can make accurate forecasts of their costs. 

An open auction can also assist this process since bidders can use information 

on competitors’ bids to adjust their own forecasts. A smaller number of bidders 

will also reduce the likelihood of a winner’s curse. However, as explained above, 

all these factors can increase the risks of collusion. 

CONCLUSION 

Competitive tendering allows the government to retain ownership of public 

assets whilst harnessing the sharper incentives for efficiency and innovation 

offered by the private sector. We have set out above a number of factors that 

could influence the way in which this is implemented. Clearly, there are tradeoffs 

to be made here – decisions which address concerns over asymmetric 

information may increase the likelihood of collusion between participants, for 

example. Nevertheless, by considering the weight that should be attached to the 

risks identified above in any particular circumstance, it will be possible to 

identify which approaches are most likely to be successful in that particular case. 

The case study on competitive tendering of prison services in Part IV assesses 

the evidence on how competitive tendering in that case affected cost efficiency 

and innovation, and looks at whether the potential problems highlighted by 

theory have been encountered in practice. Specifically, we have examined 

whether problems of market power and incumbency advantage arose in the 

market for prison management services, and whether costs were cut at the 

expense of quality. We also considered how problems of asymmetric 

information have been overcome in the design of incentive contracts to avoid 

both ‘winner’s curse’ and ‘hold-up’ problems. 

User choice 


In some cases, full competitive tendering of a service may not be considered an 

option. For example, quality may be difficult to control or competitive tendering 

49


would not be considered politically acceptable. However, even in these cases 

where the service is to remain in public hands, it can be possible to use carefully 

targeted market-based mechanisms to deliver a more efficient and customerresponsive 

service. This can be done by introducing what we term ‘user choice’. 

At one extreme (a so-called ‘command-and-control economy’), the government 

decides who gets which service, at which location and at what time. With this 

system, the citizen is effectively presented with a ‘take it or leave it’ choice. For 

example, consider the case of state-provided nurseries. In a command-andcontrol 

system, the state would tell parents which nursery their child has a place 

at. In such a system there is no competition between nurseries and parents have 

no choice where to send their child. As a consequence, there is little incentive for 

efficiency on the part of nurseries, apart from any intrinsic reward in providing 

good services. 

The situation is significantly different under a ‘user-choice’ system. Under a 

user-choice system, resources follow the citizen rather than the citizen following 

the resources. Government commitments to supply given services (e.g. the 

government will provide free nursery places) are expressed in terms of citizen’s 

‘entitlements’ to a given good (i.e. each child is entitled to a nursery place) that 

have an (implicit) monetary value. In the example of nursery care, this can be 

seen as analogous to a system where each citizen has a ‘voucher’ (whether 

explicit or implicit), which can be exchanged in return for the specified service. 

User choice could be introduced in a system of purely public provision; it could 

be introduced by selecting providers from the private sector; or it could be 

introduced in a system that allows users to choose between both public and 

private sector providers. For example, the ‘nursery voucher’ could be exchanged 

for a place at either a state or privately run nursery. If the rationale for 

intervention is to address concerns over the equity of provision, then this could 

be addressed by providing each child with a voucher (or possibly providing 

vouchers, or higher value vouchers, only to poorer children). There is no reason 

to restrict the use of the voucher to public sector providers. 33 

BENEFITS 

Introducing user choice can generate benefits through both the demand-side 

and the supply-side of the market for the publicly provided good or service 

concerned. The main benefit achieved through both channels is improved 

efficiency, and so it is worth briefly considering the different types of efficiency 

that can be achieved in an economic system. The first of these is allocative 

efficiency: 34 this refers to efficiency in the allocation of scarce resources amongst 

alternative uses. In an allocatively efficient outcome, no one can be made better 

33 Nor is it necessary to operate such a scheme by issuing physical vouchers to parents. A similar result can be 

achieved without vouchers if all nurseries, state and private-run, receive a given amount of funding per child. 

The only difference in this case is that private-run nurseries receiving funding must commit to not charging fees 

for places. 

34 Also known as Pareto efficiency. 

50

off by transferring resources from one activity to another without making 

someone else worse off. Productive efficiency is a pre-condition for allocative 

efficiency, and refers to efficiency in production. It occurs when a specific 

outcome or level of output is achieved using the most cost-effective means. An 

economy can achieve both allocative and productive efficiency in the short run 

whilst still being inefficient in the longer-run, for example by not spending 

enough money on research and development. Long run, or dynamic efficiency, 

refers to the efficient use of resources over time and ensures, for example, that 

new products are designed to meet evolving needs and new production 

methods are developed to lower future production costs. 

Supply-side benefits 

User choice provides direct incentives for public sector organisations to provide 

a service that responds to the needs of users. Many of the benefits from 

introducing choice derive from the competitive stimulus that choice applies to 

service providers. The benefits of competition have been discussed earlier in this 

report, and include improved resource allocation (allocative efficiency), an 

improved responsiveness of providers to user preferences, and sharper 

incentives for quality, productive efficiency and innovation (long-run efficiency). 

Providers offering a poor service will attract fewer customers and consequently 

fewer funds than those providing a superior service. The system consequently 

can give clear and direct feedback on the relative performance of a unit in a way 

that is not visible under a command-and-control system. This benefit can help 

solve the problem of a lack of comparable performance measures, which can be 

the case in the public sector. 35 Improving quality of public services is obviously 

of merit in itself, but may also lead to improvements in measured outcomes. For 

example, in the context of education, Hoxby (2003) notes that schools may be 

forced to issue more information in order to attract parents: better-informed 

parents are then likely to become better ‘customers’ with positive impacts on 

student performance. 

Demand-side benefits 


Even if the increase in competition created by a user-choice system is minimal, 

encouraging customer choice can improve allocative efficiency by revealing 

information that may not be immediately visible in a command and control 

system. For example, a centrally administered allocation of places may result in 

a suboptimal allocation of resources if it does not take individual preferences 

into account. As Bradley and Taylor (2002) note in the context of education, if 

parents and students have less control over their choice of school, there is a 

greater possibility of mismatch between student and school and therefore of 

poorer student performance. A system that involves a role for customer choice 

can help prevent this problem. 

35 Tirole, J. (1994) ‘The internal organisation of government’, Oxford Economic Papers 46. 

51


Empowering consumers by enabling them to exercise choice can be a goal in its 

own right, as in the case of choice-based lettings, which is examined in Part IV 

below. It may also lead to improvements in customer satisfaction. For example, 

having and exercising choice over primary care physicians has been associated 

with higher satisfaction with the care received. 36 Creating a sense of 

empowerment can also improve measured outcomes by creating incentives for 

individuals to assume some of the responsibility for outcomes themselves. 37 For 

example, in the case of education, a parent who has selected a particular school 

for their child is more likely to remain involved in the rest of the child’s education 

process than a parent who felt they had no choice at the outset. This in turn is 

likely to be associated with better student performance. 

Evidence 

The impact of user choice on efficiency and standards has been evaluated in a 

number of studies, particularly in relation to the supply-side effects of 

introducing competition between education providers. Many of these studies 

use evidence from experiments with voucher schemes for education introduced 

in various locations in the US. In these voucher schemes, each parent is given a 

voucher for the value of a child’s education, which can be given either to a state 

or to a private school. For example, the Milwaukee (Wisconsin) Parental Choice 

Program was introduced in 1989 and offered low-income families state support 

for tuition costs of private schools. Evidence since 1998 shows competition has 

had positive impacts on state schools. Hoxby (2003) finds that where 

competition was strongest, state school test scores are 8 percentile points higher 

in maths and languages and 14 percentile points higher in science relative to 

areas untouched by competition. The scheme was also designed to reduce 

inequality. Competition was increased most where there were more children 

from less well-off backgrounds as more students in these areas qualified for 

vouchers, and performance improved most where competition was strongest. 

APPLICATIONS 

Choice can be exercised in a variety of dimensions, including the quantity 

consumed, which provider delivers the service, and the type of product 

consumed. 38 Areas of public service provision into which consumer choice has 

been introduced include schools, health services and social housing. 

Educational Choice in the UK 

Since 1988, parents in England and Wales have been able to send their children 

to any school of their choosing, capacity constraints permitting. Improvements 

36 See Amyx, D., JC Mowen and R Hamm (2000) ‘Patient satisfaction: a matter of choice’, Journal of Services 

Marketing, 14, 7; Kalda, R., K. Polluste and M. Lember (2003) ‘Patient satisfaction with care is associated with 

personal choice of physician,’ Health Policy 64(1); Hsu, J., J. Schmittdiel, E Krupat , T Stein, D Thom, B Fireman 

and J Selby (2003) ‘Patient choice: a randomised controlled trial of provider selection’, Journal of General Internal 

Medicine, 18(5). 

37 See Osborne and Gaebler (1992) Op Cit. 

38 Where the good or service concerned can be horizontally differentiated. 

52

in outcomes are difficult to distinguish from other education reforms enacted 

during the period. However, Bradley and Taylor (2002) find evidence to suggest 

that standards improved more sharply where there was greater competition 

between schools. They estimate that a 3 per cent improvement in the 

performance of a secondary school’s competitors at GCSE level is associated 

with a 1 per cent improvement in the school’s own GCSE results, and find that 

new admissions are positively related to a school’s own performance and 

negatively to the exam performance of its competitors. Glennerster (2002) finds 

evidence that educational inequalities have narrowed under a system of choice, 

with the worse performing schools experiencing the largest improvements in 

students meeting target levels. 

Choice-based lettings 

The use of consumer choice in the provision of social housing in the UK is 

described as one of our case studies in Part IV. 



implementation issues can affect the success of consumer choice schemes: 

● capacity constraints; 

● inequality of access; 

● segregation; 

● information; and 

● incentives to over-consume. 


we summarise the main conclusions we have drawn from this evidence 

Capacity constraints 


The introduction of consumer choice is likely to lead to capacity constraints for 

those providers that are most popular with users. On the supply-side of the 

market, this problem can lead to the need for some form of rationing between 

consumers, reintroducing some element of command and control. One rationing 

mechanism is for the provider to ‘cream skim’ the most desirable consumers. For 

example, schools may decide to allocate places to the most academically able 

pupils. This cream skimming can allow the school to improve its apparent 

performance without increasing its actual performance. To some extent, the 

effect on apparent performance can be addressed if more sophisticated measures 

of performance are used (which adjust for differences in pupil intakes, for 

example). The problem can also be dealt with by specifying the rationing 

mechanism to be used. 

53


Capacity constraints can also influence outcomes through the demand-side of 

the market. Customers who are unable to exercise their right to choice due to the 

existence of capacity constraints may become despondent and consider the 

allocation process unfair. This will lead to reductions in customer satisfaction, 

and may reduce policy performance against other measures if, for example, it 

leads to customers disengaging from the processes concerned and ceasing to 

participate effectively. 

The underlying problem here is that supply does not expand to match increasing 

demand, as we would expect to happen in private-sector markets. To address 

this problem there would need to be some mechanism to ensure that investment 

decisions reflect information revealed by the consumer choice ‘market’ rather 

than being made in isolation from the scheme. 

Inequality of access 

Where consumer choice is introduced it may be that certain members of society 

(those who are wealthier or better educated) may be better able to exercise their 

right to choose. For example, those with better access to transport may find it 

easier to use a hospital or school of their choice. Depending on the 

circumstances, this may still be a better outcome than when consumers had no 

choice – which in the case of education can lead to the better schools being, in 

effect, reserved to those who can afford to buy houses near to the most 

desirable schools. The problem might be reduced by measures taken to improve 

consumers’ ability to choose: the provision of appropriate information and 

access to transport, for example. 

Inequality can be distinguished into inequalities of opportunity and outcome 

inequality. Inequalities of opportunity include better access to transport links, for 

example, and may give rise to inequalities in outcomes if those with better 

opportunities are able to use them to obtain a superior result. Inequalities in 

outcomes can arise between individuals or between geographical regions. 

Geographical inequality is more likely to occur when mobility is low and users 

are effectively locked into their local suppliers. This can allow the market to 

develop into sub-sectors of under-performing suppliers located in 

disadvantaged areas and excellent suppliers located in more advantaged areas, 

with users in disadvantaged areas unable to exercise their choice by switching 

to a better-performing provider. 

Segregation 

Introducing user choice can lead to an increase in segregation through both the 

supply and demand sides of the market. On the supply side, segregation may 

arise as a result of discrimination by providers. This problem is linked to 

the capacity constraint problems outlined above and can be limited using 

the same controls. On the demand side, increased segregation can occur either 

as a direct result of the exercise of choice by individuals of the same 

ethnic/working/educational background, or as an indirect result of any increase in 

54

inequality. Measures to limit increases in inequality can therefore be helpful in 

preventing further segregation. But direct controls, like quota systems, are likely 

to introduce other problems by reducing the amount of effective choice on offer. 

This suggests that a different market mechanism should be considered for cases 

in which segregation is both undesirable and likely to occur as a direct result 

of choice. 

Information 


For user choice to generate positive outcomes, consumers must be able to make 

rational decisions. They will be able to do so only if they posses sufficient 

relevant information in a language and format they will be able to understand. 

Even then, consumers must still be willing to bear the costs of collecting and 

analysing this information, which in some cases may be considerable. 

Information can impact outcomes through both the supply and demand sides of 

the market. On the supply side, service providers must face the correct 

incentives to provide appropriate information to all consumers. On the demand 

side, consumers must be willing to gather and process the information provided. 

The costs of introducing choice where consumers lack the necessary 

information or the ability to process it will be greatest for experience goods. 

These are goods where consumers only learn their actual quality after 

purchasing them, for example health care products. In the private sector, 

advertising can be used as a signal for quality to help prevent consumers making 

costly mistakes when purchasing such goods. Because consumers will make 

repeat purchases of goods only if they turn out to be of high quality, only high 

quality firms can generate sufficient revenue from advertising to make it 

compatible with a profit-maximising strategy. Consumers are aware of this, and 

therefore expect that an expensive advertisement campaign signals high 

quality. 39 However, the same is not true of the public sector, where funding is 

often independent of performance. Public sector providers must therefore 

develop alternative means of signalling quality, perhaps by providing more 

detailed information regarding historical performance. 

With credence goods, 40 the provision of trustworthy information becomes even 

more important. These are goods where the consumer cannot assess the quality 

of the product, even after consumption has taken place. For example, 

in healthcare services, a patient may recover following his doctor’s 

recommendations for other reasons and yet ascribe his recovery to the high 

quality service provided by his doctor. The ability of a consumer to make rational 

choices about credence goods is therefore limited even after they have 

consumed the good from that provider before. 

39 The concept of experience goods and the intuition behind advertising as a signal of quality was first developed 

by Nelson (1970, 1974). See Nelson, P. (1970) ‘Information and consumer behaviour’, Journal of Political Economy 

78 and Nelson, P. (1984) ‘Advertising as information’, Journal of Political Economy 82. 

40 The concept of the credence good was first introduced in Darby, M. and E. Karni (1973) ‘Free Competition and the 

Optimal Amount of Fraud’, Journal of Law and Economics 16. 

55


Incentives to over-consume 

Whilst rationing the availability of a public good or service can lead to problems 

of cream skimming and customer dissatisfaction, not rationing availability may 

also generate unfavourable outcomes. This will be the case when introducing 

choice creates incentives for individuals to consume more of the good or service 

than would be socially optimal. Some schemes have natural limits that can be 

applied to prevent this without restricting effective choice, for example allowing 

a child to be enrolled in a maximum of one school at any one point in time. In 

schemes where citizens can exercise choice over how much of a good or service 

they consume, however, this balance may be more difficult to strike. 

CONCLUSION 

Introducing user choice to public services can lead to improved efficiency, a 

more customer-responsive service, and confer a sense of empowerment on 

consumers. However, it can also have adverse consequences in terms of 

inequality and segregation, and outcomes may suffer if there are informational 

failures. Our case study on choice-based lettings evaluates the evidence on all of 

these issues, and looks at how user choice has been successful in the area of 

social rented housing despite binding capacity constraints. 

Marketable permits 

Marketable permits have been used in the environmental sector as a means of 

controlling pollution. In this system the total amount of pollution allowed is 

‘capped’ and property rights are assigned to would-be polluters. 

The theory behind marketable permits stems from Coase’s intuition that 

problems caused by externalities can be resolved, without government 

intervention, if there are no transaction costs. 41 Coase noted that there is always 

someone who benefits and someone who loses from any given externality. For 

example, a factory that pollutes a river may damage the livelihood of farmers 

living downstream. If the property rights of the factory and farmers are welldefined 

then the externality can be addressed by a transaction between them. For 

example, if the farmers have a right to clean water then the factory owner buys 

from the farmers a right to pollute (which is rational provided the benefit to the 

factory exceeds the cost to the farmers). Conversely, if the factory owns a right to 

pollute the farmers can pay it to stop polluting (which is rational in the opposite 

case where the cost of pollution to the farmers exceeds the benefit to the factory). 

41 Coase, R. (1960)’ The problem of social costs’, The Journal of Law and Economics 3. 

56

However, the conditions required for this sort of trade are very restrictive and 

include well-defined property rights, low bargaining costs, perfect competition, 42 

perfect information and the absence of wealth and income effects. These 

conditions rarely hold in the real world. For example, although the source of air 

pollution may be easy to identify, the victims are likely to be numerous. 

Reaching a solution between many individuals will not be straightforward, and 

any solution may be vulnerable to ‘free rider’ problems: any individual could 

withhold his contribution, hoping that everyone else will contribute and he will 

benefit from their actions. Such a solution would therefore be difficult to enforce 

without government intervention. 

Nevertheless, the intuition that private sector agents can arrive at an equilibrium 

outcome through bargaining, whatever the initial assignment of property rights, is 

central to the idea of marketable permit schemes. 43 Under marketable permits, the 

government sets a limit to the total amount of pollution allowed, and then assigns 

permits to firms which give them the right to produce set amounts of the pollutant. 

Firms are then allowed to trade permits among themselves, so that those who 

pollute less than their quota can sell the remainder. Firms will therefore sell 

permits as long as the marginal cost of reducing pollution is less than the market 

price of the permit. In equilibrium, therefore, every firm will pollute at a level such 

that the marginal cost of pollution reduction equals the market price of the permit. 

BENEFITS 


Evidence suggests that this mechanism can achieve the desired objective with 

lower compliance costs and greater incentives for innovation than under the 

command-and-control alternative. 44 The use of marketable permits offers two 

main benefits compared with non-tradable quotas. These are that it allows 

pollution to be reduced at the lowest cost and that it allows the market to 

determine the appropriate price for pollution. 

42 Perfect competition is required for an efficient outcome to obtain that is independent of initial property right 

allocations. If one party to the trade enjoys bargaining power as an extension of market power, for example, an 

inefficient agreement is likely to be reached. Coase (1960) argued that assuming zero transactions costs was a 

suitable proxy for perfect competition, but this assumption does not preclude the existence or exercise of such 

bargaining power. Furthermore, firms operating in anything other than a perfectly competitive market will not 

necessarily face the same incentives to reduce inefficiency and are therefore unlikely to exhaust the entire gains 

from trade. 

43 Montgomery, D. (JET, 1972) ‘Markets in Licenses and Efficient Pollution Control Programs’, Journal of Economic 

Theory 5. 

44 Incentives for innovation are likely to be stronger than under a direct control or technological standard approach 

because firms can expect to keep some or all of the gains from innovation in the form of reduced abatement 

costs and payments for permits. For example, Burtraw (2000) looks at how the sulphur dioxide allowance market 

in the US affected the nature and pace of innovation. He finds evidence that the incentives and flexibility 

provided by the scheme led to organisational innovation at firm, market and regulatory level as well as process 

innovation by electricity generators and upstream fuel suppliers. 

See also Downing, P. and L. White (1986) ‘Innovation in Pollution Control’, Journal of Environmental Economics 

and Management 13(1); Jung, C, K.Krutilla and R. Boyd (1996) ‘Incentives for Advanced Pollution Abatement 

Technology at the Industry Level: An Evaluation of Policy Alternatives’, Journal of Environmental Economics and 

Management 30(1); Milliman, S. and R. Prince (1989) ‘Firm Incentives to Promote Technological Change in 

Pollution Control’, Journal of Environmental economics and Management 17(3). 

57


Pollution can be reduced at the minimum cost 

Stavins (2001) notes that imposing a blanket reduction across all firms may force 

some firms to control pollution through unduly expensive means. 45 Typically the 

cost of controlling emissions varies greatly among firms, and so the appropriate 

technology in one instance is likely to differ from others. Market-based 

instruments allow the desired environmental outcome to be attained at the 

lowest cost to society by providing incentives for the greatest reductions in 

pollution to be made by those firms that can achieve reductions most easily. This 

is achieved without the government having to obtain information regarding 

firms’ compliance costs. 

Rapid discovery of the appropriate price 

By contrast with a system of taxes (discussed below) tradable permits allow a 

market mechanism to be used without incurring a risk of excessive pollution 

through the setting of too low or too high a tax level. Permits can be set at a 

fraction of current pollution levels or current production levels: the latter formed 

the basis of the successful acid rain program in the US, as it avoided penalising 

those firms that had already invested more heavily in pollution reduction. 

EMPIRICAL EVIDENCE 

The benefits of marketable permits in reducing pollution at the lowest cost have 

been largely confirmed by empirical research. 

Carlson, Burtraw, Cropper and Palmer (2000) assess the impact of the market for 

transferable sulphur dioxide emission allowances among electric utilities 

introduced in the US by the 1990 Clean Air Amendments using econometric 

estimates of marginal abatement cost functions for affected power plants. 46 They 

find that technical changes and lower input prices were the main sources of cost 

reduction rather than trading per se, but that in the long run allowance trading 

may still result in annual cost savings of $700-800 million relative to a command 

and control alternative. They compare potential cost savings in 1995 and 1996 

with actual emissions costs, and find that most gains from trade were unrealised 

for the first two years of the program. 

Although potential savings were not realised in the early stages of this 

programme, research suggests that an efficient market for the trading of sulphur 

dioxide permits was nonetheless able to develop. Joskow et al (1998) find close 

alignment of permit prices and significant volumes of trade after 1994, 

suggesting the operation of a relatively efficient market. 47 They also note that the 

45 Stavins, R. (2001) ‘Lessons from the American Experiment with Market-based Environmental Policies’, RFF 

discussion paper 01-53. 

46 Carlson, Burtraw, Cropper and Palmer(2000) ‘Sulphur dioxide control by electric utilities: what are the gains from 

trade?’, RFF discussion paper 98-44-REV. 

47 Joskow, P, R. Schmalensee and E. Bailey (1998) ‘The Market for Sulphur Dioxide Emissions’, The American 

Economic Review 88(4). 

58

annual EPA auctions were successful in bringing parties to the market and 

helping to establish a range of market valuations, prerequisites for the 

development of private market trading activity. 

Newell and Rogers (2003) assess the US tradeable permit scheme for reducing 

lead in gasoline. In this scheme in the 1980s, permits for lead levels were 

assigned to refineries that could either trade these between themselves or ‘bank’ 

them for later use. 48 They conclude that the program was effective in meeting 

environmental objectives, and that allowing permit banking contributed to the 

speed with which these objectives were obtained. The market-based program 

provided incentives for more efficient adoption of lead-removing technology 

relative to a uniform standard, and thereby minimised the costs of the lead 

phase down. 

Although the potential for cost savings is substantial, the extent to which these 

have been realised varies widely across different schemes, suggesting that 

design is critical to success. Hahn (1989) assesses the evidence on experience 

with marketable permits in this light and finds that the capacity to monitor and 

enforce a scheme can dramatically affect its performance. 49 Where monitoring is 

easy within the existing regulatory infrastructure and there is agreement from 

the outset about the allocation of property rights, realised cost savings will be 

closer to their theoretical potential. These features characterised the lead permit 

trading programme in the US, which enjoyed a high level of trading activity and 

savings in excess of $228 million from the permit banking rule alone. This 

performance is in contrast to the Wisconsin Fox River water permits scheme, 

which saw only one trade during the first six years of operation and therefore 

minimal cost savings despite the potential for $7m per annum. Savings from the 

US emissions trading programme have amounted to billions of dollars, but they 

have arisen mainly from the internal trading of permits. Increased external 

trading would lead to greater savings still, but is discouraged by high 

transactions costs. 

APPLICATIONS 


Marketable permits have been used mainly in the field of pollution control. In 

this system, a limit is set on total emissions levels. This level can then be altered 

over time to meet the required emissions target. This system has been used in 

a number of different environmental control schemes since the 1970s. 

During the 1970’s, the Environmental Protection Agency (EPA) in the US, in 

compliance with the Clean Air Act of 1970, set standards to protect public health 

for ozone, sulphur dioxide, lead, particulate matter, nitrogen dioxide and carbon 

monoxide. It designated metropolitan areas that did not comply with these 

48 Newell, R. and K. Rogers( 2003) ‘The market-based lead phasedown’, RFF discussion paper 03-37. 

49 Hahn, R. (1989) ‘Economic Prescriptions for Environmental Problems: How the Patient Followed the Doctor’s 

Orders’, Journal of Economic Perspectives 3(2). 

59


standards as ‘nonattainment areas’ and established the set of technology and 

performance standards for a variety of emission sources. In the late 1970’s, in 

order to provide some flexibility in reducing emissions, the EPA introduced a 

trading policy. The scheme delivered some benefits but also demonstrated some 

design problems that limited the cost savings with little volume of external 

trading. 

In 1994, the Southern California Air Quality Management District, in response to 

the increasing cost of air quality regulation, and the inefficiency of the thencurrent 

system of trading rules, began a tradable permit system known as 

Regional Clean Air Incentives Market (RECLAIM). RECLAIM was designed to 

reduce emissions of nitrogen oxides or sulphur oxides. The program has been 

successful in reducing emissions in a cost-effective manner and ozone standard 

violations in 1998 were roughly two thirds fewer than in 1980, and half the 

number in 1993. 

In 1990, the Clean Air Act Amendments directed the EPA to design a tradable 

system for Sulphur Dioxide (SO 2 ). The programme was designed to counteract 

acid deposition, also known as acid rain, which can acidify lakes, resulting in fish 

kills, reduce alkalinity of forest soils harming tree species and degrade various 

ecosystems functions. Additionally SO 2 is also associated with respiratory 

problems. The program allocated permits based on the product of a common 

emissions performance standard and historical utilisation, although a small 

percentage was auctioned in the Chicago Board of Trade. The SO 2 market has 

had very active participation and resulted in substantial cost savings. 50 

A recent example of the use of such market mechanisms is the UK Emissions 

Trading Scheme, which aims at reducing the emissions of greenhouse gases, 

which are believed to cause global warming. This program is examined in Part IV. 



implementation issues can affect the success of marketable-permit schemes: 

● the initial allocation of property rights; 

● location problems; 

● market liquidity; and 

● market power. 


we summarise the main conclusions we have drawn from this evidence. 

50 Chairman of the Council of Economic Advisors (2000), Making Market Work for the Environment, Economic 

Report of the President, Chapter 7. USA 2000. 

60

Initial allocation of property rights 

Economic theory suggests that property rights should be allocated through an 

auction, rather than based on historic levels of pollution, although it appears that 

in practice rights have not been auctioned. An auction is likely to raise the cost 

of pollution, encouraging greater reductions in emissions from the outset. It also 

provides revenues that can be used to reduce other more distortionary taxes and 

so improve economic efficiency. However, over time an allocation based on 

historic emissions will provide firms with permits which have an opportunity 

cost (the value that can be earned by selling them in the market) and this will 

provide incentives to reduce emissions at the margin. 

Location problems 

For some types of pollution, emissions will have different impacts depending on 

their location. Emissions by firms in areas where there are few other polluters 

may have a lesser environmental impact than emissions by firms located in a 

region with many other polluters. Pollution targets for emissions trading are 

typically set by reference to the level of pollution that would be appropriate at an 

aggregate level. This approach can lead to localised pollution problems 

emerging even when national targets are met, if there are areas where polluters 

concentrate their activities or where pollution has a greater environmental 

impact. In these circumstances it may be desirable to introduce caps at a local or 

regional level rather than at a national or international level. However, this can 

affect the liquidity of the resulting market by limiting the number of participants. 

Liquidity 

A well-functioning, liquid market in permits is more likely to develop where there 

are a larger number of participants. Where possible, permits of different kinds 

should be exchangeable, so that they can be traded in the same market. This 

approach is possible where the relative impacts of different types of emissions 

can be easily compared (different types of greenhouse gases, for example) but 

is more difficult where their relative impacts are difficult to compare (emissions 

into individual rivers, for example). A well functioning market will also require a 

well developed infrastructure, including exchanges, brokers and available price 

information, for example. 



Market power problems can arise in two ways. First, firms may hoard permits in 

order to exclude potential entrants in the same industry. This problem is most 

likely to occur where permits are ‘grandfathered’: so that permits are allocated 

to existing producers in proportion to their existing production. This method of 

allocation favours existing producers over new entrants, since a new entrant has 

to purchase permits from market incumbents. In principle, an incumbent should 

be willing to sell its permits to any more-efficient new entrant. However, if the 

incumbent possesses market power that might be undermined by the new 

entrant, it may have an incentive to refuse to sell permits to this new entrant. 

61


Market power problems are less likely if permits are sold in an auction rather 

than grandfathered. 

Even if permits are allocated through an auction, however, market power 

problems can still arise. For example, one firm might outbid others in order to 

obtain enough permits to monopolise its product market. This outcome can be 

avoided if safeguards are included in the allocation process, which might involve 

limits on the proportion of permits that can be allocated to any individual firm. 

This problem is also less likely to occur where the scheme involves participants 

across several industries (and hence economic markets) so that new entrants to 

one market can purchase permits from firms operating in other markets. 

Second, firms may hoard permits in order to manipulate the market for the 

permits themselves. Economic theory suggests that it may be rational for firms 

to attempt to corner the market in this way. As with issues of liquidity, this risk 

can be reduced by maximising the size of scheme across emission types and 

geographic boundaries. 

CONCLUSION 

Marketable permits can allow government to limit the level of a negative 

externality to a socially desirable level with lower costs and greater incentives for 

innovation than alternative methods of regulation. Our case study of the UK 

emissions trading scheme looks at how a system of marketable permits has been 

implemented in practice, the impact this has had on the cost efficiency with which 

emissions reductions have been achieved, and the extent to which the potential 

problems described above arose in practice and how they were dealt with. 


Marketable permits are one method by which externalities can be corrected for. 

In the case of marketable permits, the government sets the total quantity 

allowed of the negative externality and then lets the market determine the price. 

An alternative method is for the government to set the price, and allow the 

market to determine the quantity. The government can set a per-unit tax in the 

case of a negative externality, 51 or a subsidy in the case of a positive externality. 

The aim is to change the market price to reflect social costs and benefits and so 

to encourage an optimal level of production. 

WHAT ARE THE BENEFITS OF THIS SYSTEM? 

The benefit of per-unit taxes and subsidies are that they may align private and 

social interests more closely so that users pay close to the ‘true’ cost. However, 

as we noted earlier, considerable information with regard to the right level of the 

tax is required. 

51 Or a subsidy for reducing the externality. 

62

Due to the negative externality, these taxes can provide a source of public 

revenue that is likely to be less distortionary than existing taxes. 52 In fact, Terkla 

estimates that revenues from an effluent fee charged on particulates and sulphur 

oxide emissions would provide substantial efficiency gains of up to $3.05 billion 

(in 1982 US dollars) if substituted for either federal individual income tax or 

corporation income tax. 53 

APPLICATIONS 

Unit taxes in the form of effluent fees have been employed to regulate water quality 

and noise pollution in Europe. However, their goal has largely been to raise money 

to finance projects for water quality management rather than to regulate optimal 

effluent discharge. Evidence from the Netherlands, however, suggests that fees 

have had a measurable effect on reducing emissions. For example, Bressers (1983) 

and Brown and Bressers (1986) use econometric techniques to find that firms have 

responded to fees by cutting back significantly on discharges of water borne 

pollutants. 54 Although a command and control situation would also have reduced 

pollution, the benefit of the taxes and subsidy system is that the cost of the 

pollution is internalised and the market adjusts to find the optimum level of output. 

WHEN ARE TAXES PREFERABLE TO MARKETABLE PERMITS? 


In a world of perfect information and certainty, tradable permits and taxes would 

have identical effects on emissions abatement and costs. 55 In the real world, 

however, uncertainties about costs and benefits can influence which approach is 

preferred. For instance, in cases where a small increase in the level of emissions 

could result in a large decrease in benefit a tradable permit approach may be 

preferred. In cases where the cost of achieving a given emissions level is 

uncertain the charge approach may be preferred. 56 

52 Lee, D. and Misiolek, W. (1986) ‘Substituting Pollution Taxation for General Taxation: Some Implications for 

Efficiency in Pollution Taxation’, Journal of Environmental Economic Management 13(4). 

53 Terkla, D. (1984) ‘The Efficiency Value of Effluent Tax Revenues’, Journal of Environmental Economic 

Management 11(2). 

54 Bressers, H. (1983) ‘The Effectiveness of Dutch Water Quality Policy,’ Mimeo, The Netherlands: Twente University 

of Technology. 

Brown, G. and H. Bressers (1986) ‘Evidence Supporting Effluent Charges’, Mimeo. The Netherlands: Twente 

University of Technology. 

55 Using taxes to address environmental externalities leads to an efficient level of pollution abatement, which can 

occurred at the lowest marginal cost. Baumol,W.J.(1972) ‘On taxation and the Control of Externalities’, American 

Economic Review 62 (3). 

56 See for instance Stavins, R. (2001) ‘Lessons from the American Experiment with Market-based Environmental 

Policies’ RFF discussion paper 01-53: and Chairman of the Council of Economic Advisors (2000), Making Market 

Work for the Environment, Economic Report of the President, Chapter 7. USA 2000 

63


Marketable permit schemes share many features with environmental taxes. 

However, there are two main differences: 57 

a. taxes fix the value assigned to pollution but leave the quantity undetermined, 

while trading schemes fix the quantity and leave the value to be determined 

by the market; and 

b. the distributional consequences can vary depending how permits for trading 

schemes are allocated. 

In cases where there is a choice between using a tax or tradable permit scheme, 

the choice between the two options will depend on the goal of the policy to be 

implemented and a cost-benefit analysis of each option. In other words and as 

stated by HM Treasury: 58 

a. Is it essential to bring pollution down to a set quantity or is it the aim to 

internalise the known externality? 

In the former case a tradable permit scheme may be preferred, in the latter a 

per unit tax. 

b. What is the relationship between the marginal benefits of reducing emissions 

and the marginal cost of abatement? 

If this relationship is very uncertain, a tradable permit scheme may be 

preferred, as it allows the price to be determined by the market. A per unit tax 

could result in too great or too low a level of pollution abatement. 

c. Can a trading scheme be implemented at a reasonable cost and is there likely 

to be a well-functioning market in permits? 

If the answer is no, a marketable permits scheme is unlikely to given an 

optimal result. 



implementation issues can affect the success of taxes and subsidies: 

● existing market failures; 

● measurement of emissions; 

● determining the appropriate tax rate; and 

● problems specific to subsidies 


we summarise the main conclusions we have drawn from this evidence. 

57 Cabinet Office (2002), The Energy Review, available at 

http://www.number-10.gov.uk/su/energy/TheEnergyReview.PDF. 

58 HM Treasury (November 2002) Tax and the environment: using economic instruments, available at: 

http://www.hm-treasury.gov.uk/media/D54/07/adtaxenviron02-332kb.pdf. 

64

Existing market failures 

If an existing market failure, in addition to the externality, exists, the use of a tax 

may fail to maximise social welfare. For example, in an industry with a 

monopoly supplier we would expect (everything else being equal) output to 

already be lower than the socially optimal level. Where we have both a pollution 

externality and monopoly power it will not be clear whether existing output is 

above or below the socially optimal level. In the latter case a pollution tax would 

reduce output further below the socially optimal level. In the presence of market 

power it may therefore be appropriate to have a lower tax, or no tax at all. 

Measuring emissions 

Where a tax is used to control pollution it will be necessary to accurately 

measure emissions. Where measurement is not feasible it may be possible to 

use a proxy measure, such as an input associated with the relevant pollutant – 

coal could be used as a proxy for SO 2 emissions, for example. The use of such 

proxies can reduce measurement and enforcement costs, but can also reduce 

the efficiency of the tax. The tax might fail to provide incentives to use 

technologies which reduces the level of emissions per unit of input, for example. 

The appropriate tax rate 

Calculating an appropriate tax rate would in theory require accurate information 

on the marginal cost to society of the externality that is taxed. In practice this 

information is unlikely to be known, which may suggest that a marketablepermit 

system might be more appropriate. Where a tax is used it will be 

necessary to adjust its level form time to time to reflect the effects of inflation 

and economic growth – a process which occurs automatically through changes 

in market prices under a marketable-permit scheme. 

Subsidies 

Subsidies raise many of the same issues as taxes. In addition, where a subsidy 

is used to reward reductions in a negative externality by increasing the quantity 

consumed of a substitute good (reductions in pollution, for example) there is a 

risk that the subsidy will encourage new entry into the industry, thereby 

increasing the overall level of the externality. For this reason, a tax is likely to be 

more effective at reducing a negative externality. 

CONCLUSION 


Taxes and subsidies can be a more efficient means of achieving a desired level 

of externality than direct regulation. They may be preferable to a marketable 

permit scheme where uncertainty surrounding the cost of externality reduction 

means that setting the wrong quantity of permits could have significant and 

undesirable economic impacts. However, they can also drive the economy 

further from the socially optimal outcome when other market failures are 

65


present, and may be difficult to implement if there are problems measuring the 

externality or in determining the appropriate tax rate. No case study was 

conducted for this particular market mechanism. However, available 

international evidence on the above issues is set out in Part V. 

Opening-up access to natural monopolies 

Natural monopolies occur when it is cheaper for a single firm to produce for the 

entire market than to have several competing firms. A natural monopoly exists 

when there is great scope for economies of scale to be exploited over a very 

large range of output. Indeed the scale of production that achieves productive 

efficiency may require that a single firm services a high percentage of the total 

market demand for the product. 

Natural monopolies tend to be associated with industries where there is a high 

ratio of fixed to variable costs. For example, the fixed costs of establishing a 

national distribution network for a product might be enormous, but the cost of 

supplying extra units of output may be very small. In this case, the average total 

cost will continue to decline as the scale of production increases, because fixed 

(or overhead) costs are being spread over higher and higher levels of output. 

In the recent past, telecommunications, electricity, railways and water provision 

have all been considered as natural monopolies. In each of these sectors there 

is an element of the industry that is inefficient to duplicate. For example, the 

existence of several companies supplying the same area would result in an 

inefficient multiplication of cables, transformers, pipelines, transmission 

systems etc. However, in each case there are other elements of the industry 

where competition is possible. Although it may be inefficient to have more than 

one national grid, it is efficient to have several different generation firms. 

Similarly, although economies of scale make it implausible to have competing 

telecoms companies physically connected to each individual house, competition 

is possible in calls, or in the core backbone. By allowing access to the natural 

monopoly element at regulated terms, it is possible to have competition in the 

other areas. For example, if all generators can obtain access to the national grid 

at an appropriate price, then competition is made possible in generation. 

BENEFITS 

The benefits of regulating access is that if the natural monopoly element can be 

isolated from other elements, then competition can work in the other areas. This 

means that these other areas can benefit from the discipline of market forces, 

including incentives for efficiency, reducing the total cost of provision and a 

greater responsiveness to customer needs. This system has been used in 

telecoms (local loop unbundling allows rival operators access to the ‘last mile’ 

connecting customers to their local exchange), electricity (where access to the 

national grid has to be provided on regulated terms), railways (where ownership 

66

of the track is separated from operating the trains), and gas (where the gas 

network is separated from retail supply). 

Studies of these industries have founded that this isolation of the natural 

monopoly from other elements has resulted in significant improvements in 

efficiency compared with government ownership. Littlechild (2003) found that, 

taken together, restructuring, competition and private ownership enabled a 

nearly 50 per cent increase in output of the UK nuclear programme. 59 

A social cost-benefit analysis of the restructured and privatised England and 

Wales electricity industry by Newbery and Pollitt (1997) reveals that social 

benefits amounted to a permanent reduction in costs of six per cent compared 

to the counterfactual. 60,61 The tangible benefits of restructuring in England and 

Wales provide a stark contrast to the performance of the Scottish privatisation 

program. Pollitt (1999) performed a social cost-benefit analysis of the Scottish 

electricity generating companies and finds negligible benefits. 62 He suggests that 

this is due to the lack of restructuring. This finding highlights the fact that the 

change of ownership of assets is not by itself a guarantee that efficiency will 

improve: competition is also required. 

APPLICATIONS 


Regulating access is only an appropriate solution in a limited number of cases 

where, without such access, competition is unlikely to be possible. In practice, 

these cases have also tended to be where the natural monopoly was not 

developed through competition or investment but through the privatisation of a 

former state monopoly. This has been the case in each of the examples listed 

above (gas, telecoms, electricity, railways etc). 

As we noted earlier, it is important that the use of regulated access is severely 

restricted as otherwise there is a risk that firms who have legitimately invested 

in an industry see the benefits of their innovation shared with competitors. If 

access to infrastructure is granted too easily, then there is no incentive for rival 

producers to develop their own infrastructure, so competition and innovation 

may diminish. 

59 Littlechild, S. 2003. ‘Reflections on incentive regulation’ Review of network economics 2 ( 4). 

60 Newbery, D. and Pollitt, M. (1997) ‘The restructuring and privatisation of the CEGB- was it worth it?‘, Journal of 

industrial economics XLV(3). 

61 Newbery(2001). It should be noted that one difficulty in such studies is identifying what the effect would have 

been in the absence of deregulation, in other words defining the correct counterfactual. 

62 Pollitt, M. (1999) ‘The restructuring and privatisation of the electricity supply industry in Scotland’, Mimeo. 

67



The main implementation issues in providing access to natural monopolies are: 

● excessive intervention; 

● asymmetric information between the regulator and monopolist; and 

● the costs of regulation. 

The first issue arises because requiring access can reduce incentives for firms to 

invest in new assets. For this reason intervention has generally been limited to 

a small number of sectors, which in the UK are almost exclusively former 

nationalised industries. 

The second issue arises because the regulator will know less about the firm than 

its own managers. This issue can be particularly important in setting access 

charges and other terms and conditions, where asymmetric information can 

lead to the setting of sub-optimal access fees. It can also lead to the firm inflating 

its costs, particularly in the period immediately before any review of its access 

charges. 

The third issue is in part a consequence of the asymmetric information issue. 

That problem leads to the need for a well-resourced regulator and significant 

burdens on regulated firms in terms of the monitoring and reporting of 

information on costs and quality of services. This burden can create significant 

costs of regulation. The process of opening up access, which may involve the 

restructuring of businesses to separate monopoly from competitive functions 

and the introduction of new systems to facilitate open access, can also lead to 

one-off and ongoing costs. 

All these factors need to be balanced against the benefits of opening up markets 

to greater competition. 

CONCLUSION 

Opening up access can bring the benefits of competition in terms of incentives 

for efficiency and innovation to the non-natural monopoly elements of an 

industry. However, it can also reduce the incentives for the monopoly element to 

undertake investment, and asymmetric information may expose regulators to 

the potential for capture. The evidence outlined above suggests that in some 

industries, the resulting efficiency savings dominate the costs of regulation. 

However, ensuring the emergence of genuine competition in the contestable 

elements of the unbundled monopoly is crucial to realising the potential 

benefits, highlighting the importance of competition. This market mechanism is 

not considered in our case studies since there is already an extensive literature 

documenting the success of the mechanism, for example in the regulation of 

privatised network industries in the UK. 

68

Limitations on the use of market mechanisms 


When successfully implemented in an appropriate area, all of the market 

mechanisms outlined above can have beneficial effects for public policy. 

However, each of the mechanisms are also associated with potential pitfalls that 

must be addressed in the policy design. A failure to do so properly could result 

in the desired goal not being achieved, or being achieved to the detriment of 

another public policy objective. With this in mind, the case studies in Part IV 

provide illustrations of how the identified potential problems with each market 

mechanism have been addressed in practice. 

A particular market mechanism may be well suited to one area of public policy 

but completely inappropriate for another. For example, competitive tendering 

for core aspects of national defence would be impossible because of political 

and security considerations. Similarly, user choice could not be introduced to the 

provision of hospital accident and emergency services for obvious practical 

reasons. The case studies highlight these potential limitations for each market 

mechanism, and help to provide practical guidance regarding the areas of policy 

each mechanism is most likely to suit. 

Competition can yield substantial benefits for public policy but there are also 

significant financial and opportunity costs associated with the introduction of 

any market mechanism. For example, as we illustrate in our case study, each 

tendering process for a new private prison can cost around £1m in government 

resources. In the case of prisons, independent studies have suggested that these 

costs have been easily recouped through reductions in costs to the prison 

service. However, in other cases, the benefits may not outweigh the cost, or it 

may be difficult to find funding to meet the initial start-up costs. This issue is 

explored further in each of the case studies. 

69

SECTION 8 

Framework for assessing 

market mechanisms 

In Part IV of this report we examine a number of case studies in order to draw 

lessons on best-practice in the use of these mechanisms. In this section we set 

out a framework for analysing the performance of different market-based 

mechanisms. We focus on two issues: the choice of market-based mechanism 

and the implementation of that mechanism. 

The choice of market-based mechanism 

As explained in sections 5 and 6, policy makers designing public-policy 

interventions have to balance two factors. Market failure (or issues of equality) 

may provide a rationale for some form of intervention, but intervention may 

itself give rise to government failures that may outweigh the problem that 

intervention was designed to correct. This balance suggests two options: 

intervening in the expectation that government failure will not undermine the 

achievement of the policy objective, or not intervening on the basis that it is 

better to live with some degree of market failure rather than create even greater 

problems through public-sector intervention. As explained in Section 7, a third 

option is to use a market-based mechanism in order to minimise the 

government failure that might arise from intervention. 

It follows that, in assessing the performance of a market-based mechanism, 

there are two principal situations to use as a comparison: no intervention or 

intervention using some other mechanism. In practice, we assume that in the 

absence of a market-based mechanism the government would still have wished 

to intervene in the areas we are studying (for example, because intervention had 

already been taking place before the market-based mechanism was adopted) so 

the appropriate counterfactual is one where the government intervenes using a 

more traditional command-and-control mechanism. In the case studies below, it 

is possible to identify an alternative method of intervention that has been used 

in the past to achieve the same or a similar policy objective, and we use that as 

the basis of our comparison. 

In the case studies we therefore compare the market-based mechanism with the 

mechanism that had previously been used in the same or a similar area. 

70

Implementation issues 

A further comparison that can be made is between the scheme as it was 

implemented and what might be termed an ‘optimal’ public-policy intervention. 

In section 7 we identified a number of issues that arise in the implementation of 

specific market-based mechanisms. These issues have been suggested by the 

academic literature on the use of market-based mechanisms and previous 

experience of their use. In the case studies we consider the implementation 

issues associated with specific market-based mechanisms. These issues are 

specific to the mechanism under consideration (although there may be some 

overlap between different mechanisms). In Part II we made general 

recommendations on how policy makers might best deal with these issues and 

implement the chosen market mechanism in practice. 

Summary 

Section 8 – Framework for assessing market mechanisms 

The case studies in Part IV are designed to provide practical illustrations of the 

theory developed in this literature review. They have been selected to cover a 

range of different mechanisms used in different economic and policy contexts. 

Each study looks at the policy goal the market mechanism was designed to 

deliver and the problems with previous methods of intervention that motivated 

the introduction of market forces. We describe the way in which each 

mechanism was introduced and, with reference to theoretical predictions, we 

look at the extent to which scheme design has been successful in capturing 

potential benefits and avoiding potential problems. We also consider 

implementation issues and conclude in each case by drawing lessons that could 

be helpful for policy makers considering the use of this particular mechanism. 

71

Part IV 

Case Studies 

73

SECTION 9 

Competitive Tendering 

of Prisons 

Introduction 

Competitive tendering refers to the process of inviting a number of organisations to 

prepare proposals to deliver a particular good or service, and subsequently 

evaluating these proposals against criteria such as price and quality. This case study 

examines the introduction of competition to prison services in the UK through 

contracting out and market testing, two different types of competitive tendering. 

Competition was first introduced to prison services in 1991 by contracting out the 

management of a new prison centre to a private sector provider through competitive 

tender. Since 1994, the scope for private sector involvement has been extended to 

include the design, construction and finance of new prisons. In 2001, market testing 

was introduced for underperforming publicly managed prisons. 63 

The competitive tendering of prison services provides an example of how to 

manage outsourcing in situations where the quality of the service, as opposed 

to price alone, is also important and not readily observed. In this case study, we 

first provide a background description of the market, including supply and 

demand conditions. We then discuss the perceived failings that led to the 

introduction of a market-based mechanism, and why the particular marketbased 

mechanism was chosen. The next section examines the potential 

problems with this market mechanism and how these problems were 

addressed. In the final section we provide an overall assessment of the policy. 

This case study draws on the following sources: 

● an interview with David Kent, Head of the Office of Contracts and 

Competitions at the National Offender Management Service (NOMS); 

● the CBI report on the effects of competition in the prison service; 64 

● the National Audit Office (NAO) report on the operational performance of 

private prisons; 65 

● a case study by •econ assessing the impact of prison service procurement on 

competition; 66 

63 Under ‘market testing’ the management of existing prisons is placed out to competitive tender and bids are 

invited from the current team and from outside suppliers. This differs from the initial contracts which were for 

new rather than existing prisons. 

64 CBI (2003), Competition: a catalyst for change in the prison service. A decade of improvement, available at 

http://www.gslglobal.com/downloads/CBI_report.pdf. 

65 National Audit Office (2003) The Operational Performance of PFI Prisons, London: The Stationery Office, available 

at http://www.nao.org.uk/publications/nao_reports/02-03/0203700.pdf. 

66 Econ (2004), Assessing the impact of public sector procurement on competition, Volume 2: case studies, Prepared 

for the Office of Fair Trading. 

74

● the Green and White papers behind the introduction of the policy; 67 

● the Competition Commission report on the acquisition by Group 4 Falck 

(Group 4) of The Wackenhut Corporation (TWC) in 2002; 68 and 

● an interview with a Director of Business Development at an operator of 

several private prisons. 

Market Background 

Section 9 – Competitive Tendering of Prisons 

The market in this case study is the building and management of prisons 

designed for the custody and rehabilitation of adults convicted of criminal 

offences, which we call ‘prison services’. 

The public sector is the only buyer of prison services in the UK, and purchases 

these through Her Majesty’s Prison Service (HMPS) in England and Wales, the 

Scottish Prison Service (SPS) in Scotland and the Northern Ireland Prison 

Service (NIPS). Because there is only one privately run prison currently 

operating in Scotland, 69 and no prison centres in Northern Ireland have been 

contracted out to date, this study focuses on HMPS and the market for prison 

services in England and Wales. 

Procurement of prison services in England and Wales can be for: 

● Management-Only (MO) contracts. These are contracts for the management 

of newly-built, re-built or existing prisons; or 

● Design, Construction, Management and Finance (DCMF) contracts. These are 

integrated contracts for the provision and management of new prisons, 

including their design, construction, management and finance. 

There have been no contracts to date in which the design, construction and 

finance elements were tendered separately from the management component. 

The Prison Service considers such contracts unlikely as the design of a prison 

can make it much easier to run. In particular, modern prisons are designed to 

accommodate more recreational and educational facilities than are available in 

Victorian prisons. This approach leads to synergies in design and management. 

Each prison under private management is appointed its own controller, who 

confirms the number of prisoner places available and monitors the operation of 

the centre. The Chief Executive of the National Offender Management Service 

67 Green Paper (1988) Private Sector Involvement in the Remand System, Cm 434, London: The Stationery Office; 

and White Paper (1990) Crime, Justice and Protecting the Public, Cm 965, London: The Stationery Office. 

68 Competition Commission (2002) Group 4 Falck A/S and The Wackenhut Corporation: A report on the merger 

situation, available at http://www.competition-commission.org.uk/rep_pub/reports/2002/471group4.htm. 

69 The reconstruction of a public sector prison, Low Moss, is also underway in Scotland. 

75


(NOMS) also has direct responsibility for private prisons, including the 

assessment of their performance and the review of contracts. 70 

Policy history and timetable 

The introduction of private provision of prison services has been achieved 

through two Acts of Parliament governing private sector prisons in England and 

Wales: the Criminal Justice Act 1991 and the Criminal Justice and Public Order 

Act 1994. The 1991 Criminal Justice Act allows for private firms to be involved in 

the provision of prison services, and led to the contracting-out of the 

management of newly constructed prisons. In the same year invitations to 

tender were issued to potential contractors for the new Wolds prison. The fiveyear 

MO contract was won by Group 4, and the prison opened in 1992. 

The Private Finance Initiative (PFI) was proposed in 1993 as an alternative means 

of raising capital to invest in the provision of public services. In 1994 the Criminal 

Justice and Public Order Act enabled prisons to be provided under the PFI, 

extending the role of the private sector to include the design, construction and 

financing of new prisons. The PFI coincided with a need for a programme of 

prison building due to increasing conviction rates and changing sentencing 

practices, for which no government capital was available. As a result, the first 

DCMF contract was offered for tender by the Prison Service in 1995. 

The first three MO contracts were for the management of new-build prisons only. 

Early plans to market test prisons led to a tender for the management of the 

newly rebuilt HMP Manchester, won by the in-house bid in 1994. The in-house 

team was awarded the first example of a Service Level Agreement (SLA), which 

is an agreement between what was formerly the Prison Service (now the Office 

of Contracted Prisons. or OCP) and an individual public sector prison stating the 

number of prisoners the prison will hold and specifying the standard of 

performance expected in return for a fixed budget. The Manchester SLA was 

designed to operate in a similar manner to a private sector contract. 

Market testing plans were suspended following a challenge by the Prison 

Officers’ Association, and legal concerns regarding underlying lease 

arrangements, but reintroduced in 1998 at the expiry of four MO contracts. Of 

the contracts subject to market testing, two were won by the in-house team 

leading to allegations of discrimination in favour of the public sector. These 

claims were investigated by the NAO but not upheld. However, as a result of the 

aborted Brixton prison market test (described below) the Prison Service 

introduced performance testing of publicly-run prisons. Performance testing 

gives underperforming prisons six months to produce an improvement plan 

without the involvement of external bidders. If the plan is accepted, the prison is 

awarded an SLA and if not, the prison is contracted out without an in-house bid. 

70 The National Offender Management Service (NOMS) oversees the management of offenders and is responsible 

for market testing and competitive tendering in prisons. 

76

A prison failing to deliver on its SLA will also be opened up to competition 

without an in-house bid. 

In 2003 a benchmarking programme was introduced for all prisons. Under this 

scheme, poorly performing prisons are subject to performance testing, and 

high-performing prisons may attract bonus payments and be awarded an SLA 

with operational and financial flexibility. Prisons falling in the middle range will 

be required to develop and implement improvement plans, which, if 

implemented successfully, will result in an SLA. Failure to improve will result in 

the prison being nominated as a candidate for performance testing. 

DEMAND 

The UK was one of the first countries, following the USA and Australia, to create 

a market for prison services by contracting out the management of certain 

prisons to the private sector. Since 1991, twenty-one contracts have been 

awarded in total, of which four were MO contracts and one an SLA re-tendered 

upon expiry. Competition for the management of Brixton prison, considered to 

be failing, was opened up in 2001 but no private contractor submitted a bid. 

There are currently eleven private sector prisons, and three market-tested SLAs. 

Tables 9.1 and 9.2 list tender dates for all MO and DCMF contracts. 

Table 9.1 

MO Contracts 


Tender Winning 

Prison(s) date Competitors bidder 

Wolds 1991 GSL, Securicor, UKDS, Mancare, Pricor, Burns, Serco, Securiguard, WCC. GSL 

Wolds 2001 GSL, Premier, HMPS, Burns. GSL 

Blakenhurst 1992 GSL, Premier, Securicor, Reliance, UKDS, Burns, Securiguard. UKDS 

Blakenhurst 2000 Premier, Securicor, UKDS, HMPS. HMPS 

Doncaster 1993 GSL, Premier, Securicor, UKDS, HMPS, Mancare. Premier 

Doncaster 1999 GSL, Premier, Securicor, UKDS, HMPS, Mancare. Premier 

Buckley Hall 1994 GSL, Premier, Securicor, HMPS, Mancare. GSL 

Buckley Hall 1999 GSL, Premier, HMPS. HMPS 

Manchester 1992/93 GSL, Premier, Securicor, UKDS, HMPS, Mancare, Securiguard. HMPS 

Manchester 2000 GSL, Premier, Securicor, UKDS, HMPS. HMPS 

Notes: All firms that submitted bids and not just short-listed bidders are included as competitors. 

Source: •econ report, Competition Commission (2002), HM Prison Service website (www.hmprisonservice.gov.uk). 

77


Table 9.2 

DCMF contracts 

Tender Winning 

Prison(s) date Competitors bidder 

Altcourse 1994/95 GSL, Premier, Securicor, UKDS, SCS. GSL 

Parc 1994/95 GSL, Premier, Securicor, UKDS, SCS. Securicor 

Lowdham Grange 1996 GSL, Premier, Securicor, UKDS, CSC, SCS, Cornell, Bobby Rose. Premier 

Bronzefield 1997 Premier, Securicor, UKDS. Premier 

Forest Bank 1997 GSL, Premier, Securicor, UKDS, CSC. UKDS 

Rye Hill 1998 GSL, Premier, Securicor, CSC. GSL 

Dovegate 1998 GSL, Premier, Securicor, CSC. Premier 

Ashford 2001 GSL, Premier, Securicor, UKDS, CSC. UKDS 

Peterborough 2001 GSL, Premier, Securicor, UKDS, CSC. UKDS 

Notes: ‘Competitor’ is defined as a firm that pre-qualified and submitted a bid. Not all competitors were short-listed. 

Source: •econ report, Competition Commission (2002), NOMS. 

SUPPLY 

The majority of UK prison services are self-supplied by HMPS. There are 

currently four private firms supplying prison services in the UK: 

● Group 4 Securicor, an international security services company formed from 

the merger between Securicor Plc and Group 4 Falck A/S’s security business, 

completed in July 2004. Group 4 Securicor is listed on the London Stock 

Exchange, with a secondary listing in Copenhagen. 

● GSL, a UK-based firm providing security and other support services in the 

UK, South Africa and Australia. Following the de-merger and divestment of 

Group 4 Falck A/S in May 2004, GSL is now owned by private equity investors 

Englefield Capital and Electra Partners Europe. 

● Premier, owned by Serco, a UK company listed on the London Stock 

Exchange. Previously a 50:50 joint venture between Wackenhut Correctional 

Corporation (WCC) and Serco, it has been owned and managed solely by 

Serco since Group 4 sold its shares in WCC in 2003. 

● UKDS, a subsidiary of Sodhexo Alliances SA, a French company listed in 

Paris. 

All have an international presence and supply services to governments in other 

countries. Between them, these four companies currently manage eleven 

different contracts listed in Table 9.3. 

78

Table 9.3 

Companies providing prison management services in the UK 

Source: •econ report, Group 4 Securicor website 

There are 17 firms providing prison-management services globally, of which 

only six currently operate outside of the US. 71 

Introduction of a market mechanism 

PERCEIVED FAILING 


Firm MO contract DCMF contract 

Group 4 Securicor Parc 

GSL Wolds Altcourse 

Buckley Hall (until 1999) Rye Hill 

Premier Doncaster Lowdham Grange 

Ashfield 

Dovegate 

UKDS Blakenhurst (until 1999) Forest Bank 

Ashford 

Peterborough 

Outsourcing was introduced into prison services in the 1980s. Changes in 

sentencing practice in the 1980s led to a growth in the prison population that 

public-sector capacity at the time was unable to meet. There was also a belief 

that the public sector was inefficient and that private-sector provision would 

allow for the cost-efficient expansion of capacity. A feasibility study into privatesector 

involvement in prison services was carried out by the House of Commons 

Home Affairs Committee (the ‘Committee’). The Committee identified problems 

in the prison service including the age of prisons, the state of over-crowding, 

sanitary conditions and the slow pace of modernisation. 72 

In 1987 the Committee visited the US to report on the effects of private-sector 

involvement in prison management there. The Committee recommended that 

the Home Office experiment with contracting out management of new prisons in 

order to meet the demands of a growing prison population. A study was then 

carried out assessing the feasibility of introducing private-sector provision in 

prison management. This study concluded that the private sector could be used 

to increase the number of available prison places whilst delivering cost 

efficiency and spurring innovation. 

As noted in Part III, private sector providers are motivated by profits and so have 

a stronger incentive to reduce costs than their public sector counterparts. Private 

sector providers also face sharper incentives to innovate because they are able 

71 Data from http://web.crim.uft.edu/pcp/census/2001/Market.html 

72 House of Commons Home Affairs Committee (1987) Contract Provision of Prisons, London: The Stationery Office. 

79


to capture the returns to a successful innovation in the form of greater profit. 

Public sector providers on the other hand often face a reduced budget if they 

reduce costs or innovate successfully, and are therefore less likely to do so. They 

may also be more constrained in their ability to innovate, for example because 

of restrictions on firing or rewarding employees. 

Acting on the Committee’s recommendations, the Government published a 

Green Paper in 1988 entitled ‘Private Sector Involvement in the Remand 

System’. The Green Paper concluded that it would be: 

wrong to ignore the possibility that ... private sector involvement could make 

a speedier and more cost-effective contribution [to the improvement of 

prison services] 73 

The Green Paper also identified the objective of private-sector involvement as 

being: 

to improve the cost-effectiveness of the remand system by ... making 

additional remand accommodation available more quickly and flexibly than 

would otherwise be possible... thus accelerating the ... elimination of overcrowding 

and improving conditions for remand prisoners. 74 

DIFFERENT MARKET-BASED MECHANISMS CONSIDERED 

The involvement of the private sector could have been achieved through one of 

two main methods: contracting out or market testing. The difference between 

these procedures is that market testing involves the private sector submitting 

bids in competition with an in-house team, whereas in contracting out only the 

private sector is allowed to bid. However, the distinction between the two is not 

substantial, and both can be expected to have similar results in terms of 

incentives for efficiency. Arguably, these are greater under market testing as a 

wider range of bidders (both public and private sector) is involved. Although 

market testing was considered, the initial contracts were open to private bidders 

only. Market testing has been used for all MO contracts except Wolds in 1991 

and Blakenhurst in 1992. The in-house bid has won four of the eight contracts 

tendered since then. 

US EXPERIENCE WITH PRIVATE PRISONS 

Private sector involvement in US prisons can be traced back to 1607 (Feeler, 

1991). 75 However, pursuit of profit maximisation and lack of contract supervision 

led to such poor conditions and exploitation of inmates that public agencies 

were forced to assume responsibility for all US correctional facilities by the 

73 Green Paper (1988) Private Sector Involvement in the Remand System, Cm 434, London: The Stationery Office, p.3. 

74 Green Paper (1988), Op.Cit, p.9. 

75 Feeler, M. (1991) ‘The privatisation of prisons in historical perspective’, Criminal Justice Research Bulletin 6 (2). 

80


1920s (Austin and Coventry, 2001). 76 Private sector management of prisons was 

re-introduced to the US in the 1980s in response to problems of overcrowding. 

Privatisation of existing prisons was achieved by contracting out management 

and, more radically, transferring ownership of the prison and its management 

responsibilities to a private operator. Some private prisons have been built 

speculatively, in that the contractor constructs the prison without having a 

contract from the prison service. The operator then seeks to obtain a contract 

once the prison is already constructed. There are 158 private correctional 

facilities in the States, making up less than 5 per cent of the current market 

(Austin and Coventry, 2001). 77 

A nationwide survey conducted by the Bureau of Justice Assistance in 2001 found 

that, rather than the projected 20 per cent savings, the average saving from 

privatisation was only about 1 per cent, and most of this was achieved through 

lower labour costs. The study concluded that in general privately operated 

prisons function as well as publicly managed prisons, with the exception of the 

rate of inmate-on-inmate assaults, which was 35.1 per cent in private prisons 

compared to 25.4 per cent in public prisons. This was attributed to a number of 

factors, including the 15 per cent fewer staff employed by private prisons. 

These labour cost savings, achieved through reductions in number of staff, 

fringe benefits and working patterns, have been the source of great controversy 

because they have been linked with some highly publicised management 

failures. These failures are often cited as examples of why the private sector 

should not be involved in prisons. One such example is the Northeast Ohio 

Correctional Center, constructed by CCA in 1996 as a speculative build prison. 

Within the first 15 months of operation, 17 inmates had been stabbed, 6 had 

escaped and 2 had been murdered. Furthermore, in 1999 the US District Court 

granted preliminary approval of a $1.6m settlement on behalf of inmates who 

claimed they were abused, denied adequate medical care and not properly 

separated from other inmates (Clarke, 1998). 78 Northeast’s problems were found 

to result from a lack of basic security practices, inexperienced staff, inadequate 

training and a willingness to accept inmates who should not have been 

transferred to the facility. 

Another example of private prison failure is that of the Elizabeth detention centre 

in New Jersey, operated by Esmore Correctional Services Corporation, where 

attempts to cut costs led to the hiring of inadequately qualified prison guards. 

This was in breach of its contract, but inadequate monitoring resources meant 

the breach went undetected until a riot broke out in 1995. Following an 

investigation that found under-qualified staff to be a contributing factor to the 

76 Austin, J. and G. Coventry (2001) Emerging issues on privatised prisons, Bureau of Justice Assistance, National 

Council on Crime and Delinquency. 

77 Op.Cit. 

78 Clarke, J.L. (1998) Report to the Attorney General: Inspection and Review of Northeast Ohio Correctional Center, 

Washington, DC: Office of the Corrections Trustee for the District of Columbia. 

81


riot, the contract was terminated (Domberger and Jensen, 1997). 79 Other wellpublicised 

incidents of poor performance have occurred at private prisons in 

Colorado, Louisiana, Oregon, South Carolina and Texas. 80 

The UK experience has differed to date for two main reasons. Firstly there have 

been no instances of speculative build prisons. Private firms can enter the 

market for prison services only by winning a tender for a specific contract. 

Speculative build prisons in the US have been the most difficult to monitor and 

regulate. 81 Secondly, the UK has devoted a significant amount of resources to 

contract specification, monitoring and enforcement. Where management 

failures have occurred in the US, they have typically been the result of problems 

in the contractual framework. 

DESCRIPTION OF THE MARKET MECHANISM 

The process for procurement is identical for both MO and DMCF contracts, and 

between contracting out and market testing. The main dimension in which 

contracts differ is that of contract duration. DCMF contracts are typically 

awarded for 25 years and MO contracts and SLAs for 10 years. 

There are some technical differences in the way a DCMF contract is drawn up, 

reflecting the complexity of the contract, which must cover the construction of 

the prison. DCMF contracts are made between NOMS and a Special Purpose 

Vehicle, a type of holding company in which the construction company, 

architect, operating company and finance provider all have a stake. All operating 

risk is passed to the operating company through a sub-contract between the SPV 

and the operating company, so that, in practice, all negotiations pertaining to 

contract enforcement occur between the operating company and NOMS. 

Tendering out operations 

Procurement is centralised and conducted by the NOMS Commercial and 

Competitions Unit, working closely with the Office of Government Commerce. 

HMPS publishes an announcement inviting private companies to express an 

interest. To qualify for bidding, bidders must demonstrate the capability to 

operate a prison safely, either through a proven track record or related 

experience, and the capacity to meet necessary financial obligations arising 

during the contract life. Only bidders who meet these criteria are invited to 

submit sealed bids. As noted in Part III, the use of sealed bids helps to limit the 

scope for collusive behaviour amongst potential bidders because this implies 

that bids are private rather than public information. This means that rival bidders 

lack information about each other’s bids, and that it is therefore more difficult to 

79 Domberger, S. and Jensen, PH (1997) ‘Competitive tendering and contracting out: theory, evidence, prospects’, 

Oxford Review of Economic Policy 13(4). 

80 Austin, J. and Coventry, G, ‘Emerging Issues on Privatized Prisons’, p.59, Bureau of Justice Assistance. 

81 Austin, J. and Coventry, G, ‘Emerging Issues on Privatized Prisons’, P.xi, Bureau of Justice Assistance. 

82

detect any deviation from a collusive agreement. This reduces the probability 

that a cheating bidder will be punished, and so makes any agreement more 

difficult to sustain. 

Pre-selected bidders are required to specify: 

● the plans for the design and construction of the centre (if a PFI contract); 

● any plans for renovation/maintenance/repair; 

● plans for operating the prison (including staff involved, how the centre will be 

organised and how prisoners will be managed); and 

● the cost of providing the service. 82 

Bids are then evaluated qualitatively and by means of a score based on an 

assessment of individual criteria. The bid evaluation process assesses 

deliverability, price and quality. Innovation has recently been added to these 

criteria. Subject to considering that the bidder is able to deliver the service, the 

quality and innovativeness of bids is assessed using a complex matrix marking. 

This score is used to adjust the price of the bid to reflect the quality of service 

being proposed, and the contract is then offered to the bid with the lowest 

quality-adjusted price. Details of the weighting and criteria are made available to 

bidders in the invitation to tender. This kind of allocation mechanism is known 

as a weighted beauty contest. 83 

For design plans, bid criteria include: 

● how many prisoners the centre could support, 

● the operational advantages/disadvantages of the design, 

● the flexibility of purpose of the centre, 

● the likely longevity of the building; and 

● the aesthetics of the building. 

For operational plans, the criteria include: 

● security, 

● ease of moving prisoners, 

● time out of cell for prisoners, 

● recreational services, 

● educational services, 


82 Specified as the cost per prisoner-place per day 

83 A beauty contest is a means of allocating an asset (such as the contract to provide prison services) that involves 

firms submitting proposals regarding their plans for managing the asset that are then evaluated, typically by a 

committee, in terms of criteria such as price and quality. A weighted beauty contest is one in which bidders know 

in advance the criteria against which they will be assessed, and the relative weighting attached to each. 

83


● fair treatment of prisoners; and 

● efficient management of resources. 

The weighting assigned to these criteria will differ according to the purpose of 

the particular prison: for example, safety will be of more concern in a highsecurity 

prison. 

Once a contract has been awarded, each centre is assigned its own Controller to 

monitor the operations of the prison and ensure contract terms are being met. 

Each controller is answerable to NOMS headquarters. Prisons are then 

monitored against performance measures stipulated in individual contracts 84 as 

outlined in further detail below. 

The degree of risk borne by the private contractor depends on which party is 

best able to bear it. Risk is transferred to the private sector through a 

combination of payment mechanisms and specific contract provisions. For 

example, the risk of the required number of prisoner places being available by 

the scheduled date is transferred from HMPS to the contractor through the 

payment stream of a DCMF contract: contractors are paid a daily rate for prison 

places made available, so no payment is made until the prison is up and 

running. The private contractor is also responsible for the risks of obtaining 

detailed planning permission, construction-cost and time over-runs, changes in 

general legislation and maintenance. Prices are reviewed every five years to 

cover external factors that have significantly affected prison operators’ costs, 

reducing the risk of the contract for both parties. 85 

Multi-sourcing involves sourcing the same good or service from multiple 

suppliers, rather than relying on one supplier to meet all requirements. Despite 

a high level of aggregation within individual contracts, HMPS has been able to 

engage in multi-sourcing by placing the management of a number of different 

prisons out to tender over time as discussed above. Multi-sourcing not only 

ensures competition for the market in the future, by allowing more than one firm 

to develop any incumbency advantages, but also allows for the analysis of 

relative performance, encouraging competition within contracts. This latter 

feature is one HMPS hopes to make increasing use of with the development of 

its benchmarking programme. 

The procurement process adopted by HMPS has worked moderately well in 

practice, although some private contractors feel there is scope for improvement. 

In particular, one operator expressed concerns that whilst the procurement team 

84 This is in contrast to public prisons, which are monitored according to performance relative to a set of Key 

Performance Targets. Private contracts have recently been adapted to incorporate the same KPTs that apply to 

public prisons, with annual performance measures now defined in relation to the appropriate KPTs. This is 

discussed in more detail later. 

85 For example, HMPS faces the risk that costs in the prison service industry may fall during the life of the contract, 

and that it would not then be delivering the most cost-efficient service possible. The contractor faces the risk that 

industry costs change, for example staff costs increase, and this may threaten both its ability to deliver its 

contractual obligations and its commercial viability. 

84

at HMPS began as an equal mix of those specialised in operating prisons and 

those with professional procurement skills, operational staff have had less input 

in recent contracts. This operator feels that this has led to problems of 

professional procurers not understanding the service requirements and focusing 

on less important issues whilst not always recognising more important 

operational issues. They would also welcome greater transparency around 

evaluation, for example regarding who makes the decisions and the relative 

importance attached to different elements of a bid. Furthermore, bids are 

currently very expensive to produce because of the level of detail required 

regarding operational plans. 

Although no economists were involved in the design of the policy, economic 

rationales can be seen behind many of the design features outlined above, for 

example, in using a sealed bid auction design to limit the scope for collusion and 

engaging in multi-sourcing to ensure the development of a competitive market 

for prison services. 

Private-sector involvement is currently limited to 11 prisons and this is unlikely 

to increase dramatically in the near future. Contracting out a greater proportion 

of prisons would be likely to encounter political resistance and private-sector 

capacity is presently limited. Greater use of market testing is anticipated in the 

future however. 

DEVELOPMENTS OVER TIME 

As HMPS has developed more experience in procuring services, the process has 

been modified over time. 

Contract length 

The first MO contracts were offered for five years, with three options for 

extension by another three years upon contract expiration. This length was 

found to be too short for a project with a long lead-in time with the result that 

the contract length was extended to ten years. PFI prison contracts were given a 

25-year duration in order to allow sufficient returns to be realised on the 

construction of the prison. 

Benchmarking 


Performance measures contained in contracts are defined in absolute terms 

based on stipulated targets. These targets are set at the beginning of a contract, 

and would normally last for the entire contract duration. However, as contracts 

can be as long as 25 years, some performance targets are less appropriate at 

later points in the contract. Benchmarking, on the other hand, involves the 

comparison of relative performance between prisons at specified points in time. 

It allows revision of the performance targets based on how the prison has 

performed relative to other prisons. This approach means that a prison could be 

considered to be underperforming even if it has met its stipulated targets, if it is 

85


felt to be lagging behind similar prisons. It ensures the competitive stimulus is 

present throughout the contract duration and provides flexibility to renegotiate 

contracts to reflect significant changes in industry conditions. 

The first prison management contracts contained no provision for performance 

measures to be revised during the contract duration. Later contracts addressed 

the potential need for renegotiation of a DCMF contract, if industry costs were to 

fall during the contract life, for example, by allowing for benchmarking of the 

operational subcontract at 15 years. The most recent contracts have introduced 

benchmarking to the entire contract at 10 and 20 years. Benchmarking will be 

undertaken if NOMS believes it could obtain the same service more cheaply from 

another supplier. In this case, the incumbent is invited to re-tender at a lower 

price. If the incumbent does not re-tender, or HMPS is not satisfied with the offer, 

the contract may be opened for bids from other private firms. This leads to 

greater risk for the contractor, which is reflected in a higher contract price, but 

reduces the risk of tendering long-term contracts for HMPS. 

Performance measure rationalisation 

Early contracts were designed with a greater number of performance measures 

than were required to achieve the desired outcome, implying excessive contract 

specification and monitoring costs as well as unnecessary restrictions on 

innovation. Recently tendered contracts have taken this into account, and have 

not only rationalised the number of performance measures but have also 

introduced a system of bonuses as well as penalties. 

One criticism of the performance measure system is that it focuses on specifying 

inputs (e.g. hours of education per prisoner per week) to achieve desired outputs 

rather than outlining desired outputs (e.g. 50 per cent of prisoners to pass a level 

1 literacy certificate) and giving the contractor freedom over how best to deliver 

these. One operator of private prisons felt that this restricted its scope for 

innovation as HMPS began specifying operational requirements in increasing 

detail. This operator hopes this problem will be addressed in the near future as 

contracts are refreshed and performance measures revised. They note that a 

number of input-related measures contained in existing contracts have recently 

been changed to focus more on outputs. For example, a measure stipulating the 

number of hours that each prisoner must spend learning in a classroom has 

been replaced by a target number of level 1 literacy certificates to be obtained. 

Another side-effect of using performance measures is that it encourages 

operators to concentrate their resources on the measurable aspects of service 

quality to the detriment of others. One such example is the requirement to repair 

or replace all broken items in the building within 24 hours. This requirement 

caused problems when one prison introduced a new initiative to provide 

inmates with toasters in their cells: when toasters broke they were not replaced 

within the required timeframe and so the operator began to accumulate penalty 

points. Even though it was not a contractual requirement to provide toasters, 

the penalty points were the same as those for more important breakages 

86

(e.g. lighting). This impact could have caused the operator to withdraw its 

toaster scheme altogether, although its eventual solution was to buy a large 

stock of toasters to allow for speedy replacement in the event of a fault. 

Conversely, other important areas of performance, such as staff attitude towards 

prisoners, which may be equally important for a harmonious regime, are not 

directly measurable, although anecdotal evidence suggests that prisoner-staff 

relations are better in private-sector than public-sector prisons. 

Risk-sharing 

As the private sector now has experience in the management of prisons, it is more 

comfortable taking on risks at a lower premium than before, making it efficient for 

the Government to shift more risk to the private sector. Initially, the main risks 

borne by the private contractor were the design, construction, management and 

financing of the prison. Whilst the public sector continues to retain responsibility 

for the risks of adequate demand and the residual value of the property, it has been 

able to transfer risks such as insurance to the private sector. 

Dovegate Therapeutic Centre (TC) is the only centre in which the private sector 

is able to influence the number of places as courses provided by the centre are 

voluntary and can be advertised to other prisons to attract applicants. 

Accordingly, the public sector has shifted some volume risk to Dovegate TC in 

the design of its contract. 

The contracts for Ashford and Peterborough saw the contractor taking on the 

risk of filling the top 5 per cent of places, despite being unable to influence 

demand. This approach was largely as a result of new accounting treatment 

standards, and has been found an inefficient means of allocating risk because 

both contractors simply charged a higher premium to reflect the increased risk. 

It will therefore not be pursued in future competitions. 

Potential problems 


In Part III, we noted that although economic theory says that introducing 

contestability can lead to greater efficiency and can provide incentives for 

innovation, these benefits can only be achieved if there is adequate competition. 

Moreover, although the incentives for cost reduction can be stronger in the private 

sector, if not properly controlled through well-specified and effectively monitored 

contracts, these costs reductions can come at the expense of the quality of the 

service. This problem is a particular concern in an area such as prisons, where a 

poor quality service can have outcomes such as riots or increased prison suicides. 

Competitive tendering may also lead to problems of market power and 

asymmetric information. 

In this section we first summarise these potential problems, focusing on those 

that theory suggests are most likely to impact the procurement of prison 

87


services. We then discuss how these problems were dealt with and the success 

of this process. 

POTENTIAL PROBLEMS IN PRISON PROCUREMENT 

Political Constraints 

Sometimes the implementation of a market mechanism may be affected by 

political constraints that prevent the full potential benefits of the policy being 

realised. One such constraint in prison procurement was the limit placed on the 

size of the private sector market that could develop by the Government’s 

commitment to retain most of the prison estate under public sector management. 

In 1993 the then Home Secretary announced a target for 10 per cent of prisons to 

be privately managed. This target reflected a balance between concerns about 

private sector involvement in the delivery of a politically sensitive service and the 

need to offer a sufficient number of contracts for a private market to develop. 

However, the fact that there are only four private sector suppliers of prison 

services today in the UK suggests that current procurement levels might not 

guarantee a sufficiently high level of demand to encourage new entry. Today 

there are 11 prisons under private sector management out of more than 139. 

There is no explicit target under the current administration for the level of private 

sector involvement but rather a desire to maintain healthy competition between 

public and private sector providers. 86 Plans to extend market testing could result 

in an increase in the level of private sector involvement. 

Another constraint acting on prison procurement policy-makers was the internal 

resistance felt at the time competition was first introduced. This continues today 

and is particularly strong in the Prison Governors’ Association and Prison 

Officers’ Association (POA), trades unions representing public sector prison 

workers. A recent example of this opposition is the POA’s vote against plans to 

market test clusters of prisons from 2005. With a 70 per cent turnout, union 

members voted by 87 to 13 per cent not to take part in the market testing on the 

grounds that it is likely to lead to increased privatisation of prisons. The POA’s 

general secretary, Brian Caton, has warned that industrial action is likely if the 

Government continues with its plans. 87 The proposed market testing of Emley, 

Standford Hill and Swaleside has since been suspended and there is no certainty 

about whether it will be resumed. 

Economic Constraints 

In the main report, we identified a number of problems with outsourcing 

suggested by economic theory. These problems arose from issues of market 

power, the hold-up problem, asymmetric information and incomplete contracts. 

We now consider each of these potential problems in turn, looking at why they 

may arise in the context of prison service procurement and how the 

procurement process was designed to mitigate their effect. 

86 White Paper (2002) Justice for All, London: The Stationery Office. 

87 Prison Reform Trust (2005) Private Punishment: Who Profits?, Briefing Paper, p.11. 

88

MARKET POWER 

The full benefits of competition can be realised only if there is sufficient 

competition between firms. However, this can be undermined if there are a small 

number of bidders, for example, because of incumbency advantages and other 

barriers to entry, or if bidders engage in collusive behaviour. These sources of 

market power are addressed in turn below. 

INCUMBENCY ADVANTAGES AND OTHER BARRIERS TO ENTRY 

Incumbency advantages can arise from a variety of sources, including preselection 

criteria, switching costs and asymmetric information. Each of these has 

the potential to arise in the prison service. 

Given the concerns over quality in the prison service, the potential barriers to entry 

created by pre-selection criteria can be a major concern. For example, one method 

that is sometimes used to try to avoid poor-quality service delivery is to require 

that the bidders have a proven track record in the area. This obviously gives 

incumbents an advantage over new entrants. Furthermore, because winning firms 

are required to take on existing staff, considerable switching costs exist when 

transferring staff to a new contractor. Incumbents are also likely to enjoy superior 

information regarding costs and the prison building concerned. They will be better 

acquainted with tender requirements, and as such will not only incur lower 

tendering costs but will also enjoy a higher probability of success. 

Incumbency advantages combined with high bidding costs could be expected to 

impose substantial barriers to entry. Both incumbency advantages and barriers 

to entry reduce competition for the market in the future, leading to higher 

procurement costs in the longer run. 

Controlling for incumbency advantages 


Although only a few prison contracts have yet come up for renewal, HMPS has 

taken several steps to try to reduce incumbency advantages. 

When a contract comes up for renewal, the incumbent supplier has an 

informational advantage over rival bidders in relation to costs. The incumbent 

supplier has gained years of experience in how the prison operates and how 

much it costs to run. In order to try to reduce this advantage, the incumbent is 

required to disclose cost information to potential bidders and to allow access to 

the prison being offered for re-tender. Although increasing cost transparency is 

beneficial in limiting incumbency advantages, there is a trade-off to be made 

against the increased scope for collusion. 

As described in Section 7, one of the factors that makes a collusive agreement 

easier to sustain is readily available information on rivals’ costs and prices. The 

sharing of information on costs would tend to increase the likelihood of 

collusion between suppliers. However, since it is difficult for other bidders to 

89


verify that cost data represent the true running costs of the prison, this effect is 

unlikely to be very strong. One prison operator observed that requiring cost 

disclosure has little effect on incumbency advantages in practice because there 

are means of presenting cost information in a way that is not helpful to potential 

bidders. 

HMPS also tries to limit incumbency advantages through multi-sourcing, so that 

there are more companies with experience in operating prisons. For example, in 

1995 and 1996 a PFI contract was awarded to each of Securicor and GSL, despite 

the fact that one bidder had offered a lower price for both contracts. This 

attracted criticism from the NAO 88 but HMPS defended its decision with 

reference to the need to ensure competition for future contracts. 

An additional way in which competition is encouraged is through a proactive 

approach to encouraging firms to bid. There are no examples of potential 

suppliers being pre-qualified without previous relevant experience, largely as a 

result of strict pre-qualification criteria. However, these criteria do not require 

previous experience in running prisons, but only experience in security issues. 

For example, Securicor and GSL had no prior prison experience but satisfied 

tender requirements by proposing to recruit experienced prison staff from the 

UK public sector. Whilst the HMPS procurement group is unable to relax its preselection 

requirements, it has nonetheless tried to encourage entry by actively 

inviting bidders with experience in custodial services both in the UK and abroad 

to submit tenders. The Prison Service is aware of other potential providers who 

could be encouraged to submit tenders in the future, and has taken an active 

approach to increasing the size of the market by speaking to these firms directly. 

As a consequence, two new entrants have submitted bids for the management 

of a Scottish prison and competition for the prison management market in future 

tenders is hoped to increase. 

The considerable expense involved in the bidding process represents a barrier 

to entry, particularly in the case of PFI contracts. 89 One way to encourage bidding 

in spite of high costs is to increase the reward for winning a tender by offering 

more valuable contracts. It can be achieved by aggregating contracts 

horizontally, vertically or over time. Contract aggregation refers to the bundling 

of service requirements into fewer, larger contracts that are tendered less 

frequently. Contracts are aggregated horizontally when identical requirements 

are pooled and put out to tender, for example, if one contract were offered for 

the management of multiple prison centres. Vertical aggregation refers to the 

bundling together of different stages of the value chain, for example, sourcing 

one supplier to design, construct, manage and finance a new prison under a 

DCMF contract. 

88 See National Audit Office (1997) The PFI Contracts for Bridgend and Fazakerley Prisons, London: The Stationery 

Office. 

89 See Competition Commission (2002) Group 4 Falck A/S and The Wackenhut Corporation: A report on the merger 

situation, available at: http://www.competition-commission.org.uk/rep_pub/reports/2002/471group4.htm, p.21. 

90

However, it should be noted that tendering larger contracts may also impede 

entry, both directly by excluding smaller firms who are unable to provide the 

complete bundle of requirements and indirectly by reducing the chances of 

winning a contract. Furthermore aggregating contracts not only influences the 

entry decision but also has wider implications for market performance, some 

positive and some negative. For example, contract aggregation helps provide 

incentives for long-term investment and limits the scope for collusion, but may 

exacerbate incumbency advantages. It may also reduce procurement costs by 

reducing the number of tenders conducted and the number of ongoing contracts 

that must be monitored, as well as allowing for the exploitation of economies of 

scale and scope. Economic theory provides no clear answer regarding the 

appropriate degree of contract aggregation because this will vary with individual 

industry characteristics. In the case of prison management, there are efficiencies 

from aggregating together the provision of all services provided at one location 

(see below). Dividing the requirement up into smaller contracts, or allowing 

contractors to bid for part of the contract, could prevent these efficiencies from 

being realised and lead to higher procurement costs. 

Prison management contracts are aggregated both across time and horizontally. 

MO contracts are for all aspects of prison management and no DCMF contract 

tenders have yet separated design, construction and finance from management. 

There are efficiencies from aggregating contracts in this way arising from 

natural synergies between the designer and the operator. The poor performance 

of early PFI schools gives an example of problems that can arise when the 

interests of designer and operator are allowed to diverge. 90 

Theory suggests that a high level of contract aggregation could lead to problems 

of incumbency advantages lessening competition for future tenders. The issue 

of advantaged incumbents is discussed above, but it is worth noting that HMPS 

has retained many of the benefits of multi-sourcing despite high levels of 

individual contract aggregation. These benefits include competition within the 

market as well as for future tenders. Ensuring the continued existence of 

multiple private-sector suppliers and encouraging new entry to the market have 

helped secure these benefits. 

Performance in practice 


The fact that few tenders have come up for renewal makes the assessment of 

incumbency advantages difficult. However, there is some evidence to suggest 

that incumbents have an advantage in bidding. Incumbent providers have won 

four out of the six contracts put to re-procurement, with the other two being won 

by the public sector rather than another private sector firm. Although this 

suggests that incumbents have an advantage in the re-tender process, the fact 

that the price of bids in tenders has tended to fall over time suggests that the 

process is competitive. 

90 For example, a report by the Audit Commission found that early PFI schools performed significantly worse than 

those that were traditionally funded. See The Audit Commission (2003) PFI in schools: the quality and cost of 

buildings and services provided by early Private Finance Initiative schemes. 

91


Moreover, the fact that two prisons previously under private-sector management 

were lost to an in-house bid, indicates that the incumbency advantage is not 

absolute. An evaluation report by HMPS and the NAO report both concluded that 

these bids were won by the public sector on the basis of cost and quality, rather 

than as a result of discrimination. 91 Indeed, to the extent that the procurement 

process has encouraged the public sector to become more competitive, 

competition may even have been increasing over time. 

COLLUSION 

The nature of public procurement means it can be susceptible to collusion 

amongst bidders. Collusion is most likely to arise when many similar contracts are 

tendered at frequent intervals because this can allow bidders to allocate contracts 

between themselves. Requiring bidders to meet certain pre-selection criteria helps 

HMPS guarantee the quality of its suppliers but restricts the number of potential 

bidders and creates barriers to entry. These latter effects may increase the scope 

for collusion, as might the practice of publishing tender information. As noted 

above, when information regarding rivals’ bids is in the public domain it is much 

easier for colluding bidders to detect any deviation from their agreement. This 

increases the likelihood that defectors will be caught and subsequently punished, 

and so lowers the returns to cheating. Reducing the temptation to renege on an 

agreement in this way makes collusion easier to sustain. 

Controlling for collusion 

Although HMPS has not made any conscious efforts to try to prevent collusion 

in tenders for prison contracts, the way the process is run means that such 

collusion is unlikely. First, the use of a sealed bid auction design reduces price 

transparency, making it more difficult to detect and punish any member cheating 

on the agreement. As collusive agreements require an effective punishment 

mechanism to be sustainable, this has the effect of making coordination more 

difficult. Second, the number of contracts is few – just 21 in total since 1991. This 

has reduced the potential for collusion in two ways. First, as each contract is very 

valuable, it is always tempting for firms to cheat on any collusive agreement to 

secure the contract. Second, as there have been few of these contracts put to 

tender there have been limited opportunities for interaction amongst the 

competing firms. Because collusion is easier to sustain where rivals interact 

frequently, this naturally limits the scope for collusion. 92 

The allocation of public sector funding in the UK is such that plans can only ever 

be made three years in advance at most. This limits the extent to which collusion 

can be sustained by introducing a large amount of uncertainty into the future 

demand for private prison services. However, the overall effect of this practice 

91 A level playing field is ensured whenever an in-house team puts forward a bid by adding the costs of their bid to 

the proposed contract, as well as an allowance for public sector overheads and differences in pension service 

provision. 

92 For example, two firms competing for twenty-one contracts may allow for collusion whereas twenty firms 

competing for the same number of contracts is unlikely to do so. 

92

on competition is uncertain. The ability to commit to a longer-term programme 

of contract competitions would provide a greater degree of certainty to the 

private sector that may encourage new entrants to undertake the costs 

associated with joining the market. Increasing the number of market players 

could then also be expected to reduce the scope for collusion. 

The threat of self-supply reduces the potential for collusion by providing what is 

effectively a reservation price. The Prison Service can tender in-house bids for 

MO contracts, but is obviously unable to do so for DCMF contracts. It can and 

does, however, compute the likely cost of self-provision for such tenders. This 

measure is known as the public sector comparator. A collusive agreement is 

more sustainable when its participants value the future benefits of colluding 

more than the immediate benefits of cheating, which will occur when they attach 

a relatively high importance to future rewards. As noted by Thomas (2001), the 

appropriate use of a reservation price can substantially increase the weight that 

must be attached to the future to make a given agreement sustainable. Doing so, 

effectively limits the range of situations in which collusion could occur. 

Although certain characteristics of the prison-management market may appear to 

make collusion likely, a closer inspection reveals this is unlikely to be the case in 

practice. Because services procured vary greatly from contract to contract, the 

public availability of prices for previous tenders is unlikely to support a collusive 

outcome. Prices could be lower because a firm is cheating on a collusive 

agreement or because the standards required for a particular prison could be met 

at a lower price than others. Firms in an agreement would find it difficult to 

distinguish between the two scenarios, limiting the effectiveness of a punishment 

mechanism. Furthermore, tenders are relatively infrequent and the value of 

contracts is large, two features that further lessen the scope for collusion. 


There is no evidence to suggest that there has been collusion in prison tenders. 

The cost per place for a male prisoner at a local prison has fallen over time, 

which does not appear to be consistent with collusion. Costs may have fallen 

because the perceived success of the design, construction and management of 

prisons by the private sector has led to contractors being prepared to take on 

more risk for a lower price premium. It could also reflect contractors becoming 

more efficient as they learn more about the prison management market, or the 

adoption of new technologies associated with lower running costs. 

HOLD-UP PROBLEM 


The hold-up problem occurs in contracts when an initial commitment by one party 

exposes that party to ex post opportunism by the other. As noted in Part III, the 

Government’s inability to commit to not behaving opportunistically after 

investment is undertaken may lead to sub-optimal levels of investment, particularly 

in the case of long-lived specific assets. Laffont and Tirole (1993) consider the case 

93


of such assets and conclude that investment may not be undertaken at all if there 

is a high probability of the incumbent being replaced at the next re-tendering of the 

contract. This occurs because the service provider will be aware that the remaining 

returns to an asset will be appropriated by the new service provider unless precommitment 

to an appropriate transfer price is possible. 

Prison centres constructed under DCMF contracts are an example of long-lived, 

specific assets. 

Controlling for the hold-up problem 

Since buildings constructed under PFI contracts become the property of HMPS 

upon expiry of the contract, the Government can therefore overcome the holdup 

problem and encourage appropriate levels of investment. As the longevity of 

the building is taken into account during the contract negotiation period, the 

Government is essentially able to pre-commit to a transfer rate that is implicit in 

the contract price. The decision to award DCMF contracts of 25-year duration 

reflected this need to ensure suppliers received an appropriate return on their 

investment. 

Aggregating contracts over time into 25-year bundles is one means of 

encouraging suppliers to undertake investment in specific assets. Indeed, the 

tendering of fewer and larger, contracts creates something more akin to a 

bilateral hostage situation: the procuring body is as dependent on the private 

supplier as the supplier is on the procurer when it has few alternative suppliers 

from which to source the service. This situation limits the risk of ex-post 

opportunism by the procuring body relative to a situation in which there are a 

greater number of alternative sources of supply. 

ASYMMETRIC INFORMATION 

Asymmetric information problems arise when either the public sector has less 

information than potential service providers, or when some service providers 

possess less information than others. The former situation can lead to private 

providers exploiting their informational advantage, for example, by claiming an 

increase in costs is due to external factors rather than their own inefficiency. 

Asymmetric information amongst bidders can lead to the winner’s curse, a 

situation which arises when bidders do not know the true costs of providing the 

service and base their bids on different estimates of these costs. The winning 

bidder is the one with the lowest forecast, and therefore the one most likely to 

have bid below true cost. Although this outcome is mostly a problem for the 

winning supplier, rather than the Government, it can have implications if the 

supplier is then unable to fulfil all their duties or seeks to cut quality in order to 

save costs. An extreme winner’s curse outcome could even jeopardise service 

delivery altogether. A winner’s curse outcome is most likely when there are a 

large number of bidders and uncertainty surrounding costs. 

94

Controlling for problems of asymmetric information 

Although there is no explicit provision to deal with the winner’s curse in the 

procurement of prison services, there are two aspects of the tender process that 

reduce this risk. 

First, there is no obligation on HMPS to purchase from the lowest bidder. The 

tender evaluation process begins with a deliverability test that does not consider 

costs at all but focuses on whether the proposed operational plans are feasible. 

Bids are often eliminated at this stage. Even though, in theory, all remaining bids 

are deliverable, the evaluation team will still not necessarily accept the lowestpriced 

bid, but instead will apply a complex matrix marking for quality. They 

then attempt to price quality, and select the contract with the lowest qualityadjusted 

price. Of the nine DCMF contracts in existence, four were not won by 

the lowest-priced bidder. 

Second, rival bidders are provided with detailed information on costs. The 

publication of contract competition, and the requirement that incumbent providers 

make cost information available to interested bidders, should both reduce the risks 

in bidding. However, there is some anecdotal evidence to suggest that the latter 

measure is less effective in practice because it is possible for incumbents to 

present cost information in a way that is unhelpful to other bidders. 


There are some concerns that competition between providers has led to contract 

prices that will not cover costs adequately. Parc prison saw very poor 

performance as a result of failing to provide sufficient staff with the appropriate 

level of experience. The same was true of Ashfield, whose assessment of the 

costs involved in recruitment and retention of the required staff fell short of the 

actual costs, with the result that staffing levels fell significantly below 

requirements. After several months of warnings, HMPS relocated half of the 

Ashfield inmates and installed its own Governor in place of the private 

management team. As a consequence, the operating service provider, Premier, 

improved the terms and conditions it offered staff, was thus better able to recruit 

and retain staff and has since performed well against contractual criteria. 

Problems at Ashfield may have arisen partly because the role of the prison was 

changed after the contract was signed from a centre for three-hundred juveniles 

and one-hundred young offenders to a centre for four-hundred juveniles. 

Although the contract was revisited accordingly, it is possible that the failure 

occurred at the renegotiation stage. 

Controlling Service Quality 


For the market to deliver an efficient outcome, contracts must be complete. 

However, in reality contracts are almost always likely to be incomplete. For 

example, there may be some aspects of service quality that are too difficult to 

95


measure or it may be prohibitively costly to include a provision for every 

possible contingency. Incomplete contracts 93 in competitive tendering can lead 

to two main problems, cost reductions being achieved at the expense of quality 

(‘quality shading’) and fears of the ‘hold-up’ problem previously discussed. In 

the case of prison procurement, quality shading is of particular interest because 

the economics literature has cited this as the main reason that private sector 

involvement in prison services is inadvisable. 

QUALITY-SHADING 

Quality shading means that the private sector firm running the prison service 

reduces costs partly or mainly by reducing the quality of the service provided. 

Quality shading has been found in privately provided prisons in the US, which 

have been subject to a great deal of criticism. 94 It arises where there are multiple 

objectives to be pursued, some of which are more readily observable than 

others. Agents will tend to focus efforts on improving the performance of the 

measurable output to the detriment of the others. Hart, Shleifer and Vishny 

(1997) developed this idea in relation to public-sector procurement, and 

concluded that, where non-contractible quality is important, the public-sector 

should retain both ownership and management of the service. One of the public 

services they concluded was therefore unsuited to private sector management 

was prison management. 

Because issues of incomplete contracts have been central to the introduction of 

competition to prison services, features of the procurement process designed to 

control for quality are considered in detail in the following section, along with an 

evaluation of the quality of private prison services in practice. 

Hart et al. (1997) concluded that prison management was unsuited to private 

sector involvement on the grounds that the quality of prison services is very 

important, but costly for a private sector provider to deliver and difficult to specify 

in a contract. Whilst the first two points are without dispute, HMPS has shown 

that it is possible to contract for quality: this has been an important part of 

contract design and monitoring, as discussed in detail below. Whilst the quality 

shading problems associated with incomplete contracts have been limited largely 

through designing contracts that are as complete as possible, HMPS has also 

tried to address this potential problem through the bid evaluation procedure and 

more recently through incentives for enhanced performance. It is worth noting 

that firms face additional incentives to deliver a high-quality service arising from 

the fact that they care about their reputation. This is particularly important given 

the need for bidders to demonstrate a proven track record in security services to 

be considered for the contract. 

93 Because virtually all contracts are incomplete, this potential issue is one of degree rather than existence. However 

for simplicity here we use the term ‘incomplete contracts’ to refer to contracts that are sufficiently incomplete to 

cause the problems discussed. 

94 See for example Logan (1990) and Shichor (1995) for a summary of evidence for and against private prisons in 

the US. 

96

Procurement process design 

One way in which quality can be controlled for, even if contracts are incomplete, 

is by making it an explicit part of the process for evaluating bids. Tendering for 

a prison management contract takes the form of a beauty contest, with price just 

one criterion on which bidders compete. Other criteria related to quality of 

service may be assigned equal or greater weight in the decision process and in 

many cases the bid accepted is not the lowest price bid. 

Contract design and contract monitoring 


Critics of prison privatisation in the US have pointed to evidence of quality 

shading, lending support to the Hart et al. (1997) conclusion that prison service 

quality is non-contractible and is therefore likely to suffer from the involvement 

of the private sector. Quality shading in the US has been observed particularly in 

relation to staffing levels and qualifications. However, the UK experience so far 

demonstrates that it is possible to contract for quality if sufficient resources are 

devoted to contract design and monitoring. The UK system is now described in 

detail below. 

The winning bidder taking on management of a prison signed a contract with the 

Commissioner for Correctional Services, whose post was replaced by the Chief 

Executive of NOMS on 1 June 2004. Each contract sets out the level of service 

that contractors are expected to provide, the payment system and the 

mechanisms by which the Commissioner/Chief Executive can make financial 

deductions for poor performance. Individually negotiated contracts are linked to 

a national monitoring system that applies to all prisons, whether privately or 

publicly managed. Fifteen Key Performance Indicators (KPIs) measure whether 

the Prison Service as a whole is meeting its objectives of protecting the public 

and reducing crime. For example, one KPI for 2005/6 is to ensure that the rate of 

escapes is less than 0.05 per cent of the average prison population. National KPIs 

are supported by 48 Key Performance Targets (KPTs) that measure the 

performance of individual prisons against planned activities. Target figures are 

agreed on an individual prison basis, and vary according to the nature of the 

centre concerned. For example, each prison will agree to keep escapes below an 

appropriate level, in order to ensure that the national KPI is achieved. Contracts 

have recently been adapted to incorporate the same KPTs that apply to public 

prisons, with annual performance measures defined in relation to the 

appropriate KPTs. Performance measurement in relation to individual contracts 

is addressed in further detail below. 

In addition, contractors are obliged to comply with national operational 

requirements laid out in primary and secondary legislation, Prison Service 

Standards, Prison Service Orders and Prison Service Instructions. Compliance 

with these requirements is measured by the Prison Service Standards Audit unit, 

which allocates each prison an overall rating of superior, good, acceptable, 

deficient or unacceptable on the basis of its visits. 

97


The procurement department at HMPS has invested considerable resources in 

trying to measure the different elements of quality provision within prison 

management. The result is that the tenders for individual management contracts 

outline 30 to 40 performance measures covering different aspects of prison 

management quality which bidders have to commit to meet. These performance 

measures typically fall into seven broad categories: 

● keeping prisoners in custody; 

● maintaining order, control, discipline and a safe environment; 

● providing decent conditions and meeting prisoners’ needs; 

● providing positive regimes; 

● preparing prisoners for their return to the community; 

● delivering prison services; and 

● community relations. 

For example security is a key aspect of keeping prisoners in custody and is 

monitored according to both a quarterly and an annual performance 

measurement system. Penalty points are accrued on a quarterly basis for: 

● failure to achieve an agreed percentage of planned searches; 

● discovery of serious items smuggled in; 

● failure of security procedures laid down in the Prison Service Security 

Manual; and/or 

● failure to observe key/lock procedures laid down in the Prison Service 

Security Manual. 

Annual penalty points are incurred for: 

● failure to achieve an ‘acceptable’ or higher rating in the Security Audit during 

the relevant performance year; and/or 

● failure to achieve the agreed Key Performance Target percentage compliance 

with local planned preventative maintenance with respect to all equipment. 

Credit points can be awarded for a rating above ‘acceptable’ in the Security 

Audit. These can be offset against penalty points incurred against certain annual 

performance measures, specified in the contract. 

The performance-management system is based on points for failing various 

performance metrics, such as the occurrence of an assault. As no prison will ever 

be without failure, contract negotiations include a threshold number of points 

below which no financial penalty is incurred based on the particular 

characteristics of the prison. These thresholds apply quarterly. At the end of each 

quarter, performance points are summed together and if they lie below the 

contractual threshold, no further action is taken. If they exceed this level, 

98

however, financial deductions are made at a rate reflecting the number of points. 

Although this could potentially lead to problems of moral hazard in reporting 

poor performance, the penalties for failure to report are far stronger than any 

other penalty. Furthermore, the HMPS Controller and the Independent 

Monitoring Board (previously the Board of Visitors) provide on-site independent 

monitoring services so that the probability of poor performance being detected 

even if it is unreported is very high. 

The quality and number of employees hired by a private contractor is crucial to 

ensuring the quality of service provision. The quality is partly ensured through a 

legal requirement under the 1991 Criminal Justice Act that staff recruited by 

private contractors are required to be certified by the Prison Service as Prisoner 

Custody Officers. Certification involves a training course of approximately ten 

weeks’ duration. This certification means that no unqualified staff are allowed to 

work in private prisons. 

The number of staff that the contractor will use is not part of the initial tender 

documents, but does form part of the contract signed with the winning bidder. It 

was decided not to include detailed requirements for staff numbers in the tender 

documents because this might restrict innovation. Instead staffing levels 

proposed in bids are scrutinised closely during the bid evaluation stage and then 

form part of the final contract. This attempts to balance the need to ensure 

quality is maintained with providing sufficient contractual flexibility to 

encourage innovation. Because quality of prison service provision is crucial, 

where trade-offs between price and quality have been made they have been in 

favour of service quality. 

One aspect of service quality that cannot normally be measured is the ability of 

a centre to reduce the re-offending rate. Measurement is impossible because 

prisoners rarely serve an entire sentence within the same prison, so the effects 

of different centres on behaviour following release cannot be distinguished. The 

one exception to this is that of Dovegate Therapeutic Centre. This centre 

specialises in running courses for the rehabilitation of offenders. An unusual 

aspect of this centre is that participation is voluntary and prisoners have to apply 

to be sent there. Once there, the volunteers spend the entire duration of an 18month 

programme within the centre. As the aim of the program is to reduce reoffending, 

this is then an explicit part of the system for assessing performance. 

Contract monitoring 


A rigorous monitoring process supports the performance measures set out in 

the contract. Each prison is allocated an on-site controller, a deputy controller 

and support staff whose job is to monitor the performance of each prison. In a 

recent drive to standardise controllers’ approach to contract management, and 

minimise the risk of regulatory capture, an Assistant Director of Contracted 

Prisons was appointed to oversee all monitoring. 

99


Private and public sector prisons: 

● are also subject to inspections by HM Chief Inspector of Prisons and 

Probation; 

● have all Independent Monitoring Board as an independent watchdog 

composed of representatives from the local community monitoring the 

physical state of the prison, its administration and prisoner concerns; and 

● are subject to prisoner complaints procedures administered by the Prison and 

Probation Ombudsmen. 

Incentives to provide a high quality service 

The initial contracts contained only penalties for failure to meet the performance 

targets, they did not include rewards for exceeding targets. More recently, 

attempts have been made to include incentives for high-quality service, as well 

as the penalties for poor performance. These incentives take two main forms. In 

the special case of Dovegate Therapeutic Centre, the centre can earn financial 

bonuses for performance above the expected standard. 

However, in all other contracts bonuses take the form of credits that can be offset 

against poor performance points. Such bonuses were introduced in the two most 

recent contracts, Bronzefield and Peterborough, and have since been negotiated 

and applied retroactively to all existing contracts. Moreover, all private contractors 

have the incentive to perform well in order to be considered for re-tender. 

The final aspect of the quality assurance regime is the ultimate sanction of 

terminating the contract early. The Prison Service is empowered to take over the 

prison if it appears that the director has lost, or is likely to lose, effective control 

of the prison or any part of it. This power has been exercised in the case of 

Ashfield, where HMPS assumed control for five months in 2002 following 

concerns for inmate safety. 


The available evidence suggests that the system of performance measures and 

contract monitoring used by HMPS has largely been successful in ensuring service 

quality, although there are exceptions. Two independent studies have both found 

that the best private prisons are among the best prisons in the country. 

The NAO evaluated a sample of 21 prisons 95 and found the best PFI prisons are 

outperforming most public prisons but that the lowest-performing PFI prison is 

among the worst overall. The Coopers and Lybrand (1996) study arrives at a 

similar conclusion. It finds that contractually-managed prisons perform well or 

better on escapes and visiting entitlement, and better in terms of the number of 

95 The NAO’s methodology consisted of collating all available information into a traffic light structure assessing the 

performance of individual prisons against a range of indicators and then ranking them according to the number 

of red indicators. 

100


hours during which prisoners are unlocked and average weekly hours of 

purposeful activity. However, the study also observes that assault rates are 

higher at privately managed prisons than at comparable public prisons. 

This evidence suggests there may be tension between different objectives. In 

general, PFI prisons outperform publicly managed prisons on decency criteria 

but the reverse is true for safety/security criteria. 96 The NAO report observes that 

it appears difficult for any prison, whether public or private, to perform well in 

both of these areas, suggesting that there may be some degree of trade-off 

between the two. The observed differences in performance may arise from the 

fact that public prison decency targets are often set at lower levels than for 

private prisons, 97 perhaps enabling public prisons to make this trade-off where 

private prisons could not without breaching their contract. They may also reflect 

differences in staff culture across the types of provider. Private prisons often hire 

workers with no previous experience in prison management, and therefore have 

staff who are more likely to accept changing attitudes towards prisoners than 

their more experienced public sector counterparts. 

Not all evaluations of private prisons have been so positive. For example, the 

Prison Reform Trust has criticised private prisons for cutting labour costs to the 

detriment of service quality. It finds that these labour cost savings have been 

achieved in two main ways. First by reducing the number of employees: the 

private sector hires on average 17 per cent fewer staff per prisoner. 98 Second, by 

offering worse terms and conditions to prison officers than those enjoyed by 

public sector employees. The average basic salary for prison officers in state run 

prisons in England and Wales in April 2003 was £23,071, compared to £16,077 in 

privately managed prisons. 99 The average contracted working week is two hours 

longer and annual leave two to ten days less per annum. By including 

differentials in overtime pay and pension entitlements, some estimates have 

arrived at the conclusion that staff in private prisons may be up to 70 per cent 

worse off than public sector prison officers. 100 

The Prison Reform Trust has suggested that inferior terms and conditions have 

led to the hiring of young and inexperienced staff with little prior knowledge of 

the prison system, as well as observed higher turnover rates (25 per cent as 

opposed to 2.5 per cent). 101 It attributes problems maintaining required staff 

levels to these higher turnover rates, and suggests that the use of inexperienced 

96 Decency criteria relate to the quality of life in prison, and include measures such as hours of purposeful activity 

and respect shown to prisoners. Safety/security criteria on the other hand include measures to limit the number 

of escapes and assaults. 

97 For example, the NAO observes that the average purposeful activity target for local prisons operating in the 

public sector is 20.6 hours per prisoner per week, where the equivalent figure for PFI and privately-managed local 

prisons is 29.5 hours. 

98 Sachdev(2003). 

99 Hansard(23 March 2004). 

100 Sachdev (2003). 

101 DLA MCG Consulting (2003). 

101


staff may have compromised prisoner’s safety and quality of life. To support this, 

the Prison Reform Trust cites the fact that six out of ten private prisons in 2003- 

2004 failed to meet their targets for serious assaults, and that only one private 

prison met its target for purposeful activity for inmates. Performance relative to 

targets is given in Table 9.4. No such measures are available for public prisons 

against which to compare this performance. However the Prison Reform Trust 

does note that the average amount of time prisoners spend in purposeful activity 

is higher in private prisons than in public prisons. In 2003-2004, the Prison 

Service failed to meet its target of 24 hours per week, whereas the private sector 

prisons averaged 26.7 hours per week. 102 

Table 9.4 

Performance of private prisons against targets 

Prison Actual Performance Target Actual Target on 

on serious assaults on serious performance purposeful 

(rate on prisoners assaults on purposeful activity 

and staff) activity (average 

hours per prisoner 

per week) 

Altcourse 2.41% 1.50% 34.4 32 

Ashfield 2.52% 2.60% 29.3 30 

Dovegate 2.36% 1.30% 25.5 35 

Doncaster 0.09% 0.40% 19.6 20 

Forest Bank 0.80% 1.40% 20.9 24 

Lowdham Grange 1.15% 0.90% 26.8 28 

Parc 3.98% 1.00% 26.3 32 

Rye Hill 1.07% 0.00% 28.5 30 

Wolds 2.32% 1.50% 29.2 30 

Notes: Data relate to performance year 2003-2004. 

Source: Prison Reform Trust (2005). 

The Prison Reform Trust is not the only body to have expressed concerns over 

the experience of staff. As the Chief Inspector of Prisons observed in her report 

on HMP Dovegate: 

102 

‘There was some welcome innovation, and good staff-prisoner relationships. 

But there was also a worrying lack of experience and confidence amongst a 

young, locally recruited staff, few of whom had any previous prison 

experience, and who were operating with low staffing levels and high staff 

turnover. By contrast Dovegate’s prisoners were not inexperienced.’ 103 

102 See Prison Reform Trust (2005) Private Punishment: Who Profits?, Briefing Paper, HM Prison Service (2004), 

cited on p.10. 

103 See Prison Reform Trust (2005) Op.Cit, HM Chief Inspector of Prisons (2003), as quoted on p.8.

The Independent Monitoring Board at Rye Hill also noted in its annual report 

that: 

‘...lack of experience has led to instances of different staff giving conflicting 

information to prisoners. The Board has received a number of applications 

from prisoners who do not feel their concerns are taken seriously enough’. 104 

However, private contractors argue that their recruitment policies have been one 

factor contributing to their success. For example, some operators actively 

operate a policy of not employing public sector prison officers because they 

consider previous experience to be disadvantageous to a culture of change and 

innovation, and prefer to train staff themselves. They attribute the observed 

wage differentials to a number of factors, including differences in average years 

of experience and also in training, support and available opportunities. 

Furthermore, private contractors tend to pay at a rate reflecting local labour market 

conditions in contrast to the public sector, which conducts wage bargaining on a 

national basis. This has the effect that public sector prison officers are relatively 

less well paid in London, but receive a higher wage than they would otherwise 

hope to command elsewhere in the country, leading to a very low turnover rate. 

Some critics consider that this low turnover, combined with strong unionisation, 

can make change more difficult for the public sector to introduce than its private 

counterparts: workers who have been performing the same job for a long time are 

less likely to think of or welcome innovations than workers entering the sector with 

no pre-conceptions regarding prison management. 

If it were impossible to specify a sufficiently complete contract for prison 

services, widespread termination of contracts would be likely. The fact that no 

contracts have failed to this extent therefore suggests that contracting for quality 

has been largely successful in prison service procurement. Where problems 

have arisen with private providers they have constituted a breach of contract and 

attracted appropriate financial penalties. This outcome suggests that the range 

of performance measures included in prison contracts adequately covers most 

aspects of service quality. Most notably, most private prisons outperform their 

public sector counterparts on many measures of service quality. Even though 

this performance may be helped by having more modern facilities, it suggests 

that overall service quality in private prisons is satisfactorily maintained. 

Outcome of market mechanism 


The two expected benefits of the introduction of the private sector were that it 

would reduce costs and improve innovation. Although no specific targets were 

set, there is evidence that the process was successful in both of these objectives. 

104 See Prison Reform Trust (2005) Op.Cit, Rye Hill IMB (2004), as quoted on p.9. 

103


COST EFFICIENCY 

Two independent reports have suggested that there have been significant cost 

savings from procurement. The CBI report estimates cost savings of between 

£40m and £60m per annum from prison-service procurement, amounting to a 

total of between £200m and £260m between 1991 and 2002. This estimate is 

based on the most recent available data for cost per prisoner place, which state 

that the operating costs of privately-managed prisons are 10-15 per cent lower 

than comparable publicly managed prisons. The CBI measure also includes 

construction cost savings of 20 per cent achieved by designing and building 

prisons under PFI contracts rather than traditional procurement means. These 

savings are mainly attributable to the fact that new prisons have been completed 

on time 105 and on budget, with construction times falling by more than 40 per 

cent and the risk of cost over-runs transferred to the private contractor. The 

measure also includes operating cost reductions in the three market-tested 

prisons won by the in-house bid. 

There is some question over whether cost per prisoner place is the appropriate 

measure to use. A study by the Home Office found that whilst this measure 

reports cost savings of the order assumed by the CBI, two alternative measures 

based on the cost of available places give a different picture. These measures, 

based on cost per place, show the gap between public and private management 

costs narrowing over time to the extent that there are no longer any savings to 

be made from private sector involvement. 106 The study suggests that the 

marginal cost of accommodating an additional prisoner is small, and therefore 

that over-crowded prisons will appear more cost efficient than prisons operating 

at or under capacity when measured in terms of cost per prisoner. The number 

of prisoner places on the other hand is more stable and so reporting cost in 

terms of prisoner places provides a more reliable indicator of relative efficiency. 

Figure 9.1 opposite shows trends in these different measures over time. 

105 In contrast to prisons constructed under traditional procurement, which averaged 13% construction overruns. See 

Competition: a catalyst for change in the prison service, CBI, p.18. 

106 Park, I.(2000) ‘Review of Comparative Costs and Performance of Privately and Publicly Operated Prisons 1998-99’ 

Home Office Statistical Bulletin 6/00, RDS Directorate . 

104

Figure 9.1: Difference between the average operating costs of private prisons 

and public sector comparators 

25% 

20% 

15% 

10% 

5% 

0% 

-5% 

Cost per in-use CNA 

Cost per baseline CNA 

Cost per prisoner 


1994–95 1995–96 1996–97 1997–98 1998–99 

Notes: Cost per baseline Certified Normal Accommodation (CNA) place refers to the total number of places the prison is 

certified to offer. Cost per in-use CNA place measures the total number of places excluding those temporarily out of use. 

Public sector comparators are computed by taking the average operating costs of two or three prisons similar to the 

private prison concerned. The above figure represents the average differences in the operating costs of four private prisons 

(Blakenhurst, Buckley Hall, Doncaster and Wolds) and their public sector comparator. Data is not available after 1999. 

Source: Reviews of comparative costs and performance of privately and publicly operated prisons 1998-99, Home Office. 

The CBI has questioned the Home Office methodology on the grounds that large 

increases in over-crowding require additional staff resources and that the 

marginal cost of prisoners is therefore significant. The report also cites the fact 

that staffing costs per prisoner in 1997-98 were 33 per cent lower in contract 

prisons than in public prisons, and staffing costs per place 24 per cent lower. 107 

Because staffing costs account for a large proportion of a prison’s running costs, 

it seems likely that savings that are still being realised from private sector 

involvement. The CBI methodology states that it adjusts its total annual cost 

saving estimate for over-crowding during contract life, but does not explain how 

this is done. 

Although there is some debate over the relative improvements in efficiency of 

private prisons, there is a consensus that competitive tendering led to 

operational cost savings at least in the short run. Coopers and Lybrand (1996) 

performed a cost analysis for 1994-95 and found operational cost savings of 

between 13 and 22 per cent relative to a group of comparable publicly-managed 

prisons. It should also be noted that any improvements in the relative efficiency 

of public prisons are a likely result, at least in part, from competitive pressure 

and diffusion of best practice from privately managed prisons. This implies that 

107 CBI (2003), Competition: a catalyst for change in the prison service, p.17. 

105


private sector involvement continues to deliver significant operating cost 

efficiency benefits but that the public sector comparator is no longer the most 

appropriate means of measuring these. Operating cost savings under this 

scenario also include the lower running costs of public prisons attributable to the 

development of a private sector market in prison services. 

SHARPER INCENTIVES FOR INNOVATION 

There are three main reasons for innovation being more likely in the private 

sector. 

● First, private sector contractors capture the entire rents from cost reducing 

innovation for the duration of the contract life since prices are agreed when a 

contract is signed. In contrast, public sector managers would be likely to see 

their budget cut the following year in response to a cost reducing innovation. 

● Second, innovative working practices may also be easier to introduce in the 

private sector where working practices are less firmly established. 

● Third, the process of competition may encourage both public and private 

sector bidders to be more responsive to customer needs. 

There is indeed evidence that competition, and, more broadly, the threat of 

competition, has delivered greater innovation in the following areas. 

Staff recruitment and deployment 

The largest opportunity for innovation in a prison-management contract is in 

staff deployment, as staff represent around 80 per cent of running costs. 

Innovation in staff deployment and recruitment has included a flatter 

management structure and the recruitment of a younger, more flexible 

workforce, many of whom have had little or no prior experience in prisons. 

These features, combined with a higher average staff turnover, have facilitated 

the introduction of more flexible working practices such as shift work. As noted 

previously, low staff turnover rates in public prisons may make it more difficult 

to change established methods of operation. Shift patterns have enabled 

receptions to remain open longer, visiting times to be more flexible and 

prisoners on enhanced regimes to eat with their families. 

Although these recruitment practices may have increased flexibility, they have 

raised some concerns about security. 

Staff/Prisoner relationship 

One of the most significant innovations to occur has involved a focus on 

encouraging a more positive relationship between staff and prisoners. The CBI 

report notes that: 

106

‘While there were staff in the publicly managed prisons who wanted to break 

from the confrontational culture of the past, it required the creation of a new 

class of prison with a profoundly different management regime to bring 

about a new and more constructive culture.’ 108 

The NAO-commissioned study by MORI found that prisoners in privately 

managed prisons feel better treated than those in publicly managed prisons. 

These conclusions find support in independent work by the Institute of 

Criminology at Cambridge University 109 and even amongst some critics of 

private sector involvement. For example, the Prison Reform Trust comments: 

‘A noticeable private sector innovation has been in the attitude of staff 

towards prisoners....It is the norm in private jails for staff to address prisoners 

by their title and to develop a different style of staff-prisoner relations.’ 110 

Technological innovation 

Technological innovations have generally been introduced to reduce staffing 

requirements, and include the increased use of CCTV and the introduction of 

magnetic keys. 

Prison Design 

Under the DCMF contracts, the design of prisons has been left to the private 

sector. This has led to innovations in prison design. New prisons designed under 

PFI contracts have been built to incorporate clear lines of sight for ease of 

monitoring, for example situating control rooms at the centre of a spine system 

of wings. 

Some of these private sector innovations have helped the Prison Service 

become more competitive. For example, when building new house blocks within 

existing prisons, HMPS has drawn on private sector best practice of using prefabricated 

buildings that can be assembled on site. The private sector has also 

made use of innovative shift patterns and staff arrangements to improve 

efficiency, although the extent to which the public sector has been able to adopt 

these has been limited. 

UNANTICIPATED BENEFITS 


There have been unanticipated benefits from the introduction of competition. 

The main unanticipated benefit has been the competitive pressure that private 

sector involvement has exerted on the public sector. Competitive tendering has 

allowed for the development of an alternative market of rival suppliers, against 

108 CBI (2003) Competition: a catalyst for change in the prison service, p.25. 

109 See for example, Liebling, A. and Arnold, H. (2002) ‘Measuring the quality of prison life’, Findings no.174, Home 

Office, RDS Directorate. 

110 Prison Reform Trust (2005) Private Punishment: Who Profits?, Briefing Paper, p.10. 

107


whom the public sector has had to compete for the management of markettested 

prisons. To date, there have been eight contracts for which the public and 

private sector have competed directly. The introduction of performance testing 

for failing prisons has also provided an indirect competitive stimulus for good 

performance in the public sector, and is only possible because an alternative 

market of private sector suppliers now exists. 

That the public sector has become more efficient as a result is evidenced by: 

● its ability to win back two management contracts, Buckley Hall and 

Blakenhurst, from incumbent private sector contractors. That this is 

attributable to the improved efficiency of the public sector rather than the 

poor performance of private suppliers is demonstrated by the fact that both 

prisons received good reports from the Prison Inspectorate shortly before the 

contracts were re-tendered and lost. In the case of Buckley Hall, the report 

went as far as concluding that it was ‘... a thoroughly good prison: in terms of 

outcomes for prisoners, Buckley Hall was outperforming the majority of 

Prison Service establishments fulfilling similar roles’; 111 and 

● the fact that the prison population has increased more than proportionately 

with the Prison Service budget. In the 1980s, it was the increase in prisoner 

population that gave rise to the very concerns about over-crowding and poor 

conditions that led to the involvement of the private sector in the first place. 

Recent increases in prison population, however, appear to have been 

absorbed without any significant adverse impact on performance. This 

outcome is unlikely to reflect economies of scale, as the CBI report observes: 

‘One would expect there would have been some scale economies 

associated with overcrowding and yet the two contract prisons with the 

biggest increases in overcrowding, HMP Blakenhurst and HMP Doncaster, 

had larger increases in cost per place and smaller falls in cost per prisoner 

than the other two contract prisons. If there were scale economies 

associated with overcrowding, they cannot have been significant.’ 112 

Overall Assessment 

The overall evidence suggests that the procurement of prison services has been 

successful. The anticipated benefits of competition appear to have been realised, 

without suffering from any major potential detriments. In particular, the 

supporting performance-measurement process, combined with an extensive 

monitoring process, appears to have been sufficient to maintain quality in the 

majority of private prisons, although there have been exceptions. 

This success has not come without significant investment of time and resources. 

Each competition requires four or five internal staff at a cost of around £250k to 

111 HM Chief Inspector of Prisons for England and Wales, ‘Annual Report 1999-2000’, p.25. 

112 CBI (2003) Op.Cit. p.17. 

108

design the invitation to tender and negotiate bids. Further costs of £500-600k are 

incurred in the form of legal advice and financial insurance. In addition, each 

prison has its own on-site controller to monitor the quality of service. 

Table 9.5 

Average total costs per competition 

Source: Interview with David Kent, HMPS; interview with private prisons operator. 

However, the evidence suggests that these costs have been far outweighed by 

the benefits. The CBI reports that the prison service has saved £40-60m per year 

as a result of the introduction of competition. 113 Moreover, this measures only the 

direct benefits of having more efficient private prisons. Other benefits exist, such 

as encouraging greater efficiency and innovation in the public sector. Public 

sector comparator estimates computed by HMPS show there are now fewer 

savings from using the private sector for the operation of a prison as the public 

sector has become more efficient. This finding shows that even opening a 

limited portion of a service to competition can have significant benefits for the 

parts not directly exposed to competition. 

LESSONS FOR OTHER AREAS 


Source of cost Amount 

Design of invitation to tender and negotiation around bids £250k 

Legal advice and financial insurance £500k-600k 

TOTAL COSTS FOR HMPS PER COMPETITION £750-850k 

Legal advice £100k 

Financial costs £100k 

Building design costs £100k 

Asset management costs £70k 

Internal costs (including opportunity cost of staff resources) £200k 

TOTAL COSTS FOR A BIDDING FIRM PER COMPETITION £570k 

We have identified the following lessons that could be relevant to the use of 

competitive tendering in other areas. 

● Involving the private sector in the provision of public services can lead to 

lower service delivery costs and greater innovation. It may also increase 

public sector provider efficiency by introducing competition and allowing the 

diffusion of innovations. Even when only introduced to a small proportion of 

the sector, competition can still help to increase the sector’s overall efficiency. 

The performance of public sector prisons has improved since the introduction 

of competitive tendering and this improvement is believed to be partly 

attributable to the threat of replacement by private prisons. 

113 The CBI measure includes operating cost savings in privately-managed prisons and an estimate of savings from 

contestability in terms of lower prices for successful in-house bids. It does not include any cost efficiencies in 

non-market tested public sector prisons that may have resulted from the diffusion of best practice from the 

private sector 

109


● It may be possible to specify aspects of service quality in a contract using 

measurable and enforceable performance criteria. Combined with an 

adequate monitoring system, contract design may therefore be used to limit 

quality shading in competitively tendered services. This runs counter to the 

predictions of economic theory, which assumes that quality is difficult to 

measure and therefore concludes that private sector involvement in public 

services may lead to cost cutting at the expense of quality. Conducting the 

competitive tender process through a beauty contest mechanism may also be 

useful where quality is an important aspect of the service because this 

prevents an excessive focus on cost. 

● Targets and performance measures should be well defined and based on 

clear objectives. Most aspects of service quality involve trade-offs. 

Contractors are therefore likely to focus on delivering the outcomes that are 

most easily measurable. When designing targets it is important to bear in 

mind that measurable performance indicators will be preferred over those 

that are less easy to measure. The potential for a target to have an unintended 

consequence should be taken into account when setting the target. As no 

system is perfect, targets should also be regularly reviewed over time to take 

their actual performance into account. 

● The benefits of contract aggregation can be realised without creating 

problems for long-term competition from incumbency advantages. Requiring 

disclosure of information by incumbents to bidders and encouraging entry by 

suitable firms operating in relevant fields can help to maintain a competitive 

market. 

● When a market is relatively new, it may be necessary to select bidders not 

offering the lowest price for a contract to ensure competition for future 

contracts. Awarding early contracts to one provider only may realise shortterm 

cost savings, but it can prevent the entry of competitors who can help 

to keep costs down in the future. 

● The appropriate use of self-supply can be an effective constraint against 

collusion, but must be managed carefully to avoid creating an impression of 

discrimination in favour of in-house bids. Excessive self-supply may also limit 

the number of private sector firms the market can support, preventing the 

development of competition. 

● The risk of a winner’s curse can be reduced by increasing the information 

available to bidders, restricting the number of bidders through pre-selection 

criteria and allocating tenders through a beauty-contest mechanism. 

● Pre-committing to an appropriate transfer rate for specific assets at the end 

of the contract life can help to ensure an efficient amount of investment is 

undertaken. One means of pre-committing to this transfer payment is 

through the contract price. 

110


● There are likely to be important trade-offs in contract design when there are 

multiple objectives for quality; as, for example, in the observed trade-off 

between meeting safety/security criteria and meeting decency criteria 

contained in contracts for privately-managed prisons. 

● Learning and adapting the process as both the procuring body and the 

contractors gain in experience can improve the benefits to be gained from 

competitive tendering. In the case of prison services, HMPS has modified 

the type and length of contract it offers, introduced bonus points for 

good performance and allowed for benchmarking against other suppliers 

mid-contract. 

● Introducing competitive tendering for the provision of a service requires a 

heavy resource commitment, in both up-front and ongoing costs. Any public 

sector body seeking to introduce competition in this way must be able to 

guarantee the availability of these resources for the policy to be implemented 

effectively. However, competitive tendering has the capacity to deliver 

substantial net cost savings. 

111

SECTION 10 

Choice-Based Letting 

in Social Housing 

Introduction 

This case study looks at the introduction of choice in the allocation of social 

rented housing. Social housing is affordable housing provided by local 

authorities and Registered Social Landlords (RSLs) for people who cannot afford 

to, or do not aspire to, own or rent a home in the private sector. Social rented 

housing offers rents at sub-market levels 114 and is one of a number of affordable 

housing policies designed to offer everyone in the UK the opportunity of a decent 

home. The development of housing for letting at sub-market rents is supported 

by public subsidy (the Social Housing Grant) but maintenance costs and other 

financial commitments of RSLs are met out of rental income. As the number of 

social rented properties on offer is fixed and often outstripped by demand, an 

allocation mechanism is necessary to determine who gets which property. 

The allocation method we examine here was first introduced in England in 2000 

by Harborough and Mansfield local authorities. These districts experimented 

with housing allocation models based on successful schemes developed in the 

Netherlands in the 1990s. The resulting models became known as Choice-Based 

Letting (CBL) schemes. 

CBL schemes received increasing attention from local authorities following the 

publication of the Housing Green Paper in 2000, which encouraged greater 

emphasis on user choice in social housing. Various local authorities ran pilot 

CBL schemes partially funded by the Office of the Deputy Prime Minister (ODPM) 

between 2001-2003. Most schemes have continued operating beyond the pilot 

stage, and other areas have introduced CBL since. 

CBL differs from traditional methods for allocating social rented housing as 

follows. The traditional model involves local authority housing officers deciding 

which properties should be offered to which social housing applicants. 

Individual properties are then offered to individual applicants, one-at-a-time. 

Under CBL, all or most applicants are informed of all the properties available at 

a given point in time and have an opportunity to express an interest in any of 

these properties (subject, perhaps, to some suitability criteria). 

CBL schemes provide an example of how choice can be introduced to a public 

service previously rationed through central, administrative allocation. In this case 

study, we first provide a background description of the market, including supply 

114 Currently 30-40 per cent below market rates. See Housing Green Paper (2000) Quality and Choice: a Decent Home 

for All, London: The Stationery Office, Chapter 10. 

112

and demand conditions. Second, we discuss the perceived failings that led to the 

introduction of a market-based mechanism, and why the particular mechanism 

was chosen. Third, we examine potential problems with this market mechanism, 

how these problems were addressed in scheme design and the success in doing 

so. In the final section we provide an overall assessment of the policy. 

This case study draws on the following sources: 

● an interview with Frances Walker, a policy official at ODPM and Kathleen 

Kelly, then a senior research officer at ODPM; 

● the housing green paper behind the introduction of the policy 115 ; 

● two external studies of CBL pilots commissioned by the ODPM: an evaluation 

of the 27 schemes conducted by Bristol and Cambridge Universities 116 ; and a 

qualitative study of applicants’ views carried out by BMRB 117 in six of the 

pilots; 

● ODPM bidding guidance for local authorities; 

● an LGA study on introducing choice to government services 118 ; 

● a report published by Market Harborough officials and an academic from De 

Montfort University based on Harborough’s experience with choice based 

lettings 119 ; and 

● interviews with officials involved in the implementation of CBL pilots in three 

different areas, Blackburn, Camden and Market Harborough. These areas 

were selected for more detailed study as they encompass a broad range of 

local housing market conditions and so illustrate how user choice can be 

introduced in very different contexts. 

Market Background 

Section 10 – Choice-Based Letting in Social Housing 

The market considered in this case study is the allocation of low-cost, rented 

accommodation provided by local authorities and Registered Social Landlords 

for those considered to be in housing need in Britain, which we call the social 

rented housing market. Although this report focuses primarily on the market for 

social rented housing in England, the National Assembly for Wales has also 

supported pilot CBL schemes in Caerphilly, Swansea and Torfaen. Similarly, the 

Scottish Executive has promoted choice-based pilots in Edinburgh and 

Berwickshire. 

115 Housing Green Paper (2000) Quality and Choice: a Decent Home for All, London: The Stationery Office. 

116 A. Marsh, D. Cowan, A. Cameron, M. Jones, C. Kiddle and C. Whitehead for ODPM (2004) Piloting choice based 

lettings: An evaluation, London: The Stationery Office. 

117 BMRB for ODPM (2004) Applicants’ Perspectives on Choice-Based Lettings, London: The Stationery Office. 

118 LGA (2004) Enabling choice: research on choice in public services. 

119 Brown, T., A. Dearling, R. Hunt, J. Richardson and N. Yates (2002) ‘Allocate or Let? Your Choice: Lessons from 

Harborough Home Search’, Chartered Institute of Housing/ The Joseph Rowntree Foundation. 

113


POLICY HISTORY AND TIMETABLE 

In 1990, an alternative approach to letting social housing involving a greater 

degree of choice on the part of the applicant was developed in the Delft region 

of the Netherlands. This approach (known as the advertising model) was based 

around advertising vacant properties, with applicants then actively bidding for 

properties using a ‘currency’ allocated to them by the relevant authority, rather 

than waiting to be allocated a property by a housing official. 

The success of this model became known to some English local authorities. They 

began investigating alternative allocation mechanisms in response to mounting 

dissatisfaction with their existing systems. One such council was Harborough 

District Council, which introduced the first district-wide scheme of this kind in 

the UK in April 2000 encompassing all of its properties. Mansfield District 

Council also introduced a choice experiment at this time for its difficult-to-let 

properties only. 

A Housing Green Paper entitled ‘Quality and choice: a decent home for all’ was 

published in 2000 proposing best-practice principles for lettings schemes, and 

encouraging the introduction of choice to social housing allocation as part of the 

Government’s wider choice agenda. The Housing Green Paper aimed to test 

alternative allocation approaches that would facilitate choice and encourage a 

more pro-active role for households whilst ensuring that local authorities 

continued to meet their statutory responsibilities under the Housing Act 1996. 

Following the publication of the Green Paper, the ODPM made £13m available to 

support and evaluate pilot CBL schemes. The pilots were intended to test 

approaches that offered more consumer choice in different housing markets and 

across a variety of authority types. Local authorities were invited to bid for this 

funding in 2000. Ninety-one bids were received, of which twenty-seven were 

successful. Other local authorities subsequently introduced choice schemes 

using their own resources. 

The pilot schemes ran from 1 April 2001 to 31 March 2003 and their initial 

outcomes have since been evaluated in two research studies conducted for the 

ODPM. 120 

In April 2004, more than 20 per cent of local authorities were running CBL 

schemes. 121 The Government has announced a target for 100 per cent of local 

authorities to introduce CBL by 2010. 

120 A. Marsh, D. Cowan, A. Cameron, M. Jones, C. Kiddle and C. Whitehead for ODPM (2004) Piloting choice based 

lettings: An evaluation, London: The Stationery Office and BMRB for ODPM (2004) Applicants’ Perspectives on 

Choice-Based Lettings, London: The Stationery Office. 

121 Source: Office of the Deputy Prime Minister. 

114

DEMAND 

Anyone can apply to a local authority for social housing. Typically applications 

are directed towards the borough in which the applicant resides, but this is not 

essential. As local authorities are unable to offer homes to everyone, they design 

an allocation mechanism to ensure households with the greatest housing need 

are accommodated first. 

Allocation schemes must comply with a local authority’s statutory 

responsibilities under section 6 of the Housing Act 1996, which requires that 

local authorities have and publish a scheme that determines priorities and the 

procedure for allocating social housing. Certain people must be given 

‘reasonable preference’ under an allocation scheme in order to ensure that 

priority for social housing goes to those in the greatest housing need. These 

categories are defined in the Housing Act 1996, were modified by the 

Homelessness Act 2002, and are: 

● people occupying unsanitary or overcrowded housing, or otherwise living in 

unsatisfactory housing conditions; 

● people who are homeless; 


● people who need to move for medical or welfare reasons; and 

● people who need to move to a particular location and who would suffer 

hardship if they were unable to do so (for example to be near a special 

medical facility). 

The assessment of housing need varies from council to council, but is typically 

calculated with reference to current housing conditions and health problems. 

Applicants are allocated a ‘currency’, often in terms of points or bands, assessed 

according to the mechanism used by their local council. 

Housing market conditions can vary dramatically between local authorities. 

Some face a high level of demand relative to the supply of available properties, 

resulting in long waiting lists and many households being placed in temporary 

accommodation. Others face insufficient demand for some or most types of 

social rented property available in their area. Table 10.1 compares the market 

characteristics in the three areas where we interviewed officials involved in 

administering local schemes. 

115


Table 10.1 

Comparison of markets in different localities 

Source: Interviews with officials from Blackburn, Camden and Harborough CBL schemes. 

SUPPLY 

Blackburn Camden Harborough 

Nature of market Low demand High demand, urban area. High demand, rural area 

covering 92 different 

villages 

Number on register 6500 15,000 1600 

Number of properties/ 10,800, all owned by 30,000 3100 

ownership of properties Registered Social (22,000 owned by council) (2000 owned by council) 

Landlords 

Average waiting time 1 year Unknown 2-2.5 years 

Social rented housing is supplied by local councils and Registered Social 

Landlords. 

Local authorities traditionally owned all social rented housing. Whilst they still 

hold waiting lists for all social housing in their area, there are many that no 

longer own or manage any permanent housing. Two national programmes have 

been responsible for the transfer of social housing in England from local 

authorities to RSLs, namely the Large Scale Voluntary Transfer and Estates 

Renewal Challenge Fund programmes. An RSL is an independent housing 

organisation registered with the Housing Corporation under the Housing 

Act 1996. Most RSLs are housing associations, but they also include trusts, 

co-operatives and companies. 

Housing associations are the main providers of new social housing. There are 

currently over two thousand privately run housing associations in England 

managing over 1.45 million properties and providing accommodation for over 3 

million people. Most associations are small and own fewer than two hundred 

and fifty homes, but the largest 7 per cent of associations own 78 per cent of the 

sector’s total housing stock. 122 

There may be other housing options that solve a household’s housing needs. 

These can be considered substitutes for social rented housing and include: 

● The Homebuy scheme. This involves paying 75 per cent of the value of the 

property and receiving an equity loan for the remainder, payable upon sale of 

the property. A further 25 per cent must also be repaid upon property re-sale. 

A mortgage is paid only on 75 per cent of the property value and no rent is 

paid (unlike shared ownership). 

● Shared ownership. This involves buying a share of a property from a housing 

association and paying rent for the remainder. 

122 Statistics from the Housing Corporation website: http://www.housingcorp.gov.uk/. 

116

● Rent deposit guarantee by the local authority for private sector rental. 

● Mutual exchange with another local authority or housing association tenant 

wishing to be re-housed. 

The operation of the social housing market is subject to various laws. 

The Housing Act 1996 

This confers on local authorities a statutory responsibility for developing, 

maintaining and operating an allocation scheme showing reasonable preference 

to those in housing need. 

The Homelessness Act 2002 

The Homelessness Act 2002 amended the Housing Act 1996 in the following 

way: 

● the number of reasonable preference categories was reduced, and the 

categories themselves were changed, for example, to include the 

intentionally homeless; 

● local authorities were required to issue a statement and provide information 

on their policy in relation to offering choice or giving preferences to 

applicants; 

● advertising schemes were conferred legislative authority; 

● the requirement to keep a housing register was removed; 

● applicants can now be excluded from applying to a local authority only for 

reasons of prior unacceptable behaviour; 

● local authorities were given the power to determine priorities between 

reasonable and additional preference categories; and 

● local authorities were given the power to determine whether certain 

categories of applicants should be entitled to additional preference. 

Introduction of market mechanism 

PERCEIVED FAILING 


Social rented housing in the UK was traditionally allocated by the relevant 

landlord to households who had applied for housing, typically through the use 

of a waiting list. Vacant properties were offered to the applicant considered in 

greatest need, where need was expressed in points reflecting the unsuitability of 

current housing circumstances and waiting time on the housing register. 

The weighting assigned to different components of a household’s points score 

was left to the discretion of landlords, subject to the requirement that they give 

117


‘reasonable preference’ to certain groups as defined in The Housing Act 1996, 

and amended by The Homelessness Act 2002. When the household came to the 

top of the waiting list, it was offered a property deemed suitable by the local 

authority. Although households were able to specify to a certain extent the area 

and type of property, refusing an offer frequently resulted in penalties such as 

suspension from the waiting list. In spite of this penalty practice, some areas 

also reported high refusal rates. 123 

There were growing concerns about the traditional allocation system in terms of 

the way in which it assessed needs and priorities, as well as the extent to which 

housing officials determined the outcome of choices regarding location and type 

of property. The following key drawbacks were identified. 

● The complexity of the system was making it difficult for users to understand 

and therefore participate effectively in the process. Under the traditional 

allocation mechanism, customers had no understanding of the number of 

points required to obtain a given type of property, and did not know how their 

points assessment related to others in their area. Furthermore, housing 

associations and local authorities would often use different points schemes. 

This created confusion over how need was assessed and was also thought to 

impede mobility between neighbouring authorities. 

● A lack of transparency was leading to customer concerns about the fairness 

of the process. Users were often unaware not just of the mechanisms behind 

the allocation process, but also of the availability of social housing in their 

area. 

● The unfairness and undesirability of processes relying heavily on housing 

officers’ discretion was becoming increasingly apparent and at odds with the 

modernising government agenda. The Government was concerned that the 

dependency of applicants on social housing officials encouraged by an 

administrative allocation mechanism had adverse implications for 

individuals’ sense of empowerment and community stability. 

● The system created undesirable incentives. Points-based allocation systems 

suffered the drawback that they generated ‘points-chasing’ behaviour in 

some users, who lobbied housing officials in an attempt to increase the 

assessment of their housing need because this was the only means available 

to increase their chances of being re-housed. This potential for capture is 

common to many public-sector regulators and often a major source of publicsector 

inefficiency. It was hoped that introducing a greater element of the 

market into the allocation mechanism would increase transparency and 

thereby limit this practice by providing incentives instead for customers to 

make themselves better informed about CBL and alternative housing options. 

123 For example, Dover reported a 70% refusal rate prior to its implementation of a CBL scheme. (From interview 

with officials at ODPM). 

118

The Green Paper stated the Government’s objective for social rented housing 

policy was to: 

...promote lettings policies that offer choice, tackle social exclusion, help 

create sustainable communities and encourage the effective use and 

management of social housing. 

One means proposed to achieve this goal was the funding of pilot consumer 

choice-based lettings schemes in different areas of the country. The Green Paper 

noted that the more opportunity people have to decide trade-offs (e.g. over 

property location and size) themselves, the more likely they are to feel 

ownership of the decision and therefore to be happy with the outcome. Offering 

choice was also seen as a means of empowering people who may have been 

dependent on social housing officials in the past. 

The fundamental objective of user choice in social rented housing allocation was 

to create sustainable communities. In Part III above, we noted that empowering 

users by enabling them to exercise choice could create incentives for individuals 

to take responsibility for their own outcomes. In the context of CBL, it was hoped 

that households would be more likely to stay longer in a property, maintain 

the property and participate actively within the community. This outcome was 

hoped in turn to lead to the creation of more sustainable communities. 

Other objectives were outlined in the bidding document provided to all local 

authorities. They were: 

● to increase transparency; 

● to increase choice; 

● to give priority to those in greatest housing need; 

● to protect the interests of the vulnerable and the excluded; 

● to address particular black and ethnic minority issues; 

● to encourage mobility between areas of high and low demand; 

● to increase labour mobility; 

● to educate applicants about availability in the social rented sector, 

heightening awareness of the genuine capacity constraints; 

● to make better use of national housing stock by: 

● addressing problems of empty and unpopular stock as well as underoccupation; 

● encouraging partnerships between local authorities and housing 

associations; 

● developing lettings schemes involving private landlords; and 

● bridging boundaries between local authorities; 


119


● to use different and innovative methods of marketing and advertising 

property; and 

● to use IT innovatively, for example using new technologies to promote choice. 

Individual pilot-scheme objectives varied across different localities reflecting 

differing local housing-market characteristics. For example, low-demand areas 

wished to use CBL to stimulate demand for social rented housing whereas highdemand 

areas hoped CBL would raise awareness of capacity constraints and 

thus encourage migration into other housing options. Three examples are given 

in table 10.2 below. 

Table 10.2 

Pilot scheme objectives in different localities 

Blackburn Camden Market Harborough 

Form an effective partnership Empower applicants; Improve customer satisfaction 

between RSLs and the council; and sense of fairness by 

Increase transparency to improve increasing transparency; 

Simplify access for users; consumer understanding of their 

relative position on the register; Ensure all applicants given the 

Boost local demand for same opportunities and choices; 

social rented property; Increase awareness of capacity 

constraints; Ensure every property is advertised; 

Offer users a degree of control 

and choice; Ensure vulnerable groups and BME Provide feedback on bidding 

households are not disadvantaged; rankings; and 

Make the most efficient use and 

of IT; and Encourage movement to lower 

Use information from bidding to demand areas. 

Ensure needs of vulnerable guide strategic plans. 

groups are met. 

Source: Interviews as before. 

It is worth briefly comparing the national and local objectives for CBL schemes 

with the potential benefits of user choice identified by economic theory and 

summarised in Part III above. These economic benefits were divided into supplyside 

and demand-side benefits. Supply-side benefits are realised only if 

introducing choice leads to competition amongst different providers, and 

include sharper incentives for efficiency, quality and innovation. Demand-side 

benefits do not require service providers to be in competition with one another, 

and include improved allocative efficiency as a result of better information and 

benefits associated with empowering users. 

120

It was not an objective of ODPM or CBL schemes to encourage competition 

between social landlords, suggesting in the first instance that potential benefits 

of user choice achieved through the supply side of the market are unlikely to 

apply to CBL. However, it was an objective of CBL to raise the profile of and 

increase the demand for social housing in low demand areas, particularly local 

authority housing. This may affect demand for private landlords operating 

outside of the scheme, as some applicants who would have rented privately 

instead rent from social landlords. Similarly the objective to encourage mobility 

between high and low demand areas may have led to lower demand areas 

competing with higher demand areas for applicants, although this would also 

have occurred under the previous administrative system. 

User choice schemes can also increase efficiency through the demand side of the 

market, primarily by improving the quality of information used as the basis for 

housing allocation decisions. Allowing applicants to express an interest in the 

properties they would like to be considered for increases information relative to 

a situation in which housing officials alone decide who gets which property. Part 

III of this report highlights lack of information as one cause of both market and 

government failure, and consequently identifies improving information as one 

means of increasing efficiency. Many of the stated objectives of CBL were also 

linked with improving the quality of information, including the objectives of 

increasing transparency and educating applicants about availability. For example 

by heightening awareness of capacity constraints, applicants can make the 

decision about whether to continue waiting or to investigate alternative housing 

options on the basis of superior information. The objective to make better use of 

the nation’s housing stock by reducing the number of vacant properties is one 

means in which any increase in efficiency might be observed and measured. 

The ODPM’s main objective of building sustainable communities is an example 

of an outcome that may be improved as a result of empowering users. 

Empowering users was often an objective in its own right for local schemes, and 

is also linked to the objective of improving customer satisfaction. 

The remaining objectives relate more to the design of CBL schemes than 

measurable outcomes. These include the objective of giving priority to those in 

greatest housing need, which is achieved by giving higher priority to vulnerable 

groups. 

PROBLEMS ADDRESSED BY CBL 


Only one market mechanism, user choice, was considered in this context. 

However, the means in which it was introduced varied across local authorities to 

reflect the different needs of different areas. 

121


It was hoped by the ODPM and local authorities involved in the pilots that CBL 

schemes would address the problems of the traditional allocation mechanism in 

the following ways: 

● Complexity. Many CBL schemes involved the simplification of prioritisation 

of housing need from a points-based to, for example, a band-based system. 

It was hoped this would improve users’ understanding of the process and 

enable applicants to participate more effectively. Although this could have 

been implemented as a standalone policy, facilitating user understanding in 

this way was important in reducing the burden placed on customers by 

introducing user choice and increasing the probability that customers would 

make rational choices. Those CBL pilots that retained points-based systems 

sought alternative means of improving user understanding of the process, for 

example increasing the amount of information available to potential users. 

● Lack of transparency. CBL schemes involve advertising vacant properties and 

also providing feedback to unsuccessful bidders regarding the characteristics 

of the successful applicant. These features obviously serve to improve the 

transparency of the allocation process. It was hoped this would make the 

process more equitable and enhance users’ ability to make rational choices 

based on availability. 

● Unfairness. Moving away from a situation in which the local authority 

determined the allocation of property to one in which applicants are able to 

select the properties for which they wish to express an interest was intended 

to make the process fairer. 

● Undesirable incentives. Because CBL schemes intended to offer a simpler 

currency than before, it was hoped there would be less scope for applicants to 

waste officers’ time in ‘points chasing’ to improve their chances of re-housing. 

By increasing transparency, it was hoped customers would become more 

aware of their relative position on the housing register, the capacity constraints 

in their area and therefore their probability of being re-housed. Once they 

realised that exaggerating their housing need could do little to improve this 

probability, it was hoped that the incentives to chase additional points would 

be far lower. Instead, customers would have an incentive to find out more 

about the trade-offs they could make or other housing options they could 

consider that would genuinely increase their chances of being re-housed. 

It was hoped that cross-boundary CBL schemes would increase consumer 

choice further by breaking down barriers between local authorities and 

encouraging mobility where possible and desirable. There are currently four 

cross-boundary CBL schemes. 

Whilst most pilot schemes introduced choice to the allocation mechanism itself, 

some explored the alternative route of increasing household awareness of 

potential solutions to their housing problems outside local social housing. These 

options included various private sector possibilities or longer-distance mobility 

schemes. 

122

DESCRIPTION OF MARKET MECHANISM 

The market mechanism generally introduced was based on the advertising 

approach to lettings. This approach is based on the Delft model developed in the 

Netherlands. The Delft model follows a number of steps, although the process 

actually used may differ between local authorities: 

● Vacant properties are advertised, typically in a weekly newspaper although 

other media are also used. Advertisements usually include a property 

description and any qualifying conditions for potential tenants, such as 

household size or age. 

● Rules for applying are included with the advertisement. Households express 

an interest in a property by sending the reply coupon to the housing 

association. 

● Households are ranked according to transparent and objective criteria such as 

age, length of residence and waiting time. The property is offered to the 

household with the highest ranking. 

● Feedback is provided in the newspaper on the number of applicants for each 

advertised property and the qualifying conditions of the successful 

applicants. 

● Unsuccessful applicants are able to check the qualifying conditions of the 

successful applicants and can use this information to focus their future 

applications for properties where they would have a realistic chance of being 

ranked more highly. 

Because pilot scheme design and details were left to local authorities to 

determine, different variants of this model were implemented. Many common 

features emerged however and these are outlined below. 

Advertising is typically performed in a weekly or fortnightly cycle, with 

information being delivered through a variety of channels including: 

● a list of vacancies mailed to applicants each week; 

● a brochure placed at specified collection points; 

● a designated-purpose property shop; and 

● internet advertising. 


Once the advertising cycle has begun, households may bid for the property 

using the ‘currency’ they have been awarded. 

The principal currency can be housing need points or bands, or waiting time. 

The most common form of currency is housing need bands. Systems based on 

waiting time tend to be associated with lower demand areas and are used in 

conjunction with a time-limited priority card system for applicants in urgent 

need in order to comply with legislation. 

123


Camden is an example of a high demand area that chose to retain its pointsbased 

system largely because it felt that an effective currency expressed in 

points mimicked the operation of prices in a real market more closely than 

bands. By giving an indicative price for each property, Camden hopes 

households will look at this price relative to their currency and work out if they 

have a realistic chance of accessing a similar property or whether they should 

adjust their search strategy accordingly. 

In total, five broad approaches have been used to assess housing need for CBL 

schemes. These have allocated to households either: 

● a number of points with which to bid. These points are related to housing 

circumstances, as under a traditional points system; 

● a housing-need band with which to bid. Within bands, households can be 

ranked by date order; 

● an amount of waiting time with which to bid, typically taken from registration 

date. These systems often include a time-limited priority card for urgent 

re-housing cases; 

● differential status on the basis of tenancy history. For example, an excellent 

tenant (based on criteria including tenancy standards, such as keeping rent 

payments up to date) could be offered a property in preference to an 

otherwise identical non-excellent tenant; or 

● a property on a first-come-first-served basis. This approach typically 

complements the main CBL approach based on housing need or waiting time, 

for example, for properties receiving no expression of interest following 

advertisement. 

The means used to assess housing need strongly influences the type of 

applicant who can access which property. If no other constraints are placed on 

bidding, households awarded the highest amount of currency under the chosen 

assessment mechanism will be the successful bidders. One constraint that can 

be placed on bidding is property labelling, which can be used to restrict the type 

of applicants entitled to bid for a particular property. Labelling criteria may take 

the form of a minimum age requirement or number of children in the household, 

for example, and often appear alongside the advert for the vacant property. They 

may also be incorporated into the rules of the scheme so that applicants are told 

the type of property for which they will be eligible to bid when they register. 

Labelling is often the vehicle through which other policy priorities are achieved, 

such as policies designed to create more sustainable communities. 

Once bidding closes, a shortlist for each property is drawn up ranking bidders by 

eligibility, currency level and any other relevant criteria. The eligible bidder with 

the highest amount of currency is then offered the property, subject to 

verification of their details. 

124

Once the outcome is determined, feedback information is published. Providing 

feedback to other applicants on the housing needs band or points of the winning 

bidder helps the unsuccessful to determine whether they are likely to win a 

similar property in the future or whether they should alter their bidding 

preferences. Feedback can be provided through all or some of the channels in 

which properties are advertised. Typical feedback in relation to a property might 

include: 

● the property address; 

● the type of property; 

● the number of bids; 

● the banding, points and/or waiting time of the successful bidder; 

● whether a priority card was used; and 

● the winning bidder’s match against any labelling criteria. 

Some schemes also provide summary information over a longer time period to 

improve the quality of information available for bidders. Table 10.3 below is one 

example of this, taken from the Camden CBL website. 

Table 10.3 

Example of Feedback Information 


Property Number Average Average Highest Lowest 

Type of Bidders Number of Points Points Points 

Housed Bids Per Let For Let For Let For 

Property 

Studio 59 25 171 413 105 

1 Bed 170 92 237 439 140 

2 Bed 127 66 241 445 162 

3 Bed 47 74 367 596 170 

4 Bed 9 57 355 575 195 

5 Bed 2 41 546 672 420 

6 Bed 1 36 656 656 656 

Notes: Based on results for 415 properties advertised through Home Connections in the second half of 2003 and the 

first quarter of 2004. 

Source: Camden Council, Home Connections. 124 

Under CBL, applicants can access services through a single gateway rather than 

applying separately to local authorities and other social landlords. This makes 

the process easier to understand for the user, and also encourages partnerships 

between landlords, local authorities and housing associations. 

124 Data available at: 

http://www.homeconnections.org.uk/public/xml/advert.asp?name=camdenlets1.pdf&GUID=929C0FFDB0BD45F495 

797BD2C4397EF6&PPAGE=10214737. 

125


Local innovation was ensured by setting out national objectives in bidding 

documents and then allowing each local authority to propose the details of a 

choice-based scheme that would achieve these objectives in their locality. An 

example of different approaches taken by three local authorities is given in Table 

10.4 below. One of them, Harborough, is an area comprising 92 villages whose 

residents rarely move further than 2 miles from their existing location. Housing 

officials in Harborough have found it unnecessary to spend resources on photos 

of properties in adverts, as applicants are generally aware of the properties in 

the area in which they would consider moving. The main vulnerable group in 

Harborough has been those with literacy or health problems. This is in contrast 

to Camden, where the ethnic minority population is significant and potentially 

very vulnerable. Whereas Harborough provides information in English and 

Braille only, Camden translates its information into five different languages. 

Scheme design was therefore the product of ODPM’s bidding criteria and local 

authorities’ views on how best to implement an allocation system using choice 

for their area. Economists were not involved in either the development of 

bidding criteria or the bids. However, economists are involved in the ODPM’s 

ongoing longer-term evaluation of pilot schemes. 

Table 10.4 

Sample of scheme designs by locality 



Assessment mechanism Two bands: general and Effective currency is Three bands: priority, 

priority. Within bands, points awarded for a preference and potential. 

currency is waiting time. weighted combination Within bands, currency 

of housing need and is waiting time. 

waiting time. 

Channels used to Local press; website; Weekly local press; website; Adverts mailed to priority 

advertise properties touch-screen kiosks in brochures; email lists; and preference members; 

local offices. SMS text messages for all properties advertised 

registered applicants. on website and in property 

shop 

Information provided Size and type of property; Photo, description, Location, size and type 

in advert facilities; characteristics indicative ‘price’ in of property; facilities; 

of preferred applicant terms of points. applicant requirements 

e.g. number of children; 

rent and council tax band. 

Mechanisms to Educated organisations Bidding information Adverts on community 

support the vulnerable working with vulnerable monitored and non-bidders buses and parking tickets 

groups about CBL and contacted; housing officials to ensure information 

enabled them to act as can act as advocates available to all; involved 

advocates on their where needed; information health and social workers, 

customers’ behalf and support available in who can act as advocates 

5 different languages. 

126

DEVELOPMENTS OVER TIME 

The major modification at a national level has been to extend user-choice targets 

further. The current ODPM target is for 100 per cent of local authorities to adopt 

CBL by 2010. The Government is keen to extend CBL to cover low cost home 

ownership options and properties to rent from private landlords, as well as social 

housing. The ODPM’s five year housing plan (Homes For All) contains a new 

commitment to work towards a nationwide system of CBL by 2010. The 

Government is also keen that CBL schemes should operate on a regional or subregional 

basis. It is hoped that regional schemes will break down artificial 

boundaries and recognise existing housing and labour markets; improve regional 

mobility and help ease localised problems of high demand; give tenants more 

choice; and also help larger housing associations develop more productive 

relationships with local authorities. 

Some pilots in high-demand areas modified their allocation mechanism in order 

to ensure that non-priority households could access property. This was often 

achieved through a quota system. For example, Blackburn Council introduced a 

system that allocated vacant properties arising in high demand areas half under 

the CBL scheme and half according to a pure waiting time system. Whilst the 

CBL scheme gives priority to those in reasonable preference categories, the 

waiting time system allows some non-priority households a chance to access 

properties in highly sought-after locations. 

The major cause of modifications to pilots was the Homelessness Act 2002, in 

response to which some pilot schemes: 

● added further bands to their banding system to recognise cumulative need 

more fully; 

● changed the way households are classified into bands to differentiate more 

clearly between different levels of need; and 

● placed a limit on the amount of currency an applicant could accumulate 

through waiting time. 



In section 8 of Part III, we noted that although economic theory tells us that 

introducing user choice can improve efficiency and provide incentives for a 

more consumer-responsive service, this is only possible if genuine choice is 

offered. Furthermore, choice could have adverse consequences if some 

participants are unable to exercise this right to choice effectively or other 

restrictions on effective choice exist. 

In this section, we first summarise the potential problems with choice before 

discussing how they were addressed in CBL schemes and the success or 

otherwise of doing so. 

127


POTENTIAL PROBLEMS 

Political constraints 

Sometimes the implementation of a market mechanism may be affected by 

political constraints that prevent the full potential benefits of the policy being 

realised. In the case of CBL, this was encountered in the form of internal 

resistance on the part of some housing officials. These officials feared that a loss 

of personal influence would adversely affect housing management performance 

measures, such as void turnaround times. Their concerns were generally related 

to the fact that advertising could potentially increase the time taken for the 

letting process. 

Economic constraints 

In Part III above, we identified the following potential problems with introducing 

user choice suggested by economic theory. 

CAPACITY CONSTRAINTS 

The introduction of consumer choice may lead to capacity constraints for the 

most desirable properties, or even a worsening of existing constraints. This 

requires landlords to exercise a form of rationing, reducing the effective choice 

offered to users. Where these capacity constraints are binding, it may be 

tempting for landlords to use any discretionary powers they have to ‘cream 

skim’ the housing register for the most desirable tenants. Cream skimming could 

arise in a CBL scheme if landlords were able to reject tenants until the desired 

tenant is offered the property. It is prevented in practice by specifying strict 

criteria as the only grounds for rejections. 

Capacity constraints can also affect outcomes through the demand-side of the 

market. In areas with a relatively small flow of vacancies, the proportion of 

applicants ever accessing a property is low and choice within the social housing 

sector is correspondingly low. Users who are repeatedly unsuccessful in their 

bidding because of capacity constraints may become despondent and consider 

the CBL allocation process to be less fair than an administrative system. This 

outcome could lead to reductions in customer satisfaction and even limit the 

efficiency of the allocation process if users cease to participate effectively as a 

result of their disappointment. 

It should also be noted that the opposite can occur through CBL: by increasing 

transparency, existing capacity constraints become visible and households may 

be better placed to exercise choice in a way that redistributes interest between 

high and low demand properties and areas. Furthermore, CBL provides 

information about household preferences as revealed by bidding choices. This 

information can be used to guide strategic plans and so address capacity 

constraints in the longer run by ensuring more of the most popular types of 

property are provided. 

128

Concerns about capacity constraints were particularly strong in high demand areas. 

Controlling for capacity constraints 

The rationing mechanism was left to the discretion of local authorities, although 

this was subject to national legislation protecting those with greatest housing 

need. These statutory requirements combined with strict and specific criteria for 

rejecting applicants have made cream skimming by local authorities and 

landlords difficult. 

Problems of consumer despondency and feelings of unfairness as a result of 

limited effective choice have been addressed through extensive consumer 

consultation and the publication of information. It was hoped that making 

information on capacity constraints more visible would help unsuccessful 

bidders realise that the problem lay in limited availability of social rented 

housing relative to demand, rather than any unfairness in the allocation process. 

IT databases were designed to provide management information regarding 

revealed bidder preferences in order to guide strategic plans that would address 

these capacity constraints in the longer run. 



Research carried out by BMRB for the ODPM revealed that some users found the 

experience of repeated bidding disheartening and frustrating, particularly if they 

were in desperate housing need and had few other housing options. While many 

applicants recognised this was a problem of insufficient supply, some blamed 

the CBL allocation mechanism for their lack of success. Harborough District 

Council noted that users who had been on the housing register for more than 

four years returned considerably fewer survey forms, and attributed this to 

apathy stemming from lack of success. 125 The same survey revealed that 12 per 

cent of non-bidders cited ‘Did not think I would be successful’ as their main 

reason for not responding to any properties advertised during the period, 

suggesting possible feelings of despondency. 

Despite this, customer satisfaction on the whole appears to have improved even 

in high-demand areas where effective choice was limited. Applicants reported 

greater choice in terms of the ability to reject properties, the range of languages 

in which information was available, the choice of media through which 

information could be submitted and received, and the availability of non-social 

housing solutions to applicants’ needs. Those with high levels of currency also 

found CBL offered genuine choice, even in high demand areas. 

For example, 80 per cent of applicants who responded to a postal questionnaire 

conducted by Harborough district council and who could compare a points- 

125 Harborough District Council, Harborough Home Search April 2004 Survey: Results. 

129


based system with CBL preferred the latter. 126 Similarly, a survey conducted by 

Blackburn Council found 82 per cent of respondents considered their overall 

experience of the new scheme as being very good or good and only 2 per cent 

as very bad. 127 

INEQUALITY 

The introduction of consumer choice can lead to increases in outcome inequality 

if some members of society are better able to exercise their right to choose. If 

the more advantaged, for example, in terms of education or income, are better 

placed to bear the costs of collecting and analysing information necessary for 

rational decision-making, they are more likely to achieve favourable outcomes 

from CBL than less advantaged participants. In some cases, increases in 

outcome inequality may be driven by inequalities of opportunity. For example, 

vulnerable users may be unable to participate at all if information is only 

available in languages or formats they cannot understand. Unless these 

vulnerable consumers receive appropriate support, their housing outcome is 

likely to suffer. 

Those who could be disadvantaged in the context of a CBL scheme include: 

● households lacking access to information on vacancies, for example, due to 

language barriers, learning difficulties or physical disabilities; 

● households lacking access to bidding mechanisms, for example, due to lack 

of access to appropriate IT; and 

● households unable to make or articulate choices and adopt an appropriate 

bidding strategy. 

The sources of inequality outlined above apply to inequalities arising between 

users of the same scheme. Part III above identifies another dimension in which 

increased inequality may manifest itself, namely between geographical regions 

operating different schemes. This type of geographical inequality is more likely 

to arise when users are locked into their local suppliers, as this allows the market 

to develop into sub-sectors of under-performing suppliers located in 

disadvantaged areas and excellent suppliers in advantaged areas. As 

geographical mobility of applicants is generally low, this was a potential concern 

for the national CBL agenda. 

Controlling for inequality 

Geographical inequality was limited to some extent by the Homelessness Act 

2002. This requires local authorities to allow anyone in the UK to join their 

register where previously many authorities would only consider applications 

126 Brown et al (2002), ‘Allocate or Let? Your Choice’, p.4, Respondents included unsuccessful bidders still on the 

housing register, although those who had been on the housing register for over four years showed a far lower 

response rate. 

127 Source; Twin Valley Homes 

130

from those already located within their district. Because this increases the scope 

for geographical mobility, it reduces the probability that applicants could be 

locked into under-performing schemes because of their location. 

Inequality between individuals using the same scheme can be limited by 

enabling the less advantaged to exercise their choice as effectively as more 

advantaged users. To this end, proposals regarding support for vulnerable users 

were one of the criteria against which bids for ODPM funding were evaluated. In 

addition, legislation contained in the Homelessness Act 2002 means local 

authorities are required to provide assistance to those users who would be 

unable to participate effectively without external support. 

Because vulnerabilities in accessing CBL schemes can arise from a variety of 

different sources, enabling the vulnerable to operate effectively within CBL has 

required a multiplicity of approaches. These have included ensuring: 

● information on vacancies and processes is available in appropriate formats, 

including minority languages; 

● that bidding mechanisms are accessible to all; and 


● that systems are set up to provide assistance to those who would struggle to 

participate in the CBL process on their own, for example, by enabling carers 

or housing officials to act as advocates on behalf of these participants. 

Where possible, non-bidders are identified by local authorities and follow-up 

work is carried out to ensure applicants understand what is required of them and 

receive any necessary support. The dominant approach to supporting vulnerable 

and excluded groups is to seek the cooperation of a network of statutory and 

voluntary organisations such as Citizens’ Advice Bureaux and train them to 

assist their clients to participate in CBL. 

A number of pilots produced fully-translated leaflets explaining their schemes or 

offered translations of the English summary. As producing translations is a 

costly activity, many offered the option of requesting a translation from the local 

housing department or requesting alternative formats such as large print, audio 

tape, and Braille. Some pilots produced non-English versions of part or all of 

their websites or telephone scripts. 

For those with limited literacy in any language, pilots experimented with a 

variety of approaches to communication. Screening materials for plain English 

was a widespread practice, and some schemes replaced words with symbols 

and introduced colour-coded maps to assist applicants in identifying where 

properties were located. 

In some pilots, a multi-lingual member of staff would visit local minority 

community groups and older people’s organisations on a regular basis to explain 

the system, answer queries and, where necessary, assist with completing forms. 

131


Support to the disadvantaged also included: 

● home visits to explain the system and determine the amount of support 

required; 

● the mailing of advertising materials and bidding coupons to those unable to 

access materials through other channels; 

● telephoning applicants to alert them of relevant vacancies about to be 

advertised; 

● talking through advertised properties with applicants to determine whether 

they wished to bid and if bidding would be advisable; 

● allowing proxy bidders to be nominated; and 

● arranging for applicants to be accompanied by an advocate or social worker 

when visiting a property. 


Greater inequality between individuals as a result of introducing user choice 

would be apparent if vulnerable users participated less in the bidding process 

and as a result secured less than their share of advertised vacancies. There is 

some evidence that the more vulnerable submitted fewer bids but in general 

housing outcome inequality does not appear to have increased. 

One pilot recorded the percentages of different ethnic groups applying, bidding 

and securing lettings over the course of 506 lettings. These results are given in 

the table below. The table suggests the small proportion of Caribbean 

households are rather more active in bidding and successful in securing a 

property than others. In contrast Asian communities are active but relatively less 

successful in securing properties. These figures however, need to be interpreted 

in the light of the significant proportion of activity associated with households 

where ethnic origins are not known. 

Table 10.5 

Participation in one pilot scheme by ethnic group 

Notes: Based on 506 lettings. 

Source: p.147, Marsh et al (2004). 

Applicants Bidding Lettings 

African 20% 23% 22% 

Asian 22% 25% 21% 

Caribbean 6% 9% 10.5% 

Irish 1% 1% 1% 

Other European 3% 3% 2.5% 

British 20% 19% 23% 

Other 4% 4% 4% 

Not Known 24% 16% 16% 

132

In several areas, registrations by members of ethnic minority communities 

actually increased following the launch of CBL. Any increase was typically 

modest, with one pilot reporting an increase in applicants from minority ethnic 

groups from 35 to 38 per cent. 128 Ethnic minority households were often less 

successful in securing their share of vacancies in the area, but this is attributed 

to their bidding for larger, more scarce properties. 129 

The table demonstrates both the potential for CBL to provide useful and timely 

data on the operation of a lettings system and the difficulties in making 

inferences on the basis of incomplete data. 

Homeless households generally bid less frequently than other households. 

Research by local councils revealed that this arose from information failing to 

reach them regularly, a lack of understanding of the CBL process or a lack of 

appropriate ongoing support. The lower participation of homeless households 

was more frequent in areas of high demand. In spite of this, homeless 

households were reported to be securing a similar proportion of lettings as 

under the previous allocation system. 130 Even though homeless households 

often record a relatively low level of bidding the head start they receive through 

the award of a high banding or priority card means their probability of success 

when bidding is high. 

There have been some reports from pilots of older people bidding less 

frequently, largely in IT-based schemes where IT access and skills may be the 

root of the problem. 131 However, Table 10.6 below showing available data 

suggests that rather than being adversely affected, pensioners have secured at 

least, if not more than, their proportionate share of lettings. 

Table 10.6 

Bidding activity of older applicants 


Pilot R Pilot T 

Household Type Applicants Bidders Lettings Applicants Bidders Lettings 

Pensioner Couple 5% 5% 5% 1% 2% 2% 

Pensioner Single 5% 5% 5% 10% 12% 12% 

Source: Marsh et al (2004), Piloting Choice Based Lettings: An Evaluation, London: The Stationery Office, p.113. 

There has been no research into the impact of CBL on geographical housing 

inequality, although average waiting times and reported customer satisfaction 

varied greatly across the pilot schemes. 

128 See Marsh et al (2004), p147. 

129 See Marsh et al (2004), pg 15 and 147. 

130 See p.130, Marsh et al (2004) Piloting Choice Based Lettings: An Evaluation London: The Stationery Office. 

Pg 159-160. 

131 See Marsh et al (2004), p.100. 

133


SEGREGATION 

Segregation may increase either as a direct result of the exercise of choice by 

individuals of the same ethnic/working/educational background or as an indirect 

result of any increase in inequality. This problem is of particular concern to the 

fostering stable communities agenda, as housing segregation by ethnic group is 

thought to have been a contributing factor to the 2001 Northern town riots. 132 

Controlling for segregation 

The House of Commons ODPM Select Committee report on Social Cohesion 

(2004) recommended that CBL policy include the encouragement of greater 

integration of communities by offering support to tenants moving into areas 

where they might be in a minority. ODPM has also set up a Black and Minority 

Ethnic Housing Group to assist with a race impact assessment of CBL policy. 

In addition, addressing potential inequality problems through methods outlined 

previously is likely to have the indirect effect of limiting increases in segregation. 


There is no evidence of increased segregation to date from either local 

evaluations or ODPM-commissioned national evaluations. The issue of 

segregation and community cohesion will continue to be monitored through the 

current ODPM research, which is looking into the longer-term effects of CBL. 

Applicants’ views are also currently being sought on issues including whether 

CBL would lead them to consider moving to areas with a different ethnic profile 

to their own and will be published as part of the longer-term evaluation report. 

Results will be available in 2006. 133 

INFORMATION 

Participants in a user choice scheme must be able to make rational decisions in 

order for the scheme to generate positive outcomes. Rational decision making 

requires that the supply-side of the market provide sufficient relevant 

information in a language and format all users can understand. It also requires 

that users are willing and able to bear the costs of collecting this information and 

assessing alternatives to arrive at their decision. Informational failures arising on 

either side of the market could have significant consequences in a CBL context 

as they may prevent local authorities from housing those in the greatest housing 

need. Such failures could arise if registered households bid for inappropriate 

properties or do not bid at all, or if households in housing need do not even 

register in the first place. 

132 See Perri (2003) ‘Giving users of British public services more choice: what can be learned from recent history?’ , 

Journal of Social Policy 32(2), pp.239-270. 

133 From the ODPM research specification ‘Applicants’ longer term perspectives on choice based lettings’. 

134

Controlling for information problems 

The provision of sufficient information was ensured through the measures 

outlined above to limit inequality. In addition, local authorities made information 

as easy to access as possible and offered support in analysing information if 

requested to reduce the burden of choice on the user. 

Performance in practice 134 

If insufficient information was available or the burden of choice too great for 

rational choices to be made, we would expect to see this reflected in a lack of 

searching and bidding behaviour. Available evidence on consumers’ willingness 

to bear search costs is positive, with one pilot surveying applicants and finding 

that 85 per cent of respondents were looking in the paper every week for adverts. 

However, most pilots that examined the issue suggest that whilst many 

participants were actively searching for properties, bidding was relatively 

infrequent. For example, one pilot analysed bidding behaviour over 15 cycles 

and determined that the majority of people bid infrequently. Out of a maximum 

of 30 possible bids, it found that only 7 per cent bid more than 20 times and more 

than 25 per cent bid only once or twice. Most pilots reported that between 25 and 

50 per cent of applicants were bidding at any one time. However, this could have 

been a result of lack of suitable properties rather than an unwillingness to bear 

the costs of bidding per se. 


BENEFITS 


Theory suggests that introducing choice could have the effect of increasing 

efficiency through both the demand and supply sides of the market. As noted in 

Part III, there are three main types of efficiency relevant to our analysis of user 

choice, namely allocative, productive and dynamic efficiency. The first of these, 

allocative efficiency, refers to a situation in which scarce resources are allocated 

to the use that society values higher than all other alternative uses. In other 

words, resources are allocated in a way that maximises social welfare. In this 

situation, no one member of society can be made better off by re-allocating 

resources without making another worse off. Productive efficiency is a precondition 

for allocative efficiency, and is achieved when a specific outcome or 

level of output is obtained using the most cost-effective method. Dynamic 

efficiency refers to the efficient allocation of resources over time. 

Introducing user choice can also lead to increases in social welfare, both by 

improving efficiency and by empowering users. Reducing the dependency of 

users on housing officials can be beneficial in its own rights, and can improve 

customer satisfaction by conferring on users a sense of ownership of the 

134 All data in this paragraph taken from Marsh et al (2004), Op.Cit., p.136. 

135


decision. This sense of ownership can also encourage households to take more 

responsibility for outcomes, by actively participating in the bidding process and 

contributing positively to community life once they have secured a property. 

CBL pilots appear to have realised all of these potential benefits, although 

performance has varied between localities. An example of outcomes from 

different schemes is provided in Table 10.9 at the end of this section. 

As discussed above, many of the departmental objectives for CBL can be viewed 

as specific examples of the more general benefits predicted by theory. The 

performance of the pilot schemes against these objectives is included in the 

following discussion. The objectives identified as being in addition to the 

theoretical benefits of choice, however, are not discussed in detail here. They are 

not the outcome of a market mechanism per se and, being specific to the 

implementation of CBL, do not provide guidance for other policy areas wishing 

to introduce user choice. 

Supply-side benefits 

Allocative, productive and dynamic efficiency benefits may be realised through 

the supply side if introducing choice fosters performance-enhancing 

competition between social landlords and provides incentives for authorities to 

run a more consumer-responsive service. As noted previously, it was not an 

objective of ODPM or of CBL schemes to encourage competition between social 

landlords. However, one objective of CBL was to raise the profile of social 

housing in low demand areas, particularly of local authority housing. Raising the 

profile of social housing may have stimulated competition between social 

landlords involved in CBL and private landlords operating outside the scheme, 

leading to sharper incentives for quality, efficiency and innovation, although this 

was not a direct intention of the scheme. The objective of encouraging 

geographical mobility could also theoretically lead to competition for applicants 

between different local authorities, with similar effects on incentives. 

No studies have been conducted to see whether user choice has stimulated 

competition between social and private landlords. There is some indirect 

evidence of this though: lower demand areas have seen an increased interest in 

social housing and higher demand areas have seen a greater willingness of 

customers to consider other housing options, including the private sector. 135 It is 

unlikely that this competition was sufficient to deliver any of the observed 

improvements in productive efficiency, however. The sources of these efficiency 

improvements are discussed under administration costs. 

Because joint working was an objective of CBL, competition within individual 

schemes was minimal. In fact, one officer is reported as commenting that one 

benefit of CBL was that it had ‘taken the competition out of lettings’. 136 To some 

135 Frances Walker, ODPM. 

136 See, Marsh et al (2004), Op.Cit., p.132. 

136

extent though, it was competition between local authorities that lay behind 

increased innovation. Local authorities competed against one another to receive 

funding from the ODPM, and one of the criteria used to assess bids were the 

national objectives to use IT and advertising media innovatively. By proposing a 

more innovative CBL scheme, therefore, local authorities could increase their 

chance of receiving funding. 

Whilst competition may have been limited to date, suppliers of social rented 

housing may still face different incentives as a result of introducing choice that 

lead to a more customer-responsive service. One of the potential problems with 

public-sector provision of a service is that the absence of the profit motive 

means incentives to tailor services to meet customer needs can be weak. 

Introducing choice is a means of addressing this problem. 

CBL was typically followed by a significant increase in the demand for social 

housing, with a proportion of this interest coming from working households, 

and in some instances, households from minority communities. The extent to 

which this impact was felt varied greatly across pilots: for example, one pilot felt 

the flow of registrations was similar to pre-CBL rates where others reported 

increases of up to 50 per cent per quarter. 137 One low demand pilot area, 

Blackburn, saw the numbers on its register increase from 2,000 to 6,500 as a 

result of CBL. 138 Although rising house prices and other external factors are likely 

to have influenced this trend, at least part can be ascribed to the success of CBL 

in providing a more consumer-focused service. 

Demand-side benefits 


Allocative efficiency improvements can be achieved through the demand side of 

the market if introducing user choice means that decisions regarding the 

allocation of social rented housing are made on the basis of superior 

information. Information could be enhanced because CBL provides incentives 

for users to reveal preferences that would not be immediately obvious under an 

administrative system. This increases the likelihood of a good match between 

the properties and households. It also provides incentives for users to find out 

the kinds of properties that are actually available in their chosen area, and 

encourages them to act on this information by being more flexible over location 

and property features. Before, households simply waited to be allocated a 

property without necessarily knowing anything about availability. Under CBL, 

applicants can improve their chances of being re-housed if they make 

themselves better informed, and so face stronger incentives to do so. This 

potential benefit ties in with ODPM’s objectives to increase transparency and 

educate applicants about the availability of social housing. CBL also reveals 

information that may be used to improve dynamic efficiency, for example, by 

directing investment towards the types of property and locations for which the 

greatest number of bids were received. 

137 See, Marsh et al (2004), Op.Cit., p.132. 

138 Interview with Twin Valley Homes. 

137


One means of measuring any efficiency benefits resulting from the introduction 

of CBL is to assess the impact of CBL on housing management performance 

measures, such as void times, re-let times and refusal rates. 139 Evidence on these 

performance measures varied across pilot scheme areas but in general appears 

to be positive. 

Void turnaround times. Void turnaround time measures the length of time a 

property remains empty and is typically captured by a measure known as the relet 

time. Some housing associations reported deterioration in re-let times that 

they ascribed to the introduction of CBL. This deterioration occurred because the 

strict timing of the advertising and bidding cycles introduced a minimum period 

before a vacant property could be let under CBL that did not exist under the 

traditional allocation mechanism. These housing associations either planned to 

discontinue their involvement or at least were considering doing so as a result. 

However, very few landlords monitor and report performance indicators and so 

observations can only be made using local authority data. Drawing on this data, 

the ODPM evaluation report finds the impact of CBL on re-let times to have been 

broadly positive, although notes that it is difficult to distinguish between that 

success which is due to CBL and that which is due to improvements in other 

housing management functions introduced at the same time. Some pilots ran 

the scheme for only part of the borough, allowing a comparison of re-let times 

in the CBL area with the rest of the borough. This was generally favourable, with 

one area citing an average re-let time of 2.3 weeks for the borough as a whole 

and 1.8 weeks for the pilot area alone. 140 

Table 10.7 below shows void turnaround data for different boroughs in the Home 

Connections scheme. 

Table 10.7 

Home Connections void turnaround performance by borough 

Landlord CBL void days Pre-CBL void days Improvement (days) 

Barnet 21 32 11 

Camden 21 27 6 

Enfield 34 34 - 

Islington 19 28 9 

SPH Housing 35 50 15 

Westminster General Needs 22 22 - 

Westminster sheltered 21 80 59 

Source: Home Connections, Camden. 

139 Void turnaround time measures the length of time a property remains empty. Re-let times are one means of 

measuring void turnaround and are defined as the time from the date of termination of one tenancy up to and 

including the date a new tenancy agreement begins. Refusal rates are the percentage of offers made that are 

rejected by the household. 

140 Ibid, p152. 

138


Reductions in re-let times, along with greater interest in social rented housing, 

has contributed towards the ODPM objective to make better use of housing stock 

by reducing the number of vacant properties. 

Refusal rates. The refusal rate is the frequency with which applicants reject a 

property that they have been allocated. This increases administration costs for 

local authorities. The precise impact of CBL on refusal rates is uncertain and 

contingent on local factors. For example, some areas introduced a more 

comprehensive system of measuring refusals at the same time as CBL. These 

areas cannot measure the full extent of reductions in refusal rates because they 

are comparing results against a different baseline that reported a lower 

percentage of total refusals. In most pilot areas CBL does seem to have reduced 

refusals. In some cases this reduction has been dramatic: for example, 

Berwickshire has reported a 66 per cent reduction in refusal rates as a result of 

CBL. Another pilot estimated that the refusal rate had fallen from 20 per cent to 

5 per cent under CBL. 141 Some pilots reported higher than anticipated refusal 

rates, and others an increase following a sharp initial decline. Managers in these 

pilot areas saw this as reflecting increasing user buy-in to the idea of choice 

rather than any failure of the scheme, especially as analysis of the reasons for 

refusal found that the majority related to the condition of the property. 

The observed differences in measured outcomes across pilots at least partially 

reflects the dependence of performance measures on many factors external to 

the CBL scheme. These external factors include staff availability, the method used 

to calculate the reported statistic and the performance of contractors supplying 

maintenance work. As a result, performance measures alone cannot be used to 

determine the relative success of different scheme designs. However a comment 

from one CBL project manager suggests that some of the divergence in outcomes 

can be explained by the differing levels of commitment from local authorities: 

We have seen major differences in people we have talked to about CBL. Some 

are committed, understand what they are trying to achieve and plan carefully. 

Others are doing it because their director has told them to. There is a need 

for a committed change agent, leadership, planning and commitment to 

improving customer service. 142 

Another way in which improvements in efficiency could be observed is through 

greater flexibility on the part of users. As outlined above, increased transparency 

provides households with better information to make appropriate trade-offs 

between type of property/location and length of waiting time. As a result, one 

possible outcome of CBL is that applicants may become more willing to consider 

less-popular areas in order to access properties more quickly. Evidence from the 

Delft programme showed that in the longer term applicants altered their 

preferences in response to feedback after unsuccessful bids. 

141 See Marsh et al (2004), Op.Cit, p.86. 

142 See Marsh et al (2004), Op.Cit., p.178. 

139


Flexibility could take the form of applicants no longer bidding for properties 

where they did not meet key criteria, widening the area they would consider, 

bidding for different property types, dropping requirements, looking for less 

popular properties and looking outside of the social rented sector. There is some 

evidence of applicants using feedback information to alter their initial 

preferences and bid for different areas or property types to increase their chance 

of success. For example, some pilots reported an increase in the number of bids 

for previously unpopular property types, such as maisonettes, and a 

corresponding reduction in bids for more popular property types, such as 

houses. Similarly, one pilot observed that of the 94 properties let in one quarter, 

29 were awarded to applicants bidding for a property one or more bedrooms 

smaller than their assessed need. 143 

Consumer flexibility has been relatively limited so far, particularly in 

geographical scope. The BMRB research found that some applicants were 

willing to remain in inadequate and unpleasant circumstances rather than move 

to an area they felt to be undesirable. 144 Furthermore, evidence on transfer 

activity in one pilot area found that 22 per cent of moves were to an area of 

higher demand and only 15 per cent to areas of lower demand. 145 However, these 

data are not necessarily representative of all choices because households 

entering the social rented sector rather than transferring within it may base their 

decisions on different criteria. Greater flexibility is expected to emerge in the 

longer run. 

The main driver behind CBL was not to improve efficiency, but to create 

sustainable communities. It was hoped that empowering users by offering them 

greater choice and encouraging them to take greater responsibility for their 

outcomes would help achieve this. Most pilots believed it to be too early to 

comment on the impact of CBL in this area, although there has been some 

positive evidence to date. One pilot cited a sharp reduction in transfer requests 

among those who had been re-housed through CBL. Another pilot reported that 

its turnover rate for the stock of its lead landlord fell from 6.34 to 5.77 per cent 

in the first quarter of operation, and then to 4.4 and 3.23 per cent in subsequent 

quarters. A pilot operating a partial-borough programme observed that 

abandonment rates dropped more sharply in CBL areas than non-CBL, falling 

from 11.86 and 9.66 per cent in the CBL and non-CBL areas respectively to 4.25 

and 4.75 per cent between September 2001 and September 2002. 146 

However, as one pilot project manager observed: 

140 

It is difficult to say at this stage whether or not [CBL] has helped contribute 

towards sustainable communities. Recent evaluation reports have looked at 

this issue and have given positive feedback. Certainly the void turnaround 


144 BMRB for ODPM (2004) Applicants’ Perspectives on Choice-Based Lettings, London: The Stationery Office. 


146 See Marsh et al (2004), Op.Cit., p.161-62.

levels are reducing and new tenants are staying in their properties for a 

longer period. How this contributes towards sustainable communities and 

how much of it can be attributed to [CBL], it is difficult to say. 147 

ADMINISTRATION COSTS 

ODPM funding was provided for the pilot phase of CBL only. For subsequent 

schemes the local authority has to pay all set-up costs out of its existing budget. 

The most significant set-up costs are IT and organisational change costs. 

Organisational change costs include equipping housing officials with new skills, 

such as marketing, and helping them adapt from their previous administrative 

function to their new roles as facilitators of choice. IT set-up costs vary greatly 

depending on the approach taken to procurement. Pilots adapting existing 

systems or purchasing off-the-shelf solutions typically spent around £20,000 on 

IT whereas pilots choosing to develop a bespoke system spent closer to 

£100,000. 148 IT costs could also include the provision of computers for use by 

applicants, the purchase of camera equipment, the setting up of property 

websites and training staff. Some pilots managed to set-up on the basis of very 

limited funds, for example Market Harborough’s only development costs were 

employing a project manager for 3 months (£4,500) and establishing a new IT 

database (£2,000). 

Table 10.8 shows estimated set-up costs used by one local authority as the basis 

of its bid. 

Table 10.8 

Example of pilot set-up costs 

Category Cost 

Marketing (campaigns to increase awareness) £150,000 

PR (private sector agency to develop and oversee media strategy) £50,000 

IT costs (including 2 years’ maintenance costs, valued at £3000) £123,000 

Training for 150 staff £68,000 

Private sector monitoring £30,000 

Project co-ordinator £30,000 

Resources used in establishing the network system £25,000 

Developing links with other agencies £10,000 

Exploring and describing local area for inclusion in property details £32,000 

Cost of staff time spent in training £42,000 

TOTAL £560,000 

Notes: These costs are estimates only. 

Source: Twin Valley Homes. 

147 See Marsh et al (2004), Op.Cit.,p.162. 

148 LGA (2004) Enabling choice: research on choice in public services,p.34. 


141


Schemes were established on the understanding that local authorities would 

meet ongoing running costs out of their own budgets. A minority of pilots 

designed schemes to operate within their previous budget and used ODPM 

funding for capital investment only. To some extent there was a trade-off 

between up-front and ongoing costs, with the set-up costs of an automated 

approach being higher than those of a paper-based approach but its running 

costs lower. Schemes using a property shop, for example, faced considerably 

higher ongoing costs than those that did not. 

The main cost of running CBL relative to the traditional allocation mechanism is 

advertising. Advertising costs have varied greatly as a result of: 

● different abilities of local authorities to negotiate terms; 

● geography. Pilots located in urban and southern areas generally faced higher 

costs because there was more demand for advertising space; 

● frequency of advertising. Pilots operating weekly cycles incurred higher costs 

than those running fortnightly cycles; 

● level of detail provided in advert; and 

● size of borough. Smaller authorities could find £15,000 per annum to be a 

burden whilst larger authorities may face bills of £60,000 per annum. 149 For 

example, Camden had a budget of £30,000 for advertising in 2004/05. 150 

Where CBL resulted in an increased number of applications, there were also 

additional staff costs to be met. 

The savings associated with CBL are currently being investigated by the ODPM 

in their longer-term evaluation projects, but are likely to stem from: 

● households staying in properties longer, giving rise to taxpayer benefits and 

consumer satisfaction; 

● reductions in refusal rates; and 

● improvements in turnaround time. 

Improving the match of households and properties could be expected to lead to 

better housing performance measures. Reducing refusals rates, in particular, is 

then likely to increase the efficiency and speed of the allocation process because 

it implies less time spent finding a household who will accept the property being 

offered. Reduced void rates may also offset some costs in the short run by 

reducing rent loss. 

CBL may free up resources that could be re-deployed elsewhere, keeping 

additional staff costs to a minimum. For example, if CBL schemes have the 

149 Marsh et al (2004), Op.Cit., p.46. 

150 Home Connections, Camden Council. 

142

desired effect of limiting points-chasing behaviour, this would increase the 

amount of housing officials’ time available for productive activity. Shifting the 

costs of the matching process from officials to the customers also releases local 

authority resources for other uses. 

There is no evidence on the magnitude of any cost savings as yet. 

UNANTICIPATED EFFECTS 


There were three main unanticipated benefits arising from pilot CBL schemes, 


● Areas of low demand saw an immediate and substantial increase in the 

number of applicants beyond that which had been anticipated. In some areas, 

new applicants included groups who had not previously participated in social 

housing schemes. The statutory obligation on local authorities to continue to 

give priority to households in the ‘reasonable preference’ categories has 

ensured that this increased demand has not adversely affected those in 

greatest need. 

● CBL has demonstrated to applicants and politicians alike how little social 

housing is available in high demand areas by increasing transparency. This 

information has led to the need for greater supply of social housing moving 

up local policy agendas in some areas. 

● Many CBL schemes led to the creation of inter-organisational and joint 

working structures that have improved relationships between local 

authorities and RSLs, voluntary sector agencies and local authorities in other 

regions. 

143


Table 10.9 

Comparison of CBL outcomes in different localities 




Performance measures Void turnaround increased Re-let times have fallen Void turnaround 

initially due to advertising by 22% initially deteriorated as 

cycle; actual void rates properties that had been 

have fallen from 12% to vacant a long time were 

less than 2% let under CBL; refusal 

rates have fallen. 

Consumer satisfaction Numbers on housing Transfer rates have fallen 6 months after scheme 

register increased from and participation in tenants’ introduced, 83% of 

2000 to 6500; positive associations increased. customers surveyed 

consumer survey results preferred the new 

scheme to the old. 

Consumer flexibility No evidence Approximately 20% of Some flexibility 

properties are allocated to regarding facilities 

households voluntarily and features; none 

bidding below assessed regarding location. 

needs in terms of number of 

bedrooms; some showing 

willingness to consider other 

housing options as capacity 

constraints have become 

more transparent 

Costs Project manager, IT set-up Significant advertising and IT Initial set-up costs 

and marketing costs were set-up costs were incurred covered by £80k grant 

met by £450k ODPM funding but efficiency savings from from Joseph Rowntree 

and an additional £116k of shifting matching costs from foundation. Later 

council resources. officials to users have also received £0.5m ODPM 

been realised. funding. 

Inequality Homeless identified as No apparent problems. No apparent problems. 

main vulnerable group: 

despite comprising 3% of 

register, they secured 26% 

of all lettings during 

scheme 

Segregation No official studies conducted. No evidence yet. Only 1% of population 

Anecdotal evidence suggests non-white British: 

decline in ethnic segregation. segregation by ethnic 

No evidence of non-ethnic group not even potential 

segregation. problem. No evidence of 

non-ethnic segregation. 

Overall, the performance of choice based lettings has been positive with little 

evidence so far of increased inequality or housing segregation, two undesirable 

outcomes which had been suggested as associated with the introduction of 

choice. Although significant set-up costs were incurred and the on-going 

running costs associated with advertising are substantial, there are likely to be 

144

efficiency savings in some areas. The magnitude of these potential savings is 

currently unknown. The reduced refusal rate is likely to have led to some cost 

savings, but the magnitude is not known. 

Housing management performance has generally improved, customer feedback 

has been largely positive, and users are beginning to demonstrate a greater 

awareness of the functioning of the market by becoming more flexible in their 

search strategies. Although it is too early to judge whether the longer-term 

expected benefits fostering more stable communities have yet emerged, the 

obvious and immediate benefits of empowering individuals to make their own 

decisions through CBL provides an example of a market mechanism that has 

achieved a public policy aim. 



Social rented property is a relatively liquid market with a large number of 

different properties and users and offers users a basic choice from the outset of 

opting in or out of the scheme. Not all public services share these features. 

Lessons emerging from the CBL experience that are applicable to other areas are 


● Introducing choice can increase information about consumer preferences 

relative to a pure command-and-control allocation mechanism and, by so 

doing, allow more efficient matching of users to available resources. 

● Offering users the ability to exercise choice can make public service 

providers, such as social landlords, more consumer-focused where they have 

lacked incentives to act in this way in the past. User choice increases the 

information about customer preferences available to the service provider, 

and staff are encouraged to act as facilitators of choice rather than 

administrators. 

● User choice can therefore lead to outcomes similar to some of those 

generated by private sector incentives whilst still allowing the public sector to 

remain the sole provider. This makes choice an attractive option for services 

where involvement of the private sector is not possible or desirable but the 

Government would still like to introduce a market mechanism to improve 

outcomes. Indeed, it has always been ODPM’s aspiration to include the private 

rented sector in CBL schemes and this has now become official policy. 151 

151 ODPM (2005), Homes for All, para 5.21. ‘To increase choice and opportunity further we want to make it as easy as 

possible for tenants to move between local authority, housing association and privately owned accommodation. 

We are therefore keen to encourage the extension of choice-based lettings to cover low cost home ownership 

options and properties for rent from private landlords, as well as social housing.’ 

145


● Consumer choice can in theory have adverse effects for equality because 

there are likely to be vulnerable users who are unable to exercise their right 

to choose as effectively as others. Although all systems are likely to have 

winners and losers, ensuring that the introduction of choice does not lead to 

a less equitable outcome overall requires that these vulnerable users are 

identified and offered targeted support services. Such services are often most 

effective when offered in collaboration with voluntary sector organisations 

such as Citizens’ Advice Bureaux. Where possible, a system to identify nonparticipants 

rapidly should be put into place. 

● Scheme design and implementation is important to achieve benefits and to 

avoid risks. Benefits will only be realised if the provider introducing choice is 

committed to doing so. 

● The social rented property market has arguably adapted well to the 

introduction of choice because it has been able to increase the choice 

available to participants compared to the previous system, despite clear 

capacity constraints in high-demand areas. Where it is not possible to provide 

this increase in choice, for example, because users face prohibitively high 

costs in gathering and processing the necessary information, the dimension 

over which choice is being offered should be re-considered and/or an 

alternative market mechanism explored. 

● There is some evidence that users can perceive a well-designed market 

process to be fairer than an administrative one, as long as it is sufficiently 

transparent and adequately addresses equity issues. 

To conclude, user choice is therefore most suited to government services where 

effective choice is a genuine possibility, vulnerable consumer groups can be 

easily identified and their needs met satisfactorily, and private provision is 

neither a desirable nor feasible option. 

146

SECTION 11 

Emissions Trading 

Introduction 

This case study looks at the introduction of a market for the trading of 

allowances 152 for greenhouse gas emissions in the UK, known as the UK 

Emissions Trading Scheme (UK-ETS), which was launched by the Department 

for Environment, Food and Rural Affairs (Defra) in April 2002. The scheme is part 

of a set of policy measures that comprise the UK Climate Change Programme 

(CCP). This is a program of policy measures which are designed to help the UK 

to reduce emissions of greenhouse gases. 153 

This case study draws on the following sources of information: 

● interviews with Chris Leigh and Jill Duggan from Defra’s National Climate 

Change Policy Division, with Christopher Moir from DTI, with Gareth Phillips, 

from SGS, one of the verifiers of the program and with Bill Edrich and Kay 

Beagley from Kirklees Council, one of the direct participants of the UK-ETS; 

● a report by a task force led by Lord Marshall on Economic Instruments and 

the Business Use of Energy; 

● an NAO study of the UK-ETS; 

● NERA’s review of the first and second years of the UK Emissions trading 

scheme; and 

● several documents provided by Defra. 

Background 

The UK Government, along with governments in many other countries, is 

concerned that emissions of certain pollutants, known as greenhouse gases, are 

causing changes to the world’s climate, and that this climate change represents 

a threat to human health and sustainable development. For this reason, many 

governments, through international treaties, have decided to act together to 

gradually reduce their emissions of these greenhouse-gas pollutants. 

In 1992, a framework was established under which the international community 

could take action to reduce greenhouse gas emissions: the United Nations 

Framework Convention on Climate Change (UNFCCC). 154 The Kyoto Protocol (the 

152 In the economics literature these ‘allowances’ are often referred to as ‘permits’. These two terms are used 

interchangeably in this report. 

153 Greenhouse gases are: Carbon dioxide, methane, nitrous oxide, sulphur hexafluoride, hydrocarbons and 

perfluorocarbons. 

154 Further information on the United Nations Framework Convention on Climate Change (UNFCCC) can be found on 

the following website: http://unfccc.int/2860.php. 

147


Protocol) is an international agreement signed in 1997 under this framework. 

The signatories to the Protocol committed themselves to reduce emissions of 

greenhouse gasses. Under the Protocol, developed countries agreed to reduce 

their total emissions of greenhouse gases to 5.2 per cent below 1990 levels over 

the period 2008 to 2012 (different countries have different individual 

obligations). 

The Protocol also encouraged its signatory members to implement policies and 

measures in accordance with their national circumstances, that promote the: 

[p]rogressive reduction or phasing out of market imperfections, fiscal 

incentives, tax and duty exemptions and subsidies in all greenhouse gas 

emitting sectors that run counter to the objective of the Convention (UNFCCC) 

and application of market instruments. 155 

The Protocol envisages that that there should in future be international trading 

in greenhouse gas emission allowances, so that emissions reductions are 

achieved in a cost-effective way. 

The UK’s obligation under the Protocol is to reduce its greenhouse gas 

emissions to 12.5 per cent below 1990 levels over the period 2008 to 2012. 

However, the UK has committed itself to go beyond its obligations under the 

Protocol, and reduce its greenhouse gas emissions to 20 per cent below 1990 

levels by 2010. 

Introduction of a market mechanism 

Emissions of greenhouse gases are an example of a negative externality. When 

one person engages in an activity which leads to the emission of pollutants into 

the atmosphere, the cost of that pollution is borne largely by others, rather than 

by the person who created the pollution. Because individual people or firms do 

not personally bear the full cost of the pollution they generate, they tend to 

produce more pollution than society as a whole would consider desirable. 

This market failure creates a role for governments to intervene in order to reduce 

levels of pollution to a socially desirable level. Traditionally, this intervention has 

involved the government setting individual limits on the level of pollution which 

each economic agent can produce. For example, various Clean Air Acts 

introduced in the UK in the 20th Century restricted the burning of coal in urban 

areas. However, alternative, market-based approaches, can also be used to limit 

pollution. There are two main alternative market-based approaches. The first is 

to impose a tax on pollution emissions and the second is to set a cap on the level 

of emissions, allocating rights to produce this set level of emissions and then 

allowing individuals to trade those rights. In the UK, both of these mechanisms 

155 Kyoto Protocol (1997) Article 2, Paragraph 1, part a. 

148

Section 11 – Emissions Trading 

coexist under a set of integrated policies 156 aimed at meeting climate change 

targets, set out in the CCP, published in November 2000. 

Under the CCP there is a tax called the climate change levy, which was 

introduced on 1 April 2001. The levy is a tax on the use of energy in industry, 

commerce and the public sector. 157 Revenues raised through this tax were used 

to reduce employers’ National Insurance Contributions and provide additional 

support for energy efficiency schemes and renewable sources of energy. The 

levy is complemented by the UK-ETS, which was launched in April 2002. In this 

case study we consider the UK-ETS but not the climate change levy. 

A further emissions trading scheme is now being introduced at the European 

level, which is also beyond the scope of this case study. 

DIFFERENT MARKET-BASED MECHANISMS THAT WERE CONSIDERED 

The decision to implement the UK-ETS and climate change levy result from the 

recommendations of a task force led by Lord Marshall. 158 

In 1998 the Chancellor of the Exchequer commissioned this task force to explore 

how best to use economic instruments to improve the industrial and commercial 

use of energy and help reduce emissions of greenhouse gases. The task force 

examined two potential economic instruments: (i) a system of tradable 

emissions permits and (ii) a tax on emissions. 

The report recommended the use of a tradable-permits scheme as a way to 

encourage emissions reductions in a cost-effective way. The report, 

nevertheless, considered that it would not have been sensible at that stage to 

introduce a fully-fledged statutory scheme and therefore recommended that a 

pilot scheme should be introduced first. 

The report also considered that it might be impractical for small- and mediumsized 

enterprises (SMEs) to participate in an international trading scheme. Thus, 

the task force concluded that there could be a role for a tax if businesses in all 

sectors and of all sizes were to contribute to improving energy efficiency and 

reducing greenhouse gas emissions – especially given that SMEs account for 

around 60 percent of total carbon dioxide emissions. This recommendation 

became the basis for the Climate Change Levy. 

In summary, the two instruments considered and recommended in the task 

force’s report were implemented in the CCP in the form of the UK-ETS and the 

Climate Change Levy. 

156 For instance, the Renewables Obligation, which is also a part of the CCP. 

157 Emissions of carbon dioxide, which is produced when fossil fuels (coal, oil and natural gas) are burnt to release 

energy, is an important contributor to climate change. Improving energy efficiency, so that less fossil fuel is burnt 

to provide the same level of output, is therefore one way to reduce greenhouse gas emissions. 

158 Lord Marshall (November 1998), Economic Instruments and the business use of energy, a study for the 

Government Taskforce on the Industrial Use of Energy. 

149


OBJECTIVES OF THE UK-ETS 

The rationale for using a market-based mechanism as part of the CCP was that 

this would allow a given reduction in emissions to be achieved at minimum cost. 

Under a market-based mechanism (either a tax or a tradable permits scheme) 

reductions will be made by firms who can reduce emissions at lowest cost. Firms 

that face a high cost of reducing emissions will chose not to reduce emissions 

and instead pay the tax or (in the case of the UK-ETS) purchase permits from 

firms who have exceeded their targets for reducing emissions. 

A further rationale for the launch of the UK-ETS was that the UK Government 

expected it to create opportunities for UK firms to gain experience of an 

emissions trading scheme and develop knowledge and expertise that would 

provide the UK with a competitive advantage in future European and 

international trading schemes. This objective included allowing participants in 

the scheme (UK firms and public-sector organisations that produce greenhouse 

emissions) to gain experience of participating in a tradable permits scheme. It 

also included allowing firms who would provide services to the participants 

(such as verifiers and traders) to develop expertise that could be used to provide 

services to participants in European and international schemes in the future. 

In summary, therefore, the UK-ETS had three main objectives: 

● to secure a significant amount of cost-effective reductions in greenhouse gas 

emissions; 

● to give organisations in the UK early practical experience of emissions 

trading, ahead of the launch of European and international trading systems; 

and 

● to establish the City of London as a centre for emissions trading. 

DESCRIPTION OF THE SCHEME 

The UK-ETS has four main phases: 

● entry into the scheme; 

● the allocation of allowances; 

● the trading of allowances; and 

● reporting compliance. 

Entry into the Scheme 

In order to widen the scope of participation in the UK-ETS, four ways for 

participants to join the scheme were created. These four options were intended 

to provide a wide range of participants with opportunities to participate. This 

wider participation was expected to increase the likelihood of delivering larger 

150


emissions reductions. The four different ways of entering the programme are 

described below. 

● The first option was participation in an incentive auction where participants 

bid voluntary emissions reductions in exchange for incentive payments from 

the Government. In effect the Government bought a volume of emissions 

reductions from these participants in return for financial payments. 159 The 

participants could then trade within the scheme any excess or shortfall 

relative to these reductions. Participants who joined the scheme in this way 

are called ‘direct participants’. 

● The second option was to enter the scheme through a Climate Change 

Agreement. Only organisations from certain energy-intensive sectors that 

were liable to pay the climate change levy could enter into these 

agreements. 160 These organisations have two-year milestones and if they met 

the milestone they would receive an 80 percent climate change levy discount. 

These companies could meet their targets either by reducing their emissions 

to meet the target or by purchasing emissions permits to cover any gap 

between their actual emissions and their target. Organisations are also able 

to sell any reductions in excess of this target into the scheme subject to such 

‘overachievement’ being verified. Organisations joining the UK-ETS via this 

option are called ‘agreement participants’. 

● The third option applies to non-target holders. Emitters of greenhouse gases 

that did not want to take on a target could participate via an approved 

emissions reduction project. Non-target holders would undertake an activity 

that led to quantified reductions in greenhouse gas emissions and such a 

reduction would earn credits that could then be traded in the UK-ETS. The 

aim of this alternative was to stimulate emissions reductions in areas that 

would not otherwise be covered by the UK-ETS. However, this option was not 

developed due to the expected introduction of the EU-ETS, so no projects 

were able to participate using this option. 

● Lastly, any other organisation not participating through the previous three 

options could register with the Emissions Trading Authority and trade 

allowances/credits in the UK-ETS, regardless of whether or not they are an 

emitter of greenhouse gases. 

The table below summarises the four initial possible ways to enter the UK-ETS. 

159 A total of 31 participants entered the scheme through this option thus covering a wide range of sizes and sectors, 

from global companies such as BP and Shell to banks and supermarkets, through to smaller organisations such 

as London’s Natural History Museum. 

160 For more information about the type of energy-intensive organisations eligible to join the scheme through this 

option see www.Defra.gov.uk/environment/ccl/index.htm 

151


Table 11.1 

The different entry methods considered in the UK-ETS 

Entry Option for Method of Entry Eligibility 

Target Holders With a voluntary emissions target taken Any firm willing to offer voluntary 

(‘Direct Participants’) on through the financial incentive emissions reductions in exchange 

for incentive payments from the 

Government 

Target Holders Through an existing target set through Any organization liable to pay the 

(‘Agreement Participants’) a CCA Climate Change Levy 

Non-Target Holders (1) Via an approved emissions reduction Emitters of greenhouse gasses 

project that did not want to take on a 

target 

Non-Target Holders (2) By simply opening a trading account Any firm wanting to trade 

allowances/credits in the UK 

scheme, irrespective of whether 

they are an emitter of 

greenhouse gasses 

Note: The entry option Non-target holders (1) via an approved emissions reduction project did not develop and no 

projects participated in the UK-ETS. However, this option was considered at the beginning of the scheme. 

Source: LECG, based on Framework for the UK Emissions Trading Scheme, Defra. 161 

Allocation of allowances in the initial auction 

Allowances were allocated to direct participants in the initial auction through a 

‘descending-clock’ auction, where participants could bid emissions reductions 

over the five-year period (2002-2006) in return for a share of £215 million of 

incentive funding from Defra. 

The auction for the allocation of these allowances had the following process. 

● First, Defra published the scheme rules and announced the maximum 

amount available for emissions reductions (£215 million). Companies then 

applied to participate and once the number of participants was sufficient to 

create a competitive auction, the auction took place. This was in March 2002. 

● Second, at the beginning of the auction, Defra, announced an initial price for 

emissions reductions, which was set at £100 per tonne. 162 Participants then 

bid the quantities of emissions reductions they were willing to make at the 

announced price. 

● Third, Defra determined the final amount of the incentive fund for the auction 

at £215 million, the maximum previously indicated. 

● Lastly, if the amounts bid multiplied by the offered price exceeded the £215 

million fund then the process was repeated at successively lower prices until 

the total quantity of emissions bid multiplied by the current price was just 

within the budget of £215 million. This process was repeated nine times, 

before the auction reached a clearing price. 

161 Available at http://www.Defra.gov.uk/environment/climatechange/trading/uk/pdf/trading-full.pdf 

162 The term tonne refers to emissions reductions or allowances measured in tonnes of carbon dioxide equivalent 

(tCO2e). 

152

A more detailed and diagrammatic description of the auction process is depicted 

in Figure 11.1. 

Figure 11.1 

Allocation of allowances – the auction process 

Start 

The Department publishes 

scheme rules, announces up 

to £215 million available for 

emissions reductions and 

invites participants 

Companies apply to participate 

via 3-stage process 

The Department has discretion 

to abandon the auction 

NO 

Auction begins 

The Department announces 

starting price per tonne of 

reduction in 2006, £100 

Participants bid quantities 

of reductions they will 

make at that price 

The Department determines 

budget for the auction 

(in practice £215 million, 

but could have been less) 

Is Department 

satisfied with bids 

received? 

9 auction rounds 

took place 

Participants bid 

quantities of 

reductions they will 

make at new price 

The Department announces 

new, reduced price 

Source: Report by the Comptroller and Auditor General, The UK Emissions Trading Scheme: A new way to combat 

climate change. National Audit Office, April 2004. 

The outcome of the auction was that participants bid to reduce emissions by a 

total of 4.03 million tonnes in 2006 at a price of £53.37 per tonne in 2006, or 

equivalently £17.79 per tonne over the lifetime of the UK-ETS. 163 However, three 

direct participants subsequently dropped out so the final amount of reduction 

purchased was 3.96 million tonnes. 

The 3.96 million tonnes are to be achieved in a period of five years, thus each 

year direct participants must achieve 20 per cent of their promised reductions. 

At the beginning of the scheme, participants submitted bids for the total 

emissions reductions they would achieve in 2006, relative to a predetermined 

YES 

Is (price x quantity) 

more than the 

incentive budget? 

NO 

Auction clears – participants 

are committed to deliver 

reductions they bid in final 

round, at clearing price 

(£53.37 in practice) 

End 


163 Participants must deliver annual reductions increasing by 20 per cent per year starting in 2002 and ending in 

2006. Thus the reductions in 2006, relative to the baseline, represents one-third of the cumulative total reductions 

from 2002-06. Therefore the price of £53.37 per tCO2e in 2006 corresponds to £17.79 per tCO2e over the lifetime 

of the Scheme. 

YES 

153


base-line level of emissions. Participants were then allocated allowances 

equivalent to this base-line minus the reductions they committed to achieve for 

that year. 

To summarise, once emissions targets are set, participants are issued with 

allowances equal to their target emissions for that year. At the end of the year, 

each participant must hold enough allowances to cover its actual emissions for 

the corresponding year. A participant can decide to reduce its actual emissions 

below its target (and sell or ‘bank’ the difference), or meet its target, or buy 

allowances to cover its emissions above the target. 

Trading 

All participants in the scheme are able to trade allowances at any time, the only 

requirement is that they hold an account in the registry. 

Reporting Compliance 

An important aspect of an emissions trading scheme is the monitoring and 

reporting of compliance at the end of each year. The Government needs to know 

that direct participants’ emissions do not exceed the number of allowances that 

they hold. 

The UK-ETS requires that all direct participants report their level of emissions at 

the end of each compliance period. An independent and accredited verifier must 

certify that this information is accurate. The credibility of any emissions trading 

scheme relies heavily on accurate third-party verification of emissions data, 

which confers an important role on verifying companies. 

For direct participants, who had committed to reduce their level of emissions, it 

was necessary to establish a baseline – the level of emissions that the participant 

would otherwise have been expected to make. The purpose of setting baselines 

was to establish a participant’s expected emissions in the absence of the scheme 

so that reductions relative to this counterfactual could be measured. The 

baselines were originally calculated as an average of the participant’s emissions 

between 1998 and 2000. However, some participants had already reduced 

emissions relative to this base line in response to existing governmental 

regulations. In some cases their targets were already met before the scheme 

started in 2002. 

Defra took the view that direct participants should not benefit financially from 

achieving reductions that they were already legally obliged to make. Thus, in 

some cases, baselines were set by reference to both historic emissions levels 

and existing legal requirements. If a participant’s historic level of emissions was 

above the regulatory limit then the baseline was the regulatory limit; if historic 

emissions were under the limit then the baseline was the participant’s average 

emissions between 1998 and 2000. 

154

The costs of monitoring and reporting vary depending on the size of the scheme 

participant, as the number of staff needed to perform the task depends on firm 

size. The cost of verification depends on the number of days verifiers have to 

spend on the site. The estimated cost per day of verification is around £1,350 per 

day for large scheme participants, and around £800-£1,000 per day for smaller 

target holders. These rates reflect the high degree of specialisation, accreditation 

and liability involved. 

CONSTRAINTS THE PUBLIC SECTOR FACED IN INTRODUCING THIS 

MECHANISM 

Emissions allowances can be seen as permits to pollute, which can create 

hostility in some quarters to the idea of an emissions trading scheme. In 

practice, both direct and agreement participants were required to make 

commitments to reduce emissions in order to participate in the scheme and 

receive an initial allocation of allowances. 

On the other hand, firms that have not previously faced any costs from emitting 

greenhouse gases could have faced new costs as a result of the scheme (the 

costs of purchasing allowances), which could also have generated hostility to 

the scheme. In order to overcome such hostility the UK-ETS was launched as a 

voluntary scheme, with financial incentives for direct participants joining the 

scheme. It was hoped that by providing participants with this experience they 

would be become better placed to face the costs arising from future compulsory 

schemes. 


In Part III of the report, we noted that although economic theory says that 

marketable permits can allow governments to control the level of a negative 

externality with lower costs and greater incentives for innovation than alternative 

methods of regulation, their efficacy can be affected by various factors. 

Below we first summarise again the potential problems in marketable permit 

schemes before discussing how they were dealt with in the implementation of 

the UK-ETS and the outcomes of the scheme. 

POTENTIAL PROBLEMS WITH MARKETABLE PERMITS 

In Part III, we identified the following potential problems with marketable 

permits. 

Initial allocation of property rights 


Economic theory suggests that property rights should be allocated through an 

auction, rather than based on historic levels of pollution. An auction ensures 

that, from the beginning, the right to pollute is given to those firms that can 

155


extract the most value from it. An auction also provides revenues that can be 

used to reduce other more distortionary taxes and so improve economic 

efficiency. However, such an allocation method is likely to face more opposition 

from firms than the ‘grandfathering’ of rights, where firms are given rights free 

of charge depending on current pollution levels. 

Location problems 

For some types of pollution, emissions will have different impacts depending on 

their location. Emissions by firms in areas where there are few other polluters 

may have a lesser environmental impact than emissions by firms located in a 

region with many other polluters. Pollution targets for emissions trading are 

typically set by reference to what would be appropriate at an aggregate level. 

This approach can lead to localised pollution problems emerging even where 

national targets are met, if there are areas where polluters concentrate their 

activities or where pollution has a greater impact on the environment. In these 

circumstances it may be desirable to introduce caps at a local or regional level 

rather than at a national or international level. However, this can affect the 

liquidity of the resulting market by limiting the number of participants and 

volumes traded. 

Liquidity 

A well-functioning, liquid market in permits is more likely to develop where there 

are a larger number of participants. Where possible, permits of different kinds 

should be exchangeable, so that they can be traded in the same market. This 

approach is possible where the relative impacts of different types of emissions 

can be easily compared but is more difficult where their relative impacts are 

difficult to compare. A well functioning market will also require a well-developed 

infrastructure, including exchanges, brokers and available price information, 

for example. 


Market power problems can arise in two ways. First, firms may hoard permits in 

order to exclude potential entrants in the same industry. This problem can be 

avoided by including within the same scheme participants across several 

industries, from whom new entrants can purchase permits. 

Second, firms may hoard permits in order to manipulate the market for the 

permits themselves. Economic theory suggests that it may be rational for firms 

to attempt to corner the market in this way. As with issues of liquidity, this risk 

can be reduced by maximising the size of the scheme across emission types and 

geographic boundaries. 

156

INITIAL ALLOCATION OF PROPERTY RIGHTS 

The initial allocation of property rights matters. Economic theory suggests that 

property rights should be allocated through an auction, which is likely to 

increase the cost of pollution, encouraging the reduction of pollution from the 

outset. 

The auction 

In the UK-ETS, participants received permits based on their historic emissions 

levels. In order to encourage voluntary participation, the Government held an 

auction where participants could bid emissions reductions over the period 2002- 

2006 relative to historic emissions in return for a share of £215 million of 

incentive funding from Defra. (Participants in this auction were the direct 

participants under the first option described above.) 

The auction flowed from the recommendations of Lord Marshall’s task force. The 

task force envisaged a voluntary pilot scheme that would be a precursor to more 

wide-ranging compulsory schemes in the future. Defra chose to use incentive 

funding in order to encourage voluntary participation in this ‘pilot’ scheme. 

The outcome of the auction 

This aspect of the UK-ETS seems to have delivered results in line with the UK- 

ETS’s objectives: attracting participation by UK firms in an emissions trading 

scheme, while ensuring significant levels of emissions reductions. The auction 

attracted 34 direct participants covering a wide range of sizes and sectors, from 

global companies such as BP and Shell to banks, metropolitan councils and 

supermarkets, through to smaller organisations such as London’s Natural 

History Museum. 

The outcome of the auction was that 4.03 million tonnes in 2006 were sold at a 

price of £53.37 per tonne, which is equivalent to £17.79 per tonne per year over 

the life of the scheme. When three direct participants subsequently dropped out, 

the reduction in emissions was reduced slightly to 3.96 million tonnes. This 

reduction represents about 6 per cent of the 65.8 million tonnes reduction 

expected to be delivered by the policies and measures contemplated in the CCP. 

An alternative way of auctioning property rights 


An assessment of the auction carried out for the NAO by Frontier Economics 

suggested that an alternative, and perhaps better, way to have set and allocated 

the incentive fund would have been through a ‘sealed-bid’ auction process 

where participants submit details of how many reductions they would bid at a 

range of prices. 164 According to Frontier Economics, this auction design would 

have allowed Defra to procure emissions reductions at a lower unit cost. The 

164 For more details on the alternative auction see Report by the Comptroller and Auditor General (April 2004) 

The UK Emissions Trading Scheme: A new way to combat climate change, National Audit Office. 

157


submission of each participant’s supply curve would have allowed Defra to 

construct an aggregate supply curve and hence find the quantity of reductions it 

could buy by spending all its budget (£215 million), as well as the quantity of 

reductions it could buy for a variety of lower budgets. With an aggregate supply 

curve it would have been possible to estimate the amount of emissions 

reductions that would have been lost by setting a lower budget, which would 

have allowed Defra to set a budget for the scheme that would result in a lower 

unit cost per tonne of emissions reductions. 

It is worth noting that a ‘sealed-bid auction’ was one of the options considered 

by Defra’s consultant in the auction design. However, they felt that an auction 

based on sealed bids might have appeared complex and would thus have 

deterred potential small participants. In additional, Defra believed that greater 

flexibility over the budget might have discouraged participation and it was 

important to attract enough participants in order to create an active market. 165 

LOCATION PROBLEMS 

This issue does not appear to be relevant to the UK-ETS or the CCP in general. 

The UK-ETS and CCP are designed to address the problem of climate change 

caused by emissions of greenhouse gases. The extent of climate change caused 

by emissions of greenhouse gases depends on the concentration of these gases 

in the atmosphere across the globe. Emissions in Europe have the same impact 

as emissions in Australia, for example. 

For this reason, the UK-ETS makes no distinction between emissions arising in 

different locations within the UK. 

LIQUIDITY 

Participation in the emissions market is open to direct participants, agreement 

participants and others such as traders who do not have any need to use 

greenhouse-gas emission allowances themselves. This wide range of 

participants increases the number of potential buyers and sellers in the 

emissions market, which in turn increases the probability of a liquid market. 

However, a review by NERA on the performance of the first two years of the UK- 

ETS 166 found some evidence of liquidity problems during the initial years of the 

scheme. According to NERA, during the first two years of the UK-ETS, 946 

participants engaged in at least one trade in the market at volumes ranging from 

a singe allowance to 220,000 allowances. According to the criteria used by the 

study, there were a total of 1,331 trades during the first year of the scheme and 

165 See NAO report (April 2004), Ibid. 

166 NERA Economic Consulting (August 2004) Review of the First and Second Years of the UK Emissions Trading 

Scheme, a report prepared for the UK Department for Environment, Food and Rural Affairs, Department for the 

Environment, Food and Rural Affairs: London. 

158

only 242 in the second year. The difference in volumes of trades appears to have 

occurred because Agreement Participants had to report on their emissions every 

two years, and hence were less active in the market in the intervening period. 

During these two years direct participants were much more consistent and 

active than agreement participants, with the latter acting more as buyers than 

sellers. Overall, direct participants were the source of most of the allowances 

supplied, but because of their large numbers, agreement participants were able 

to provide additional liquidity to the market by engaging in smaller trades. 

Price developments, especially at the beginning of the scheme, suggest the 

presence of low liquidity. Between August and September 2002, the price of 

allowances increased from under £8 per tonne to more than £12 per tonne, 

which represents a price increase of over 50 per cent. Such a price increase is 

likely to be due to the relatively short supply of allowances available in the 

market, as a consequence of difficulties with the verification process, which in 

turn delayed the availability of allowances. 

By the end of 2002, the price of allowances had dropped to around £3 per tonne, 

and settled at around £2 per tonne during the following months. Although the 

reasons behind this price development are less clear, NERA suggests that ‘the 

price movements in the early days of the Scheme may have been affected more 

by low liquidity and inexperience than by underlying demand’. 167 

The operational infrastructure of the UK-ETS 


Anyone wanting to hold, buy or sell allowances or credits needs to have an 

account in the registry. The registry is an electronic, web-based system tracking 

emissions allowance holdings and transfers by all participants, from their initial 

allocation through all transfers of ownership until their final cancellation or 

retirement. The UK emissions trading registry is run by Defra and is designed to 

support the UK-ETS. 

There is no firm evidence to suggest that the operational infrastructure of the 

scheme has adversely affected market liquidity. However, some brokers suggest 

that the UK-ETS should operate via a system providing a ‘screen’ showing the 

prices offered and taken for allowances, as in any other financial market. The 

absence of such a system, the brokers argue, affects market transparency as 

small companies in the market would often contact only a single broker and 

would pay the first price they are offered. However, the NAO report points out 

that in other markets the responsibility for establishing such systems generally 

rests with brokers and their trade associations and Defra has not inhibited such 

developments. 168 

167 See NERA Economic Consulting report (August 2004), Ibid. 

168 Report by the Comptroller and Auditor General (April 2004) The UK Emissions Trading Scheme: A new way to 

combat climate change. National Audit Office. 

159


MARKET POWER 

As previously mentioned, direct participants, agreement participants and other 

traders are all allowed to trade in the emissions market. This range of potential 

participants increases both the number of participants and the number of 

sectors or industries participating in the market, which helps to improve market 

liquidity and reduce the likelihood of market power problems. 

The UK-ETS covers emissions of all six greenhouse gases. The same allowance 

can be used to meet a target for emissions of any greenhouse gas (with set 

‘exchange rates’ between different greenhouse gases to reflect their differing 

impacts on climate change). A firm that emits methane can trade with firms that 

emit carbon dioxide or nitrous oxide, for example. This market widening can also 

limit the extent to which firms can exercise market power within the scheme. 

Additionally, under the scheme rules, participants were prevented from gaining 

more than 20 per cent of the incentive fund in the initial auction, which reduced 

the amount of allowances they were able to hold and thus their ability to 

manipulate the price of allowances. 

The overachievement by the biggest participants (see below) has led to some of 

these direct participants holding a very large number of allowances. However, 

the observed movements in prices suggest that the presence of market power is 

unlikely. Prices have, on average, fallen since the launch of the program in 2002, 

and the price increases in the beginning of the UK-ETS can be explained by a 

lack of market liquidity due to delays in the verification process rather than the 

existence of market power. 


The UK-ETS has three main objectives, which were presented as being of equal 

importance: 

● to secure significant reductions in greenhouse gas emissions in the UK in a 

cost-effective manner, i.e. minimising the costs of emissions reductions for 

the UK economy as a whole; 

● to provide UK companies with early experience of emissions trading, in 

preparation for European and international emissions trading schemes; and 

● to promote the establishment of the City of London as a centre for emissions 

trading. 

160

COST-EFFICIENT EMISSIONS REDUCTIONS 


According to Defra, emissions reductions within the scheme have exceeded 

expectations with both direct participants and climate change agreement 

holders going well beyond their targets for future years of the scheme. 169 During 

the first year of the UK-ETS, direct participants, in aggregate, surpassed their 

targets for that year by 487 per cent and reported reductions of 4.64 million 

tonnes. 170 In other words, the reductions in emissions in the first year alone 

exceeded the target for reductions over the whole five-year life of the scheme by 

17 per cent. 

Since participants have the option of selling the allowances or ‘banking’ them for 

later use, the final impact of the reductions in the initial year are uncertain at 

present. Economic theory would suggest that the total volume of allowances 

available in the market will determine the total level of emissions produced over 

the life of the scheme. Given that participants can bank allowances and use them 

in later years, it may be that participants use the allowances they have banked 

to increase emissions in the later years of the scheme. This outcome might be 

the case if direct participants reacted to the price achieved in the initial auction 

(£18 per tonne per year) and calculated that at this price it would be profitable 

for them to reduce emissions by more than their target and sell the excess 

allowances generated at this market price. Since the market price is now much 

lower than this level, direct participants may in future years find it less profitable 

to reduce emissions and their emissions might therefore be expected to rise. 

A more likely outcome perhaps, is that direct participants will use some of their 

banked allowances to cover their own emissions in future years and sell the 

others to agreement participants who will then be able to exceed their targets. 

This outcome would counteract the overachievement of direct participants in the 

first year of the scheme so that the total level of emission reductions achieved 

through the initial auction might not exceed 3.96 million tonnes over the life of 

the scheme. 

However, such an outcome might suggest that the scheme has succeeded in 

achieving emission reductions in a cost effective manner, since it would suggest 

that direct participants are able to reduce emissions at a lower cost, on average, 

than agreement participants. (It would seem reasonable to expect that direct 

participants in the UK-ETS will have relatively lower emissions reduction costs 

than other firms in the UK economy, otherwise it would not have been rational 

for them to have entered ‘winning bids’ in the initial auction.) 

It has been suggested in some press reports that the goals set for some of the 

direct participants were undemanding and that some of the companies’ targeted 

levels of emissions were below their actual baselines. 171 On the other hand, Defra 

169 Third Annual Workshop on Greenhouse Gas Emission, 23-24 September 2003, ‘Country Summary: U.K Emissions 

Trading Scheme’, available at: http://www.iea.org/textbase/work/2003/ghgem/uk.pdf. 

170 Report by the Comptroller and Auditor General (April 2004) The UK Emissions Trading Scheme: A new way to 

combat climate change. National Audit Office. 

171 See NAO report, Ibid. 

161


had little information on the recent emissions of direct participants and attempts 

to go further in this respect could have resulted in unequal treatment for some 

direct participants – if, instead of using an average, the baseline for some 

participants was set only using the lowest level of emissions reported during the 

previous three years, for example. Tightening the targets could also have 

increased the risk that some of the participants might drop out of the scheme. 

The NAO’s research into four of these companies shows that, in practice, 

companies have made significant additional efforts to cut emissions and that 

incentive payments are helping to pay for emissions reductions. In addition, 

Defra believes that some of the direct participants are going beyond the goals 

set at the beginning of the UK-ETS and these firms are attempting to deliver 

further reductions, as they have discovered that further reductions lead to 

improvements in energy efficiency which are cost effective for the firm. 172 

During 2004, following the second year reconciliation 173 and the publication of 

the NAO report, Defra negotiated with direct participants, who had significantly 

exceeded their target reduction, to gain additional voluntary emissions 

reductions. As a result, the total guaranteed emissions reductions over the life of 

the scheme increased to around 20 million tonnes of CO 2 equivalent, from the 

original 11.88 million tonnes of CO 2 equivalent. 174 

It can be difficult to isolate the effect of the UK-ETS on the emissions reductions 

undertaken by firms. However, according to the NAO report, approximately 66 

per cent of the reductions reported by four of the main overachiever firms are 

attributable to the scheme. 

The market price of allowances in the UK is within the range of comparable 

markets. According to the NERA report, prices in the Chicago Climate Exchange, 

which is also a voluntary scheme, have been rarely above £0.6 per tonne since 

the exchange’s launch in 2003. In Europe, the forward price for carbon dioxide 

allowances under the EU-ETS had fluctuated between £4-£9 over the first six 

months of 2004. 175 Under the UK-ETS the allowance prices has fluctuated 

between £2 and £4 during 2003-2004. 176 

However, the price obtained in the initial auction, £18 per tonne over the life of 

the scheme, is significantly above the price estimated previous to the auction by 

172 Interview with Defra. 

173 The reconciliation process implies the verification that claimed emissions reductions correspond with actual ones. 

174 Information provided by Defra. 

175 The price of a metric tonne of CO has plunged since the UK ETS began officially on January 1, 2005, to less than 

2 

€7 (£4.7) from the informal ‘grey -market’ figure of €13 (£8.87) at the start of 2004. According to Time Magazine, 

February 21, 2005, page 49. 

176 According to DEFRA the price of allowances rose to around £4 in the beginning of 2004 when DEFRA made 

known its intention to review the scheme to deal with overachievements from direct participants. See also Report 

by the Comptroller and Auditor General(April 2004) The UK Emissions Trading Scheme: A new way to combat 

climate change. National Audit Office.;and NERA Economic Consulting (August 2004) Review of the First and 

Second Years of the UK Emissions Trading Scheme, a report prepared for the UK Department for Environment, 

Food and Rural Affairs, Department for the Environment, Food and Rural Affairs: London. 

162

consultants to Defra of £11 per tonne, although this estimation was ‘subject to 

major uncertainties’. 

In summary, experience suggests that the price paid by Defra in the initial 

auction to obtain commitments to reduce emissions was significantly higher 

than the underlying price of the allowances. A different auction design (such as 

perhaps a closed-bid auction) might have allowed Defra to obtain a higher level 

of reductions for the same cost or the same level of reductions at a lower cost. 

However, when measured against the stated objective of achieving emissions 

reductions in a cost-effective manner (in terms of costs incurred by the 

participating organisations) the scheme appears, on the basis of the evidence of 

its first few years, to have been highly successful. It has delivered emissions 

reductions in a cost effective way, by providing incentives for emissions 

reductions to take place in the industries and organisations with the lowest 

abatement costs. 

EXPERIENCE IN EMISSIONS TRADING 


The second objective of the UK-ETS was to provide early experience in 

emissions trading for UK organisations and in so doing to provide firms with an 

advantage over their international competitors in future international trading 

schemes. 

Interviews with direct participants performed by NERA, NAO and LECG suggest 

that this objective has been achieved. According to the NAO, all respondents in 

their study agreed that the scheme had improved their understanding of the 

benefits emissions trading could bring to them and, although some direct 

participants did not use the market because they had achieved their emissions 

target for that year, most of the participants said that their confidence in the use 

of the market for emissions had improved. 

In addition, of eleven participants that have sites that will fall within the scope of 

the EU-ETS, most felt that they are better prepared to take part in this international 

scheme than they would have been in the absence of the UK scheme. 

The majority of brokers and verifiers interviewed by NERA considered that their 

experience in the UK-ETS had left them well placed to provide services to 

companies participating in the EU-ETS. However, the verifiers also noted that the 

full benefits of the UK experience would only be realised if the EU-ETS integrity 

standards are similar to those used in the UK-ETS. Some verifiers expressed 

concerns that the lack of guidance on verification standards or requirements for 

accreditation under the EU-ETS would lead to different standards of verification 

across EU members, which can threaten the integrity of the programme, as well 

as presenting obstacles to the trade of verification services. 177 

177 NERA Economic Consulting (August 2004) Review of the First and Second Years of the UK Emissions Trading 

Scheme, a report prepared for the UK Department for Environment, Food and Rural Affairs, Department for the 

Environment, Food and Rural Affairs: London. 

163


Overall, the UK-ETS seems to have provided firms and participants in the UK- 

ETS with early experience of emissions trading. Most of the direct participants 

interviewed said that their understanding of emissions trading and the 

relationships between energy savings, emissions and cost has also deepened. 

Brokers and verifiers consider that their participation in the scheme has left them 

well placed to participate in the EU scheme. 

THE CITY OF LONDON AS A CENTRE FOR EMISSIONS TRADING 

The third objective of the scheme was to promote the establishment of the City 

of London as a centre for emissions trading. 

It is perhaps difficult to assess at the moment whether or not this objective will 

be achieved. Defra considers that the early experience in emissions trading has 

given the City of London a first-mover advantage that has prepared lawyers, 

brokers, bankers, traders, consultants and verifiers for the new international 

emissions trading schemes. A number of firms interviewed by NERA consider 

that the majority of greenhouse gas brokers and traders are currently located in 

London and that significant expertise in legal, financial and data requirements 

have been gained as a result of the UK-ETS. It appears that the UK-ETS has led 

to the establishment of a centre of emissions trading expertise in London. 178 It is, 

however, perhaps too early to say whether London will become the centre for 

emissions trading globally or in Europe. 

UNANTICIPATED BENEFITS/DRAWBACKS 

Defra suggested to us that the introduction of the monitoring process in itself 

provided incentives to reduce emissions, since before the scheme existed some 

participants lacked information on their total energy use. The information 

produced as part of the monitoring process has allowed participants to assess 

their total energy use and take measures to improve their energy efficiency in 

ways that would be privately profitable even in the absence of the CCP. It is not 

clear why firms had not already exploited these profitable opportunities, but it 

appears that the scheme may have revealed information to firms on their energy 

efficiency that they were not previously aware of. 

These benefits appear to be supported by evidence gathered by the NAO and 

our interviews with direct participants. According to some of the direct 

participants interviewed, participation in the UK-ETS has been an effective way 

to secure corporate commitment to projects aimed at reducing greenhouse gas 

emissions. Shell UK limited, one of the major participants in the Scheme said 

that: 

178 An example of this is the existence of London Climate Change Service (LCCS), an association of service providers 

who aim to assist international firms adjust to the European and Kyoto Regulations by providing expertise across 

a wide range of services. LCCS is also a forum to promote the shared interests of the member service providers 

in the climate change and emissions trading sectors. 

164

Participation has helped us to raise the profile of emissions management at 

all levels in our company. This has enabled us to accelerate our energy 

management programme and to progress more opportunities through 

implementation. 179 

However, the scheme seems also to contribute to improvements in energy 

management and thus energy and cost savings for smaller participants, as 

acknowledged by Kirklees Metropolitan Council: 

[T]he UK ETS is an excellent driver and tool to implement many energy 

saving schemes and initiatives towards GHG reduction, including ensuring 

that we have a process to obtain more accurate and timely meter readings 

from the utilities. 180 

Similarly, in the study performed by NERA, almost all participants reported 

improvements to internal environmental and energy management procedures 

as a result of scheme participation. 

It appears that this process has produced benefits in terms of greenhouse gas 

emissions reductions and reductions in other pollutants arising from the burning 

of fossil fuels, as well as benefits to the profitability of these firms as a result of 

the reduction in their total energy costs. 181 However, it could be argued that these 

benefits would have arisen from any scheme that forced firms to monitor their 

energy use and greenhouse gas emissions in order to meet specific targets, 

whether or not this involved the use of a market mechanism. 



The evidence available to date suggests that the UK-ETS has been successful at 

reducing levels of greenhouse gas emissions in a cost-effective manner. 

The idea of assigning property rights to a negative externality and then allowing 

market participants to work out the appropriate price, as suggested by economic 

theory, has produced positive results in other areas of environmental control, for 

instance the SO 2 allowance trading for acid rain control and the lead trading 

program in the US. 182 The evidence suggests that the UK-ETS has been no 

exception. 

179 DEFRA, UK emissions Trading Scheme: Reports, Third Year (2004) results, Views from two Direct Participants on 

what they have learnt from participating in the UK Emissions Trading Scheme, prepared for the Secretary of State 

in advance of the Conference of Parties 10 in Buenos Aires, available at 

http://www.Defra.gov.uk/environment/climatechange/trading/uk/pdf/dpviews.pdf. 

180 Interview with Bill Edrich and Kay Beagley from the Kirklees Metropolitan Council, June, 2005. 

181 For instance the Kirklees Metropolitan Council estimates that their participation in the UK-ETS will improve the 

corporate management of energy resulting in an estimated saving of up to 5 per cent of consumption over the 

five years of the scheme. 

182 Stavins, Robert (2001) ‘Lessons from the American Experiment with Market-Based Environmental Policies, KGS 

Working Paper No. RWP01-032. 

165


The UK-ETS has also provided valuable experience to the organisations involved 

in it. The process of setting baselines, monitoring and verification has provided 

UK firms with experience in an essential process of any trading scheme. Such 

experience is likely to provide them with an advantage over foreign competitors 

in international trading schemes. 

The early experience in emissions trading has given the City of London a 

potential first-mover advantage that has prepared lawyers, brokers, bankers, 

traders, consultants and verifiers with skills that can be exploited in new 

international schemes. This may, in the future, allow the City of London to 

become an important centre for emissions trading. 


A number of factors have contributed to the apparent success of the UK-ETS. 

First, the nature of greenhouse gas emissions allowed the creation of a single 

market in which allowances for all types of greenhouse gas emissions in all 

locations could be traded. This feature has promoted the liquidity of the market. 

While not all pollutants lend themselves to this degree of interchangeability 

between allowances, it would seem desirable, wherever possible, to seek the 

creation of a single wide market in convertible allowances. This approach 

promotes the liquidity of the market and allows participants collectively to make 

efficient trade-offs and achieve emission reductions at minimum cost. 

Second, the use of an initial auction, where public funds were used to purchase 

emissions reductions from direct participants, using historical emissions as a 

baseline, appears to have been successful at enticing firms to participate in the 

scheme and promoted the liquidity of a market in which other participants have 

been able to trade. 

Third, specific measures were taken to avoid allowing one participant to ‘corner 

the market’ in allowances (no participant was able to obtain more than 20 per 

cent of the allowances allocated in the initial auction). While it is not clear that 

any market power or liquidity problems would have arisen in the UK-ETS in the 

absence of this intervention, it may be an important safeguard in other schemes 

which are not able to achieve the same level of liquidity as the UK-ETS. 

Within this context of the overall success of the scheme, three issues arise that 

would require careful consideration in future tradable emissions permits 

schemes. 

The first is that the initial auction resulted in DEFRA purchasing emissions 

reductions at a price (£18 per tonne per year) that subsequent experience has 

shown is significantly above the market price for allowances (which were later 

trading in the range £2-£4 per tonne since February 2003). This suggests that the 

form of auction used failed to reveal the underlying cost of reducing carbon 

166


emissions for scheme participants and other auction designs may have 

been more appropriate. However, it is important to note that there are significant 

fixed costs of participation in the UK-ETS and thus, Defra did not expect the cost 

of reducing emissions to the Government to be the same as the secondary 

market price. 

The second is that implementation raised complex issues regarding both (i) the 

setting of baselines and (ii) the verification process. To some extent these issues 

led to delays in the allocation of allowances which caused a temporary shortage 

of allowances and affected the liquidity of the market and efficient price 

formation for a period of time. Both of these issues appear to require 

considerable resources to resolve. However, the first (setting baselines) can be 

avoided in a scheme where allowances are allocated through an initial auction 

rather than allocated on the basis of historic emission levels or reductions 

against historic emission levels. Such an approach may be difficult where it 

leads to significant cost increases for some industries that may have to reduce 

output as a result. However, such changes in industrial output are the natural 

consequence of adjusting prices to reflect externality costs. The resulting 

adjustment costs for industry should be addressed directly (through support for 

retraining of employees, for example) rather than by adjustments to the market 

mechanism. 

Lastly, the lack of a full international consensus on tackling climate change 

(e.g. the US and China have not signed the Protocol) may make it difficult for 

governments to use a market-based instrument to internalise the cost of 

greenhouse gas emissions. Without international agreement, the use of such 

mechanisms by one country may simply shift polluting industries to other 

countries without such controls, with no resulting benefit to the environment. 

167

Part V 

Annex 

169

SECTION 12 

Issues in the 

implementation of 

market mechanisms 

This section provides additional details from the economic literature reviewed in 

Part III on the main issues involved in the implementation of market 

mechanisms. Properly applied, market mechanisms can lead to a more efficient 

and often more user-friendly system than under a traditional public policy 

system. However, implementing these mechanisms is rarely straightforward and 

runs the risk of introducing market failures as well as market benefits into the 

public sector. In this section we discuss issues that can arise in implementing 

each of the market mechanisms, focusing on the potential problems highlighted 

by theory. We also suggest ways in which these issues can be addressed and 

review the available evidence on the overall performance of each mechanism. 

Competitive tendering of service provision 

MARKET POWER 

The benefits from a competitive tendering process can only be realised if there 

is genuine competition for the contract. However, if the process does not elicit 

genuine competition, either due to market power by a single firm, or due to 

collusion amongst potential bidders, then an optimal result is unlikely to be 

obtained. As a result, prices may be higher and quality may be lower than under 

government provision. Unless there are other benefits such as improvements in 

consumer choice, it is possible that consumer welfare may be reduced under the 

market mechanism compared with government provision. 

Single firm market power 

When conducting a competitive tendering process it is important to ensure that 

there will be competing bidders. This outcome is highly unlikely where only one 

firm is in a strong position to win the contract. This situation can arise for a 

number of reasons – there may be only one firm which is genuinely able to fulfil 

the requirements, the contract may be structured in such a way that only one 

firm is in a credible position to bid, or there may be strong incumbency 

advantages. 

If there is only one firm that is able to provide the required service, then it is 

debatable whether a competitive tendering process is appropriate. However, in 

some cases, this problem may be solved through appropriate structuring of the 

170

contract. In particular, dividing the contract into a number of distinct separate 

contracts may elicit greater competition. Although there may be only a limited 

number of bidders able to compete for a national contract, many more firms able 

to offer a service on a local or regional basis. 

In other cases, although there may be adequate competition when the contract 

is first awarded, in subsequent tenders the incumbent may have secured an 

advantage that prevents a competitive outcome. These incumbency advantages 

can arise if there is learning-by-doing or if the winning bidder undertakes 

specific investments. An incumbent could also earn a good reputation or 

develop a good understanding of the public sector and its requirements, which 

could create a strong advantage if the government agency is risk-averse. 

The reduced competitive discipline resulting from incumbency advantage will 

undermine the efficiency incentives that competitive tendering aims to 

encourage and could result in the government paying too high a price for the 

outsourced services. Moreover, these problems may be further compounded if 

the incumbency advantage is perceived by rival bidders. Weaker firms may not 

be willing to undertake the costs associated with compiling a tender if the 

incumbent is sufficiently well positioned to win the contract. This incumbency 

advantage discourages new entrants from participating in future tenders, 

restricting competition in the long run. 

Solutions to incumbency advantages 

Section 12 – Issues in the implementation of market mechanisms 

A number of different methods have been suggested to reduce the potential for 

incumbency advantages. 

One approach is to offer multiple contracts and award them to different bidders, 

setting limits on how many contracts any one firm is allowed to hold. Although 

this may mean the lowest-cost bidder is not always selected, cost savings are 

likely to be realised in the long run by ensuring future competition for the 

market. Awarding multiple contracts facilitates competition in subsequent 

stages because it allows for more than one firm to develop relevant expertise 

that can be drawn upon when the contract is re-tendered. Aggregating 

requirements into a single tender, on the other hand, allows only one firm to 

gain the incumbency advantage, reducing the ability of other firms to compete 

effectively in the future. Multiple contracts also help mitigate cases where one 

firm has gained market power through another means. Offering a number of 

contracts and stipulating how many each firm may hold increases the 

probabilities of success for other firms and potential entrants. This approach 

makes them more likely to incur the costs of bidding, increasing competition for 

the market and reducing rents to the advantaged incumbent. 

Seshandri et al (1991) 183 develop a model in which the level of aggregation of the 

contract determines the number of participating bidders, and find that multi- 

183 Seshandri, S., K. Chatterjee and G. Lilien (1991), ‘Multiple Source Procurement Competitions’, Marketing Science 10. 

171


sourcing will increase participation at the cost of higher prices. However, Perry 

and Sakovics (2003) show that this is true when the number of bidders is fixed, 

but not when letting multiple contracts can attract entry. In this situation, 

multiple contracts can lead to lower costs, particularly if the number of initial 

bidders is small. 184 They also show that it will never be optimal to split 

requirements equally as this would allocate the largest possible demand to the 

most inefficient supplier, maximising productive inefficiency. It would also 

create the weakest incentives for competition for the primary contract. They 

advocate a split that involves the minimum size of secondary contract required 

to attract an additional bidder to the market. 

Maintaining bidding parity may be difficult even when the buyer sources from 

multiple suppliers. Sheang (2000) notes that multi-sourcing is sustainable in the 

long run only if the learning-by-doing advantage is equal across suppliers. 185 If 

this is not the case then the cost of multi-sourcing increases as cost differences 

between suppliers increase. Sheang recommends learning-by-doing advantages 

be equalised by splitting contracts equally amongst suppliers, even though this 

means productive inefficiency for the first tender is maximised and competition 

is weakened. Together this literature suggests that when incumbency 

advantages are a real concern, it can be better to award contracts to multiple 

bidders to minimise incumbency advantages. Contract length can also be 

helpful in reducing incumbency advantages. Although a long contract length 

means that an incumbent may have significantly more experience than a new 

entrant, a long contract also increases the incentives for new entrants to invest 

in bidding and to develop the skills. Newbery (2004) looks at the interaction 

between contract design and market structure in the context of the restructured 

and privatised electricity industry in England and Wales. He notes that the use of 

long-term contracts encouraged entry of new merchant Independent Power 

Producers by reducing uncertainty. 

The terms under which the contract is offered can also affect the level of 

incumbency advantages. A fixed-price contract exposes the bidder to the fact 

that costs may be uncertain ex ante, giving incumbents an informational 

advantage regarding costs. A cost-plus contract removes this advantage, but 

introduces problems of its own, as firms have no incentive to control their costs 

and so may engage in excess investment and gold-plating of services. 

In other cases, where incumbency advantages are recognised, it may be 

worthwhile for the government to take special steps to ignore the incumbency 

advantage when re-contracting. Cabral and Greenstein (1990) cite an example of 

the purchasing of computer equipment by the US government. 186 In the 1970s 

184 Perry, M. and J. Sakovics (2003), ‘Auctions for Split-Award Contracts,’ The Journal of Industrial Economics 2. 

185 Sheang, K. (2000), ‘Production Cost, Transaction Cost, and Outsourcing Strategy: A Game Theoretical Analysis’, 

mimeo, National University 

186 Cabral, L. and Greenstein, S. 1990. Switching costs and bidding parity in government procurement of computer 

systems. Journal of Law, Economics and Organisation 6 

172

the US Government procurement procedure for mainframe computers ignored 

the often substantial conversion costs involved in changing from one system to 

another and instead opted for the system that bid the lowest. Following much 

criticism from the individual Government agencies that had to bear the 

conversion costs, this system was changed in 1980 to one where estimated 

switching costs were added to incompatible vendors’ bids. 

Cabral and Greenstein find that centralised procurement, where conversion 

costs are ignored, elicits more competitive behaviour from the bidder who has a 

competitive advantage. Although on a local level the decision to ignore 

switching costs may appear suboptimal, at a global level this policy can be 

optimal as it induces lower prices as a result of more competitive bidding. 

Consequently, it is not clear that taking switching costs into account is always an 

optimal policy for customers. 

Collusion 


Collusion arises when the firms in a market realise that they are collectively 

better off by ceasing to compete aggressively, and instead co-ordinate their 

behaviour to raise prices and maximise the profits of all. Collusion has been a 

cause for concern in many procurement processes. 187 

In order for collusion to occur, the firms in an industry must be able to explicitly 

or tacitly reach an agreement on how to share the market. Such an 

understanding can be reached in a number of different ways, such as agreeing 

to keep to a particular geographic area (geographic market sharing), or reaching 

an understanding on the price to be charged. 

Moreover, for collusion to be successful it has to be sustained over time. Within 

collusion there is always an inherent tension between individual and collective 

interests. Whilst collusion may be in firms’ collective interests, at any point in 

time, firms have an individual incentive to ‘cheat’ on the collective agreement to 

increase their sales. For example, consider the situation where firms have 

colluded to raise prices significantly above the competitive level. If any one firm 

cheats by offering a price just below the cartel price, then it can steal significant 

sales from its rivals. As a consequence, economists have found that collusion 

can only be sustained if firms that deviate from the collusive agreement can be 

detected and punished by other cartel members. 188 

187 McMillan, p. 1991. Dango: Japan’s price fixing conspiracies. Economics and Politics 3. 

Porter and Zona. 1993. Detection of bid rigging in procurement auctions. Journal of Political Economy 101. 

Pesendorfer, M. 2000. A study of collusion in first price auctions. Review of Economic Studies 67. 

188 Motta (2004), Competition Policy: Theory and Practice, Cambridge University Press. 

173


Factors that facilitate collusion 

Economists have found that the following market features help firms to reach 

and sustain a collusive agreement. 189 These are: 

● High concentration: the lower the number of potential firms in a market, the 

easier it is to reach an agreement between them; 

● Symmetry of firms: it is easier for firms to reach an agreement when they are 

similar as their interests are more likely to be aligned; 

● Transparency: a transparent market makes it easier for firms to reach an 

agreement and to monitor that the agreement is being maintained; 

● Homogenous contracts: if contracts are similar, it is easier for firms to share 

them amongst themselves; 

● Regularity and frequency of orders: if there are frequent, regular orders it is 

easier for firms to sustain a collusive agreement. It may not be worth 

deviating and undermining the agreement for a small contract. Moreover, 

punishing cheating firms is easier when the next contract comes soon; 

● Multi-market contacts: these can help collusion by increasing the symmetry 

of firms (as one may be strong in one market, and one strong in another) and 

by increasing the regularity of orders. Where firms have a ‘natural territory’ 

this can also make it easier to agree on an initial allocation of contracts; 

● Stable demand: stable demand makes it easier for firms to determine 

whether prices have fallen due to a firm cheating on an agreement or a 

genuine fall in demand; 

● High barriers to entry: this makes it less likely that collusion will be 

undermined by new entrants; and 

● Absence of buyer power: a strong buyer can make collusion more difficult 

through the design of the sales process. 

Factors that make public procurement vulnerable to collusion 

A number of the factors listed above are often found in public procurement 

processes, increasing the potential for collusion. Although governments should 

often be in a position to exercise buyer power, the design of some procurement 

processes has on occasions created conditions ideal for fostering collusion 

among bidders. For example, standard contracts are often awarded by many 

local authorities on a local basis, resulting in a high degree of regular, standard 

contracts and repeated interaction among firms. In addition, many public tender 

processes can require a past track record by a firm, creating barriers to entry and 

reducing the pool of potential firms. Risk-averse government agencies, such as 

those involved in the provision of frontline services, are likely to favour 

procurement through a steady and predictable flow of demand. Stable demand 

189 Motta (2004), Competition Policy: Theory and Practice, Cambridge University Press. 

174

allows suppliers to plan more effectively to meet demand and thus ensures 

sufficient capacity is available to deliver these services, but also makes collusion 

easier to sustain. 

An illustration of how a badly designed public procurement process can create 

conditions ideal for collusion is provided by Pesendorfer (2000) who examined 

a cartel for school milk contracts in Florida and Texas. 190 The market was 

characterised by many small contracts (in total several hundred a year between 

the two states). In each school district contracts were awarded independently of 

one another and at different dates. Each school district also published details of 

all bidders for the contract and the price bid by each. The transparency created 

by this system made it easy for bidders to collude on a market outcome (either 

in terms of price or by sharing contracts) and to detect when any firm had 

cheated on a contract. The frequency of contracts deterred firms from cheating, 

both as the gains from cheating on any individual contract were likely to be low 

and as any deviation could quickly be punished on the next contract. 

Ways to reduce the risk of collusion 

The potential for collusion can be restricted through appropriate auction design, 

bearing in mind the features that are likely to support a coordinated outcome in 

the first place. Making the process less transparent, reducing the frequency and 

similarity of contracts and reducing barriers to entry can all help in undermining 

collusion. For example, in the school milk example cited above, collusion would 

have been less likely if information on bids and bidders were not published and 

if the authority had aggregated together groups of contracts into large contracts. 

Fewer and larger contracts reduce the frequency of interaction, introduce an 

element of volatility to demand and increase the cost of losing. However, this 

must be balanced against incumbency advantages and the resulting impact on 

long-term market structure. Similarly, making bidding processes less 

transparent may limit the potential for collusion, but implies a trade-off in terms 

of the increased risk of regulatory capture that will also result. 

Auction design 


As many competitive tenders are allocated through an auction process, care 

needs to be taken to ensure that the auction design does not create conditions 

for collusion. 

Auctions can be either open or sealed bid. In open auctions, bidding proceeds in 

stages, with bidders acting simultaneously and independently in each round. At 

the end of the round, bidders observe the outcome and adjust bids accordingly. 

Under a sealed-bid auction, bidders submit bids simultaneously and 

independently. Bids are then opened and the auction outcome decided 

190 Pesendorfer (2000) as quoted in Motta (2004), Competition Policy: Theory and Practice, Cambridge University 

Press. 

175


according to pre-determined rules. Open auctions can be either ascending or 

descending, for example, and sealed-bid auctions can specify that the winner 

pays his own bid (‘a first-price auction’) or the bid of his strongest competitor, 

for example (‘a second-price auction’). Simultaneous multi-round auctions 

(SMRAs) have been used in the allocation of radio spectrum and the divestment 

of electricity generating capacity. In an SMRA, a number of items are sold 

simultaneously over multiple rounds. The auction closes when no new bids are 

forthcoming and each item is sold to the highest bidder. Over the course of the 

auction, the prices of different items vary and bidders can switch between them 

on the basis of their relative price. 191 

Klemperer points to the divergent outcomes of the European spectrum auctions 

for 3G mobile licences as evidence of the impact of auction design. 192 In Germany 

and the UK, spectrum sold for more than 600 euros per person, whereas in 

Austria, Netherlands, Italy and Switzerland the sums raised were 100, 700, 240 

and 20 euros per person respectively. Klemperer identifies the main potential 

pitfalls as permitting collusion or entry-deterring and predatory behaviour and 

outlines the means through which these traps could be avoided. 

Auction design is particularly important where the number of competitors is not 

large in relation to the number of items being sold. Brusco and Lopsmo (1999) 

prove that the possibility for collusive outcomes declines as the number of 

bidders rises relative to the number of items being auctioned, as the possibility 

of bidders agreeing on how to split the bids falls. 193 However, where the expected 

number of competitors is few, collusion can be a real concern. Klemperer notes 

that open ascending auctions can be particularly prone to collusion because: 

a. bidders can use the early stages of low prices to signal who should win which 

object and then tacitly agree to stop pushing up prices; and 

b. they offer a punishment mechanism as members can bid more aggressively 

for lots they do not want. The firm that wants that particular licence will then 

bid higher so the punishment mechanism is costless. Furthermore, by 

blocking entry, ascending auctions encourage remaining strong bidders to 

collude. 

Bidders may also be able to exploit an auction set-up to engage in entrydeterring 

or predatory behaviour. If asymmetries between bidders are too great, 

there is little incentive for others to enter given the costs associated with 

bidding. Weaker bidders are likely to perceive the outcome as a foregone 

conclusion, and so not participate. This perception creates an incentive for 

bidders to develop an advantage as an effective predatory strategy, and create a 

reputation for aggressiveness to reinforce this advantage. Predation is 

particularly easy in repeated ascending auctions as it is easier to develop a 

stronger reputation. 

191 •econ report for the OFT 

192 Klemperer, P, 2002, What really matters in auction design, Journal of economic perspectives, 16(1). 

193 Brusco, S. and Lopsmo, G. 1999. Collusion via signalling in open ascending auctions with multiple objects and 

complementarities. Working paper, Stern School of Business, New York University 

176

In a sealed-bid auction, bidders cannot use their bid to signal who should win a 

contract, making collusion more difficult. Weaker bidders have some chance of 

victory and are correspondingly more likely to enter. Winner’s curse is also less 

severe. The strongest player may well have been willing to pay the winning bid, 

therefore the winner has not necessarily over-estimated the lot’s value. 

Ways to reduce the potential for collusion in auctions 

In auctions where it is identified that collusion among bidders may be a potential 

concern, there are a number of steps that can be taken in the auction design to 

reduce this risk. 

The use of a sealed bid auction, rather than an ascending auction should be 

considered as the lack of transparency in a sealed bid auction makes collusion 

more difficult. Cramton and Schwartz (2000) and Klemperer (2002) have 

suggested this as a means of reducing the likelihood of collusion in auctions. 194 

However, it should be noted that where collusion is not a major concern, this 

may give a less efficient outcome, as firms cannot use good information about 

rivals in order to bid intelligently. 

If an ascending auction is to be used, then Klemperer suggests that the 

ascending auction can be made more robust by forcing bidders to bid in round 

numbers or aggregating lots into larger bundles. The number of bidders left in 

the auction can be kept secret and bidders can even be paid to enter the auction 

to address problems of collusion and insufficient entry. 

The use of a reserve price can also affect the risk of collusion. Thomas (2001) 

shows the strategic choice of a reserve price can dramatically reduce the range 

of discount factors over which collusion is sustainable. 195 The option to selfsupply 

is an alternative to setting a reserve price, suggesting that a valuable tool 

for reducing the scope for collusion in procurement is the threat of self-supply. 

INCOMPLETE CONTRACTS 


When drawing up a contract for supply, it can be difficult to have a contract that 

specifies what will happen in every possible contingency, either because not all 

contingencies can be foreseen, or because the costs of doing so are too high. In 

economics terms, this means that the contract is ‘incomplete’. 

In the context of public procurement, there are two areas in particular where 

incomplete contracts can lead to problems – these are in ensuring quality and 

problems caused by incumbency advantages. The latter issue has been 

194 Cramton, P. and Schwartz, J. 2000. Collusive bidding: lessons from the FCC spectrum auctions. Journal of 

regulatory economics 17. 

Klemperer, P. 2002. What really matters in auction design. Journal of Economic Perspectives 16(1) 

195 Thomas, C. 2001. Collusion and optimal reserve prices in repeated procurement auctions. Working paper no.242, 

Federal Trade Commission 

177


considered in the section on market power above. In this section we consider the 

issues that arise from the inability to adequately specify quality. 

Quality is a frequent problem in incomplete contracts as it can be difficult to 

measure and monitor quality in all its dimensions. For example, although some 

aspects of quality may be specified, such as the minimum number of customers 

to be treated, other aspects, such as how much attention is spent on each 

customer, may be more difficult to codify. Some goods, known as credence 

goods, have the characteristic that customers are unable to assess the level of 

quality they received, even after they have consumed the good. This is a 

problem arising from asymmetric information and further complicates the 

monitoring of quality. An inability to contract for and monitor quality can raise 

potential problems in situations where there is a trade-off between improving or 

maintaining quality and reducing cost. 

If contracts could be completely specified, motivating private contractors and 

public employees would amount to the same principal-agent problem and there 

would be nothing to distinguish private from public sector provision. All relevant 

measures of performance could be specified under the contracts. Under 

incomplete contracts, however, the incentives of public and private sector 

providers may differ. Where some elements of quality are specified in a contract, 

but others are not, then this can lead to an over-concentration on those that are 

specified. Holmstrom and Milgrom (1991) argue that when an agent is required 

to perform a variety of tasks, he will allocate effort to the most easily measurable 

task, often leading to an increase in productivity at the expense of quality. 196 

Grossman and Hart (1994) show that, in a world of incomplete contracts, a 

private provider has stronger incentives to engage in cost reduction than a 

government employee. 197 The private provider has stronger incentives because 

it obtains the surplus profits under the contract. However, the incentive to reduce 

costs will typically be too strong as it will ignore the adverse effect on noncontractible 

quality, with the result that costs are always lower under private 

ownership but quality may be either higher or lower. Quality tends to improve if 

there is strong competition for contract renewal, at which point, noncontractable 

quality may also be observed, or if higher quality can lead to a 

higher price for work. 

Grossman and Hart note that the public manager may have lower incentives to 

innovate due to his inability to appropriate full gains from innovations. The 

public sector employee can command the same share of rents as a private 

manager only if he is totally irreplaceable. Assuming he is not, he will have 

correspondingly lower incentives to invest in either quality-enhancing or costreducing 

technologies. 

196 Holmstrom, B. and Milgrom, P. (1991) ‘Multi-Task Principal-Agent Analyses: Incentive Contracts, Asset Ownership 

and Job Design.’ Journal of Law, Economics and Organisation 7. 

197 Grossman, S. and Hart, O..(1986) ‘The Costs and Benefits of Ownership: A Theory of Vertical and Lateral 

Integration,’ Journal of Political Economy 94 

178


Both outcomes are obviously inefficient. Which arrangement is superior 

therefore depends on which distortion is less damaging: too much cost 

reduction and too little quality improvement, or too little cost reduction and 

quality innovation. Private ownership will be superior when: 

a. the deterioration in quality resulting from cost reductions is small; and/or 

b. the opportunity for cost reductions is large and government employees have 

weak incentives. 

Public-sector provision will be superior when the adverse effect of cost reduction 

on quality is large and either quality enhancements are unimportant or 

government employees have strong incentives. 

Hart et al (1997) apply these findings to a study of private prisons in the United 

States. 198 They note concerns that have been raised regarding inmate quality of 

life and incidence of prison violence in private prisons. Donahue (1988) found 

that private prisons were 10 per cent cheaper per prisoner because public sector 

guards were paid a 15 per cent premium. This could have been due to public 

sector union activity or because private prisons hired lower quality staff. Hart et 

al conclude that incompleteness in prison contracts has led to quality 

shortcomings, and cite the example of Esmore in New Jersey where attempts by 

the private contractor to cut costs by employing inadequately qualified prison 

guards led to a riot in 1995 at the Elizabeth detention centre and the subsequent 

termination of the contract. Because the welfare consequences of quality 

deterioration are similar to the cost difference, and opportunities for quality 

innovation limited, Hart et al conclude that prison services should be retained 

under public ownership. They do qualify this conclusion however: if there were 

a means of introducing competition between providers, then contracting out 

may become more attractive. For example, competition between schools is 

associated with a higher quality of education (Hoxby, 1994). 199 They note that 

some markets are more naturally suited to competition than others. Where there 

is limited ability to assess quality, for example, in health care, competition is 

likely to be restricted even with a large number of suppliers and contracting-out 

therefore less attractive. 

Moreover, other studies have found that competitive tendering tends to maintain 

or even improve quality of service. Domberger et al. (1995) examine whether 

price reductions observed from outsourcing cleaning contracts resulted from 

reductions in quality. 200 They examine data on 61 cleaning services contracts. 

They look at contracts awarded through competitively tendered processes and 

those not put out to tender, and also distinguish between tenders that are 

contracted out and those that are awarded to the in-house team. The authors 

198 Hart, Shleifer and Vishny. 1997. The Proper Scope of Government: Theory and an Application to Prisons. 

Quarterly Journal of Economics 112. 

199 Hoxby. 1994. Does competition among public schools benefit students and taxpayers? NBER working paper 

number 4979. 

200 Domberger, S., C. Hall and E. Ah Lik Li. 1995. Price and quality in competitively tendered contracts. Economic 

Journal 105. 

179


observe that whilst competition does reduce the price of these contracts, quality 

is maintained or even enhanced. They therefore conclude that the effect of 

competition is greater on price than quality and the influence of ownership 

negligible on both. 

Ways to reduce the quality incomplete contracts problem 

The single best way to minimise the problems posed by incomplete contracts is 

to ensure that the initial contract is as ‘complete’ as possible, and to ensure that 

the resulting contract can be effectively monitored and enforced. In some of the 

cases reviewed in the literature, where private firms have reduced quality, the 

problem has been one of lack of monitoring and enforcement of contract 

provisions rather than incompleteness per se. Domberger and Jensen (1997) 

note that one example of quality reduction, at the Esmore Correctional Services 

Corporation at Elizabeth detention centre in New Jersey, USA, which resulted in 

a riot in 1995, was actually a problem of contract enforcement. In that case the 

terms of the contract were broken as the prison guards lacked the necessary 

qualifications to perform their role. 

Moreover, evidence suggests that monitoring is not particularly costly. The UK 

Audit Commission (1995) finds that contract monitoring costs amount to no 

more than a few percent of the contract price. 201 Although a number of studies 

have found evidence of such quality shading (reduced quality that meets 

contract requirements) (e.g. Cope, (1995) and Evatt Research Centre (1990)), 202 

this is generally considered preventable through the use of proper contract 

design (Domberger and Jensen, 1997) as long as appropriate monitoring and 

enforcement mechanisms are in place. 

However, even if all performance measures cannot be adequately specified, it 

may be possible to assess the overall quality of the service received when the 

contract comes up for renewal. If reducing quality adversely affects the possibility 

of a provider having the contract renewed, then this can provide a strong 

incentive to maintain quality, even when quality cannot be completely specified. 

Another means to prevent quality shading is by multi-sourcing, as this allows for 

‘yardstick competition’ through the benchmarking of suppliers against one 

another. The threat of moving demand from poor to high performing suppliers 

deters suppliers from cutting quality during the life of the contract, and provides 

incentives to exceed contractual requirements. This effect formed the rationale 

behind the multi-sourcing approach adopted by the NHS for its National 

Programme for IT, which committed to selecting at least three different suppliers 

for its regional contracts and actually chose four. 

201 See Audit Commission (1995) Making markets: a review of the audits of the chief role for contracted services. 

March 1995, London, HMSO. 

202 Cope, S. 1995. Contracting-out in local government: cutting by privatising. Public Policy and Administration 10(3). 

Evatt Research Centre. 1990. Breach of Contract: Privatisation and the Management of the Australian Local 

Government. Pluto Press: Sydney. 

180

Incomplete contracts and optimal contract duration 

If a contract is incomplete, there is a greater chance renegotiation of terms will 

be necessary once certain contingencies have been realised. Posner (1972) 

therefore suggests that franchise contracts should be short so as to avoid 

problems arising from incomplete long-term contracts. Short-term contracts 

may reduce the risk of a contract failing by allowing for more frequent 

renegotiation, but may lead to problems of bidder parity when the contract is 

re-tendered. Ensuring bidder parity reduces incentives to invest (see Laffont and 

Tirole 1993, described earlier) but encouraging investment by biasing the tender 

towards the incumbent lessens competition. 

Short-term contracts are most likely to discourage investment where investment 

is specific and non-contractable, and the asset is long-lived. This is the classic 

‘hold-up’ problem. In the procurement context, the incumbent supplier may be 

concerned about exposure to opportunistic behaviour by the government if it 

undertakes an investment specific to that contract. The incumbent runs the risk 

of being replaced at the next re-procurement and then being unable to 

command an appropriate return on its investment from the new entrant. Without 

a commitment by the public sector to transfer assets at an appropriate rate, such 

investments may not be made. 

Williamson (1976), Schmalensee (1979) and Krugman (2002) argue that the gains 

from outsourcing may be reduced by another case of the ‘hold up’ problem, in 

which the advantaged incumbent exploits his power opportunistically to extract 

rent from the government. 

Affuso and Newbery (2002) look at the problem of contract length and specific 

investments in relation to the rolling stock operators of the privatised British 

railway. Here the choice of franchise length reflected the trade-off between 

periodic contestability for the market and the need to provide sufficient 

investment incentives. Although short-term demand and long-lived assets could 

have been expected to impact investment adversely, they do not find a simple 

relationship between contract length and investment. They find that 

discretionary investment is higher where contracts are shorter. An explanation 

for this finding could be that train operators facing sooner re-procurement 

respond with increased investment to signal their commitment to the regulator 

and thereby increase the probability of being re-awarded the franchise. 

Investment towards the end of a franchise also signals aggressive behaviour to 

potential entrants and increases their costs of entry. 



Problems of asymmetric information arise when the information available to the 

government issuing the tender differs from that of the provider of the service. Two 

examples of problems caused by asymmetric information in the use of marketbased 

mechanisms are the ability to share risk optimally between parties and the 

winner’s curse effect in public procurement. These are addressed in turn below. 

181


Risk-sharing 

When the government has less information than the supplier, it may be forced 

to trade-off risk allocation and performance incentives. Principal-agent theory 

tells us that the principal (the government) is often unable to distinguish 

between the effects of an agent’s (the service provider’s) effort and random 

events on output. Transferring the risk of an unfavourable outcome to the private 

sector requires that the private-sector firm be compensated for this burden, 

leading to higher procurement costs. However, if the government accepts the full 

burden of risk, the private sector provider may be faced with inappropriate 

incentives. 

Different forms of contract strike a different balance in this trade-off. Fixed-price 

contracts provide strong incentives for productive efficiency, as an agent is 

rewarded for any cost-reducing effort he makes (Laffont and Tirole, 1993). 

However, they suffer from weak quality incentives as the agent can increase 

profit by reducing quality, particularly where quality is difficult to measure or 

observe (Holmstrom and Milgrom (1991); Hart, Shleifer and Vishney (1997)). 203 

Cost-plus-fixed-fee contracts offer weak incentives for productive efficiency, and 

may encourage ‘gold plating’ in which the supplier produces the highest 

possible quality as it is compensated for any effort it makes. Incentive contracts 

involve a fixed-fee component as well as a pre-determined fraction of costs 

incurred. For incentive contracts to achieve their desired outcomes, there must 

be both accountability and enforceability (see Stiglitz, 2000). 

Winner’s curse 

Winner’s curse arises in common-value auctions, in which competing bidders 

have different information about the value of the tender. The winner’s curse 

effect refers to the adverse selection problem that arises because the winner 

tends to be the bidder with the most optimistic valuation of the tender. As the 

probability of over-estimating the tender value increases with the number of 

competitors, bidders are aware of this and internalise the winner’s curse 

problem by bidding more cautiously. This leads to the perverse result that 

increasing the number of competitors can actually increase procurement costs. 

The more information a bidder has, the smaller the chance of falling prey to 

winner’s curse and the more aggressively bidders will therefore bid. Choosing 

an auction design to maximise information, such as the open auction, helps 

mitigate this problem as it reduces the probability that a bidder will have overestimated 

the value of the good. 204 However, it should be noted that increasing 

the availability of information may substantially increase the costs of the 

tendering process. 

203 Holmstrom, B. and Milgrom, P. (1991) ‘Multi-Task Principal-Agent Analyses: Incentive Contracts, Asset Ownership 

and Job Design.’ Journal of Law, Economics and Organisation 7. 

204 Salmon, T. 2004’Preventing Collusion’ Chapter 3 in Auctioning Public Assets: Analysis and Alternatives. Ed. M. 

Janssen. Cambridge University Press.. 

182

Empirical evidence on winner’s curse 

Flambard et al (2004) analyse snow removal contracts tendered by the City of 

Montreal under an independent, private-value procurement auction model. 205 

They find a positive correlation between costs and bids, that rents increase with 

the variance of costs and that rents decrease with the number of bidders. Their 

findings suggest that rationalising tender requirements may permit economies 

of scale to be reaped and technological progress to be induced without too great 

a cost in terms of impact on competition. 

There is some empirical evidence suggesting that the winner’s curse exists, 

although the risk is mainly for the firms bidding, rather than for the government 

agency. However, where the winner’s curse effect is particularly strong, this can 

deter bidders and so can raise the total cost of procurement. Hong and Shum 

(2001) evaluate the effect of increased competition on equilibrium bidding in 

procurement auctions using data from the New Jersey transport department. 206 

They demonstrate that the response of procurement costs to increased 

competition depends on the relative magnitude of the competitive and winner’s 

curse effect, which in turn depend upon the relative importance of the private 

and common value elements of the bid. They observe that when the asymmetric 

information, and thus winner’s curse effect, is particularly severe, authorities 

may gain from allowing collusion amongst bidders. Discussions between 

competitors may give rise to information pooling that prevents the winner’s 

curse from arising and thus leads to lower procurement costs. 

TRANSACTIONS COSTS 


Theory and empirical evidence shows us that sometimes market-based 

mechanisms may be more costly to implement than the benefits they yield. The 

procurement process itself is often very costly, and design features to limit the 

extent of its potential pitfalls may increase these costs still further. For example, 

tendering contracts more frequently and splitting up requirements over multiple 

suppliers reduces incumbency advantages, but also implies greater tender costs. 

Specifying all aspects of service quality and monitoring and enforcing the 

resulting contract is similarly costly, as is increasing the availability of 

information to reduce the likelihood of a winner’s curse outcome. However, 

theory also provides some guidance about (a) how to minimise these costs and 

(b) when a market-based mechanism is likely to be most appropriate given the 

identified costs and benefits. 

As Domberger and Jensen (1997) note, the costs of contracting can limit the 

practical application of procurement. Williamson (1979) shows that the cost of 

transacting in the marketplace can be large enough to offset the benefits, in 

which case in-house production would be optimal. Whilst this theory was 

205 Flambard, V., Lasserre, P., Mohnen, P. 2004. Snow removal auctions in Montreal: costs, informational rents, and 

procurement management. 

206 Hong, H. and M. Shum. Increasing competition and the winner’s curse: evidence from procurement. 2001. 

183


developed in the context of the boundaries of the firm, it is clearly relevant to the 

contracting out of public services. The existence of transaction costs in 

specifying contracts puts a natural limit on the size of the firm: surely they must 

also limit the extent to which government can optimally organise activities in the 

market? In the context of public sector procurement, these costs could include 

the writing of specifications and contracts, the evaluation of tenders and the 

negotiation of the final contract with the winning bidder. 

It is not necessarily easier to design incentive schemes in the private sector than 

it is in the public sector. In Laffont and Tirole (1993), problems of incentive 

scheme design in the public sector arise from the different objectives associated 

with social welfare maximisation, many of which are unmeasurable. This 

problem can lead to lower than optimal levels of investment in their model. 

Privatisation, however, brings incentive contract problems of its own arising 

from the fact that the regulator and the shareholders have different interests 

they wish to motivate the manager to achieve. Managers of privatised firms 

must balance the interests of these two principals, which may be conflicting and 

thus lead to a less efficient outcome than if a single objective had been pursued. 

User choice 

CAPACITY CONSTRAINTS 

The number of places that can be offered restricts user choice in public services. 

For example, not all children can go to the same school, or not all patients can 

be treated in the same hospital. If choice leads to an excess of demand over 

supply at a given establishment, some kind of rationing mechanism will be 

required. This rationing may be at the discretion of the service provider or 

regulated by the state and could take a variety of forms. 207 

Organisation of rationing by the service provider can result in some negative 

consequences. For example, the service provider may use the rationing system 

as a selection system to improve their performance in comparison tables. For 

example, schools allowed to design their own rationing mechanism may 

practice cream-skimming or other forms of discrimination. Cream skimming 

involves selecting the most able students to improve measured outcomes rather 

than focusing on improving actual service quality. 

However, it is not clear how strong the impact of this problem is in practice. In the 

UK, some choice in schools was introduced in 1988. Bradley and Taylor (2002) 

find that since 1992 schools with better exam results have seen a reduction in the 

proportion of low-income students enrolling, whereas schools with poor exam 

performance have seen an increase. 208 However, they note that the estimated 

impact is very small, suggesting little segregation has actually occurred. 

207 For example the school could run a lottery for places, operate a ‘first-come-first-served’ policy, or allocate places 

according to specified student characteristics. 

208 Bradley, S. and Taylor, J. (2002) ‘The Report Card on Competition in Schools’ Adam Smith Institute. 

184


In New Zealand, 1991 reforms allowed schools to exercise their own oversubscription 

schemes and thus choose their own students. Research suggests 

that schools did use this discretion to improve measured outcomes by cream 

skimming. Fiske and Ladd (2000) find that segregation between schools 

increased as a result at a faster rate than segregation between the pre-1991 

catchments areas. 209 They also find higher levels of segregation by occupational 

status and unemployment in the post-reform period, and an increase in the 

proportion of minority groups in the most deprived schools. 

However, in the US, the evidence in fact suggests the opposite. The balance of 

evidence suggests it is the underperformers and the minorities who are most 

likely to exercise their choice, and so if anything that reverse cream skimming 

occurs. Hoxby (2003) looks at all US charter schools in 2000-2001 and finds that 

they attracted disproportionate numbers of black, Hispanic and poor students 

away from state schools under a voucher scheme which allows greater school 

choice. Similarly, Hanushek, Rivkin and Kain (2002) look at the performance of 

future charter school students whilst still in regular state schools in Texas, and 

find that they perform worse than those who continue their education at the 

state schools. 

Cream skimming and discrimination can be limited through appropriate scheme 

design. As incentives to cream skim will be strongest if suppliers are rewarded 

for good outcomes alone, good design implies rewarding suppliers on a valueadded 

basis, or at least limiting the rewards to good outcomes alone. In 

healthcare services in the UK cream skimming was avoided through the 

introduction of the stop-loss insurance scheme, which provided that health 

authorities would reimburse fund-holding GPs for patients with higher than 

threshold costs and also limited the personal financial exposure of GPs. In 

education in the UK avoiding cream skimming has been more difficult to 

achieve, particularly because the main performance indicator used by parents 

choosing between schools is performance in exam league tables. 210 An LGA 

study on choice notes that there is only a limited range of actions that can be 

taken to reverse the polarising effects of cream skimming, and all of these rely 

on the local education authority enlisting the voluntary participation of schools. 

In other countries, voucher differentials have been used to increase the financial 

attractiveness of admitting pupils from more disadvantaged areas. As 

documented above, this has sometimes been sufficient to encourage reverse 

cream skimming – it is difficult to set the differential at a level which avoids 

problems in either direction. 

Even if appropriate design prevents cream-skimming and other forms of 

discrimination, capacity constraints may still have adverse consequences. In the 

short term at least, capacity is constrained by the size of the school or other 

service provider. If successful schools are unable to expand capacity in the long 

run, this will have two effects. First, parents will face constrained choice if they 

209 Fiske and Ladd (2000) When Schools Compete: A Cautionary Tale. 

210 See Bradley, S. and J. Taylor (2002) ‘The Report Card on Competition in Schools’ Adam Smith Institute. 

185


are unable to send their children to their most-preferred schools. Second, 

competition will be limited between schools because the most successful will 

cease to be a competitive threat to others once they reach capacity. However, 

this effect is mitigated as over time the most popular service providers seek to 

expand capacity. Bradley and Taylor (2002) look at data on all secondary schools 

in England during 1992-2000 and estimate that excess demand for places of 10 

per cent is associated with a subsequent increase in physical capacity of 3 per 

cent, suggesting capacity constraints are not binding in the longer run. 211 

INEQUALITY 

Inequalities could widen if the more advantaged in society are better able to 

access the required information and thus better equipped to exercise their right 

to choose. In the case of education, students from more advantaged 

backgrounds are also more likely to be able to meet the increased transport 

costs that may be associated with choice. Segregation between groups could 

also increase both indirectly through the widening of inequality or as a direct 

result of the exercise of choice. For example, parents from similar backgrounds 

may choose to send their children to the same school. 

There is some evidence in the educational choice literature to suggest that the 

better off are better at exercising choice and also that choice has led to more 

segregation. In Sweden, Bjorklund et al (2004) find that parents who attended 

university are 4.5 per cent more likely to send their children to an independent 

school, implying increased segregation by parental education level. 212 In their 

study of the New Zealand school reforms, Lauder et al (1999) found that parents 

choosing non-local schools tended to be more affluent than those who did not 

and were more likely to be from the white majority. 213 

However, these problems are often worse without choice. In the context of 

school choice, Osborne and Gaebler note that not permitting choice amongst 

state school providers restricts the exercise of choice to those able to afford 

private schools: introducing choice for all parents necessarily increases equality 

of opportunity in this sense. 214 

The potential for problems of inequality means that limits are normally placed 

on the criteria that service providers can use. For example, if an increase in 

inequality following school choice is a concern, limits can be placed on schools 

use of certain critreria when rationing places. Places could be allocated on a firstcome-first-served 

basis or on the basis of distance for instance. 

211 Bradley and Taylor. (2002) ‘The Report Card on Competition in Schools’ Adam Smith Institute. 

212 Bjorklund, Edin, Frederiksson and Kreuger (2004) ‘The Market Comes to Education in Sweden: An Evaluation of 

Sweden’s Surprising School Reforms’ SNS Welfare Policy Group. 

213 Lauder, Hughes, Watson, Waslander, Thrupp, Strathdee, Simiyu, Dupis, McGlinn and Hamlin (1999). Trading in 

Futures: Why Markets In Education Don’t Work. Open University Press. 

214 Osborne, D. and Gaebler, T. (1992) Reinventing Government Addison-Wesley. 

186

INCENTIVES 

Where citizens can exercise choice regarding how much of a publicly-provided 

good or service they consume, care must be taken to ensure that this does not 

create an incentive to over-consume. For example, choice between providers in 

the French health care system may be associated with its ranking as number one 

in the World Health Organisation’s assessment of world health care systems, but 

also with its high expenditure per capita on health. The fact that the French 

consume three times as many antibiotics as the Germans and twice as many 

anti-cholesterol drugs as the British, for example, suggest that the French 

system may encourage over-consumption of health services. 215 

INFORMATION ISSUES 


As noted previously, consumers must be able and willing to gather and process 

sufficient information if they are to make rational choices. Information issues can 

lead to high costs of providing enough information and support, and greater 

inequality if information is more readily accessible to some groups of society 

than others. 

Information issues are of particular significance for experience and credence 

goods, which both require decisions be made with no ex ante knowledge of 

quality. In credence goods, the consumer cannot even learn from previous 

experience because he does not know whether he received an appropriate 

quality of service, even after consumption has taken place. In other words, he 

must trust the information he is given to make his decision. 

The costs of providing information and support in choice-based lettings have 

been significant, with pilots reporting advertising costs as the main component 

of scheme operating costs. However, this approach seems to have been effective 

in encouraging participation and limiting inequality. In education, consumer 

feedback suggests the majority of participants feel they are provided with the 

right information to make their decisions. For example, a study conducted for 

the DfEE found that 87 per cent of parents interviewed were satisfied they had 

the information they needed to help them choose a school. 216 

The impact of information issues when introducing user choice to credence 

goods are most clearly seen in the case of healthcare services. For example, 

patients may exercise choice in the NHS by selecting their GP and the hospital 

they attend in some cases. 217 Research shows patients are unlikely to switch GPs 

or travel beyond their local hospital, even if they are dissatisfied with the 

service. 218 Although this will at least partially reflect travel costs, it also points to 

215 Aldridge, S. (2004). Presentation at the Social Market Foundation Seminar on Choice. 

216 Quoted on p.15 of LGA (2004) Enabling Choice: Research on Choice in Public Services. 

217 These include choice of GP and choice of hospital consultant for all patients, and choice of hospital only for 

patients who have been kept waiting for longer than the target for elective surgery. 

218 See p.23 andp.27, LGA (2004) Enabling Choice: Research on Choice in Public Services. 

187


potential information issues. Research finds that patients are unsure of the value 

of performance measures and hospital rankings, leading researchers to 

conclude that patients need educating in order to interpret performance data 

properly. 219 The LGA study also notes that some data crucial to consumer choice, 

such as the atmosphere and cleanliness of the hospital or GP surgery, is unlikely 

to be collected in a way that allows for comparison. 

Marketable permits (‘Cap and Trade’) 

THE INITIAL ALLOCATION OF PROPERTY RIGHTS 

One of the main issues in a marketable-permits scheme is to determine the initial 

allocation of permits. A trading scheme can have important distributional 

consequences depending on how permits for a trading scheme are allocated. 

There are two main approaches to the distribution of emission allowances. 

These are: 

● the auctioning of permits; and 

● the allocation of permits to existing polluters, based on their historic levels of 

pollution. 

Auctions are likely to be superior to the allocation of permits without charge, in 

terms of economic efficiency. 220 However, we find that in most schemes permits 

are allocated based on historic data or targeted emissions. 221 

Auctioned permits mean that polluters have to pay for the initial right to pollute. 

This approach is likely to result in higher costs for firms than under a scheme 

where they are given an initial allocation that they can then trade amongst 

themselves. The higher cost of this approach means that the initial effect on 

reducing pollution is likely to be higher. The resulting additional costs for 

participants can in principle be ameliorated by using the resulting revenues to 

reduce taxes, which can have the added benefit of reducing more distortionary 

taxes, such as taxes on incomes. 

If permits are allocated based on existing, or targeted, levels of emissions then, 

because firms do not pay for their initial permits, the initial cost to firms is likely 

to be lower. The initial reduction of pollution may be less than under a system 

of auctioning. However, at the margin, the incentives to reduce pollution should 

still be strong, since firms still face an opportunity cost from pollution: the value 

that could be realised by selling their permits. 222 

219 See, for example, Magee, H., Davis, L-J and Coulter, A. (2003) ‘Public views on healthcare performance indicators 

and patient choice’, Journal of the Royal Society of Medicine, 96, 7, pp.338-342. 

220 See Fullerton, D. and G. Metcalf (1997) ‘Environmental controls, Scarcity rents, and Pre-existing distortions’, 

NBER Working paper 6091. Goulder, L., I. Parry and D. Burtraw (1997), ‘ Revenue raising vs. Other Approaches to 

Environmental Protection: The Critical significance of Pre-existing price distortions’ Rand Journal of Economics, 

221 See Stavins (2001) and UK ETS at http://www.Defra.gov.uk/environment/climatechange/trading/uk/ 

222 See HM Treasury (2002) 

188

LOCATION PROBLEMS 

Emissions trading typically takes place on a national or multinational basis. Each 

country or block is assigned a cap on how much pollution they can emit. This 

pollution target is based on an appropriate aggregate level. However, there may 

be localised problems of pollution if, even though the overall cap is met, all 

polluters locate in a particular geographic area. This may be a problem with 

some pollutants, such as emissions into rivers, which can cause local problems. 

This can be resolved, using regional caps. 

WILL A WELL-FUNCTIONING MARKET DEVELOP? 

Another consideration is whether the existence of a well-functioning market is 

likely to emerge, since in its absence very low trading would occur and thus the 

economic efficiencies associated with such a scheme are unlikely to be 

delivered. A well functioning market may require that various associated 

services are in place. These might include some form of organised exchange 

where permits can be traded. An organised exchange would normally involve 

brokers acting as agents for participants, providing them with access to the 

exchange, and the dissemination of information on prices so that participants 

can take informed decisions on whether to hold or sell their permits. Price 

transparency is important in signalling the cost of pollution to participants who 

can then use this information to take decisions on whether to reduce emissions 

or buy permits. 

To function well, the market in permits needs to be liquid, which means that it 

must be possible for participants to buy and sell permits relatively quickly 

without creating a significant impact on the market price. The market is likely to 

be more liquid the larger the number of potential participants trading permits. 

This can be achieved by allowing permits in different pollutants to be converted 

into the same ‘currency’ and traded on the same market. For example, the UK 

emissions trading scheme allows participants to convert permits between 

different types of greenhouse gas emissions at pre-specified values that 

represent their relative impact on climate change. 

MARKET POWER IN EMISSIONS TRADING 


There are two types of market power that are usually identified in relation to 

emissions trading: 223 

● ‘exclusionary manipulation’, in which a firm holding a significant share of 

total tradable permits decides to hoard them in order to exclude other firms 

from its product market, which results in a distortion in competition for that 

product market; 224 or 

223 See Burniaux, J.-M(1999) ‘How important is market power in achieving Kyoto? An assessment based on the 

GREEN model’ OECD paper. Economics Directorate, OECD, Paris. 

224 See also Baron R (2000) ‘Market Power and Market Access in International GHG Emissions Trading’ Environment 

Directorate and International Energy Agency, OECD, Paris. 

189


● ‘cost-minimising’ (profit maximising) manipulations, which implies the ability 

to influence the transaction price of traded permits. A monopolistic seller sets 

the price at the level which maximises the difference between revenues from 

permits sales and its abatement costs. Similarly a monopolistic buyer 

manipulates the price in order to minimise the sum of expenditures from 

permits purchases and its abatement costs. 

In most cases, exclusionary manipulation is not a feasible strategy. In most 

markets for emissions trading, participants come from a very wide range of 

economic activities. This means that a new entrant into a given sector can obtain 

tradable permits from firms outside its own sector, which have no incentives to 

withhold the permits from the new entrant. 225 In practice therefore, an 

exclusionary manipulation strategy will be difficult to pursue. 226 

However, the cost-minimising manipulation strategy could arise if either 

dominant buyers or dominant sellers could exercise their market power and thus 

alter prices. For instance, a dominant seller may set a high price and sell fewer 

permits than under competitive conditions. 227 In such a case emissions trading 

will not deliver the economic efficiencies expected, since the permit price would 

reflect market power and not the cost of pollution abatement. Firms would 

therefore be induced to undertake emission reduction strategies that are not cost 

effective. Hahn (1984) and Weskog (1996) predict that a dominant seller, or a 

coalition of them, would withhold supply from the market, resulting in smaller 

aggregate cost savings than if the market had been competitive. 228 

However, Carlén (2003) in an experimental analysis focusing on the end of the 

emissions trading period, shows that in a dual auction market, where a 

dominant trader faces an opposite side of the market that is fairly competitive, 

the presence of a dominant trader does not affect market efficiency. 229 

A possible way to prevent the exercise of market power is to extend the size of 

the trading market. The greater the trading market, the lower the problems of 

concentration. This can be achieved by extending trading on an international 

basis, perhaps with aggregate caps at an industry level. 230 Burniaux (1999) and 

Bader (1996), following Hahn (1984), find that international-level trading would 

greatly minimise the risk of market power. 231 

225 See Baron (2000) 

226 Westkog (1996) shows that an exclusionary manipulation may be unlikely even in the case that governments and 

not firms where the main traders, since conflicting interests by different firms within a country would make 

difficult for countries to arrive to an effective exclusionary manipulation. Westkog H. (1996) ‘ Market Power in a 

System of Tradable CO Quotas’. The Energy Journal, Vol. 17, No 3. 

2 

227 In the same way a monopsonistic firm may set the permit price lower compared with the competitive scenario 

and abate too much (buy too few permits) relative to the competitive case. 

228 Hahn R.W.(1984), ‘ Market Power and Transferable Property Rights’, Quarterly Journal of Economics 99, pp 753-65. 

229 Carlén B, ‘ Market Power in International Carbon Emissions Trading: A Laboratory Test. Global Change, MIT 

Report No. 96, January 2003. 

230 ABARE (1995) Global Climate Change: Economic Dimension of a Cooperative International Policy Response 

beyond 2000, ABARE, Canberra. 

231 Bader P. (1996): Emissions trading; country-model vs. industry-model’. Chair of Economics, University of 

Augsburg, Germany. 

190


MARKET FAILURES 

Buchanan (1969) shows that introducing a Pigouvian tax on a monopolist could 

reduce social welfare rather than improve it, even if it led to a reduction in 

pollution. 232 In the absence of an externality, monopolists restrict output to below 

socially optimal levels already. Taxing emissions would lead to further 

restrictions in output, and so could lead to welfare losses. However, this problem 

may be overstated as others have found that the welfare effects of output 

restrictions are likely to be less than the gains from reducing emissions even in 

the absence of perfect competition. 233 

Lee (1975) and Barnett (1980) suggest a unit tax on emissions at a lower level 

than the unit tax for a perfectly competitive polluter to account for the output 

effect of the tax. The more price elastic the demand, the closer this second best 

tax will be to the perfectly competitive tax. This results occurs because, where 

demand is more elastic, distortions are reduced and the resulting output loss will 

be lower. 

MEASURING EMISSIONS 


If emissions cannot be measured directly, the alternative may involve taxing an 

input or output closely related to pollutant emissions. 234 As a second best 

solution, this approach suffers a number of drawbacks. Because input taxes do 

not target emissions directly they may not provide the right incentives to reduce 

pollution using the most cost-effective method. For example, if firms do not have 

access to suitable less-polluting substitute inputs, the tax will only lead to higher 

producer costs with no discernible environmental impact. Even if a suitable 

input is available, an input tax suffers the drawback that it does not encourage 

investment in pollution abatement technology and so will not act as a stimulus 

to pollution-reducing innovation. 235 Furthermore, it may be difficult to distinguish 

between those usages of an input that contribute to pollution and those that do 

not. As an input tax would apply equally to all uses, this would result in suboptimal 

production of the non-polluting good. Input and output taxes may also 

lead to the standard problems of second-best taxation policy, in which an 

attempt to use a tax to correct an externality pushes the market even further 

away from its optimum because of additional distortions in the market being 

232 Buchanan, J. (1969). ‘External Diseconomies, Corrective Taxes, and Market Structure,’ American Economic 

Review 59(1). 

233 Oates, W. and N. Strassman, (1984), ‘Effluent Fees and Market Structure’, Journal of Public Economics 24(1). 

Asch, P. J. Seneca, (1976), Monopoly and External Cost: An Application of Second Best Theory to the Automobile 

Industry,’ Journal of Environmental Economic Management 3(2). 

234 For papers on the use of input taxes for non-point pollution control see Griffin, R and D. Bromley (1982) 

‘Agricultural Runoff as a Non-point Externality: A Theoretical Development’, American Journal of Agricultural 

Economics and Shortle,J. and J. Dunn (1986) ‘The Relative Efficiency of Agricultural Source Water Pollution 

Control Policies’, American Journal of Agricultural Economics 68. 

235 See Blackman, A. 1999. ‘Informal Sector Pollution Control: What Policy Options Do We Have?’ Discussion Paper 

00-02-REV, Resources for the Future 

191


taxed. Market failures could arise in these markets if the input were already 

subject to some form of price distortion or if the output market were supplied by 

a monopolist, for example. These problems can be minimised through 

appropriate tax design, in particular, by taxing the input or output most strongly 

correlated with pollutant levels and by taking account of other market 

imperfections when setting the tax rate. 

DETERMINING THE APPROPRIATE LEVEL OF TAX 

The appropriate level of unit tax is the level which will lead to the optimal level 

of pollution. This requires knowledge of incremental costs and benefits of 

pollution damages over a substantial range, a feat that is likely to be difficult to 

achieve in practice. Estimating benefits of pollution reduction is particularly 

problematic. As Baumol and Bradford (1972) demonstrate, the nature of 

negative externalities mean that there is unlikely to be a single appropriate level 

of tax that would result in an equilibrium output level. In that case, it may be 

better to control the quantity of the negative externality, through permits, and 

letting the market determine the appropriate level of the tax. 

Political interference/inappropriate use of tax 

Although the purpose of the tax may be to control pollution, governments may 

be tempted to use the tax as a revenue-raising device. This may lead to the tax 

being set at a higher level than is optimal. Such inappropriate use could also 

undermine support for the real objective of correcting for the negative 

externality. 

Growth and inflation 

A nominal tax designed to induce optimal emissions at one point in time will fail 

to do so in the future in the presence of growth and rising prices. This requires 

continual upward revision of the tax by the government, which is likely to be 

both costly and politically unpopular. Tradable permits on the other hand 

automatically accommodate these features of a dynamic economy. 236 

Location 

The effect of emissions on the environment and thus the optimal level of 

emissions is likely to vary across different locations, suggesting a differential 

unit tax that is unlikely to receive political support. However, imposing a uniform 

tax may lead to sub-optimal outcomes. 237 

236 Cropper, M. and W. Oates. (1992) ‘Environmental Economics: A Survey’, Journal of Economic Literature 30(2). 

237 Cropper, M. and W. Oates. (1992) ‘Environmental Economics: A Survey’, Journal of Economic Literature 30(2).. 

192

SUBSIDIES 

In some cases, instead of taxing pollution, governments have introduced 

subsidies for pollution abatement. This can include subsidies for using lowemissions 

technology. However, the long-term effects of such subsidies have 

been poor. In some cases, the subsidy may induce so much entry that in the long 

run there is an increase the total amount of pollutant emitted. 238 For this reason, 

taxes on the emission of pollution are often preferable to subsidies for lowpollution 

technology. 

Opening access to natural monopolies 

UNDUE GOVERNMENT INTERVENTION 

As we noted in Part III, regulated access is only likely to be appropriate in a very 

limited number of cases. In practice, the majority of cases of regulated access 

have been in previously nationalised monopolies. There are good reasons for 

this. The provision of access at a regulated price necessarily involves an 

appropriation by government of some of the assets of a private firm. If the firm 

has acquired these assets through legitimate investment in the market, then the 

use of regulated access can deter investment. Any short-term benefit in terms of 

price, will likely be more than out-weighed by the long-term effects on firms’ 

incentives for investment. 


If regulated access is, however, deemed appropriate, then it should be granted 

at an appropriate level. This will normally be at a level that bears some relation 

to cost. In setting this level, the regulator is at a disadvantage compared with the 

regulated firm. The regulated firm will have more information about its own 

costs than an external regulator possess. Moreover, it faces an obvious incentive 

to have the access charge as high as possible. The result can be an incentive for 

the regulated firm to inflate its costs, with the consequence of an inefficiently 

high access charge. Moreover, even if a correct access charge were set, the 

process for acquiring and analysing the necessary information can be costly. 

COST OF REGULATION 


In the case of natural monopoly, the efficiency losses from allowing one private 

firm to supply the market and extract monopoly rent may be less than the cost 

of regulation. This is suggested by Harberger’s empirical estimates of the cost of 

monopoly in the US, which suggests the deadweight loss from monopoly is of 

a relatively small magnitude. 

238 Baumol, W. and W. Oates, (1988), The Theory of Environmental Policy, Second Edition, Cambridge, England: 

Cambridge University Press. 

Kohn, R. (1985) ‘A General Equilibrium Analysis of the Optimal Number of Firms in a Polluting Industry,’ 

Canadian Journal of Economics 18(2). 

193


Littlechild (2003) notes that there are costs and benefits to both regulation and 

competition in network industries. For example, Littlechild makes reference to 

the transactions costs of competition, including the costs to customers of 

understanding the differing and more rapidly changing prices and of choosing 

between the ever-changing options available, and the difficulties and time taken 

to contact the relevant companies and deal with problems when they arise. This 

must be balanced against the benefits that deregulation and restructuring can 

bring in terms of increasing cost transparency, i.e. improving information in the 

industry. 

Newbery (2001) queries whether the costs of competition in the case of 

electricity generation were worthwhile. Whilst the benefits are real, so too are 

the costs of spare capacity, of the creation of new market trading arrangements 

and the risks to service quality posed by unbundling. 

194

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