A Fair Field: Competitive Neutrality in UK Public Services

A fair field and no favours Competitive neutrality in UK public service markets

Policy Study 1

BY GARY L STURGESS

©Copyright The Serco Institute & CBI 2006 The content may not be copied, distributed, reported or dealt with in whole or in part without prior consent of the Serco Institute and the CBI. January 2006

Front cover image: Detail of ‘Good Government’ by Ambrogio Lorenzetti, Palazzo Publico, Siena. Among other things, the fresco celebrates the contribution that good government

Contents

makes to the development of markets.

Foreword

About the author

Gary Sturgess is executive director of the Serco Institute. As cabinet secretary in the New South Wales state government (in Sydney, Australia) in the early 1990s, he played a leading role in the development of Australia’s national competition policy and thus in the design of an early competitive neutrality framework.

Executive summary

2

1. Competitive neutrality matters

5

2. Ensuring fair procurement

10

3. Regulating anti-competitive conduct

16

4. Neutrality between ownership structures

18

5. Neutrality in structure and governance

24

6. International developments in law and policy

28

7. A comprehensive approach to competitive neutrality

30

Endnotes

35

A fair field and no favours 1

Foreword Serco has been delivering public services to governments for more than 40 years. Today we have more than 600 contracts in 37 countries around the world. We take a long-term view of market development, and therefore have an interest in the development of markets that are economically and politically sustainable. It is for this reason that the company has been active in supporting the Public Services Strategy Board within the Confederation of British Industry (CBI). In association with a number of other leading UK providers, we have been working with government and unions to ensure that public service markets are developed in a way that addresses qualitative issues as well as value for money. As the UK government moves to establish a ‘mixed economy’, where public, private and voluntary providers compete to deliver public services, it is vital that there is a level playing field between the various sectors. Failure to address this issue will lead to weaker competition and less investment in innovative services and technologies. This study was undertaken by the Serco Institute on behalf of the CBI and published by the CBI as a submission to government. It draws heavily on the experiences of CBI members and other industry associations, but it also refers to the observations made by voluntary and public sector providers about the lack of a level playing field. If all three

sectors are raising competitive neutrality as an issue, then prima facie, this is an issue that government needs to address. It is an issue, not because of government failure, but for precisely the opposite reasons – because of the major reforms that have taken place in the UK in developing a ‘mixed economy’ for public services. The report concludes that this is a complex area of policy, and that government needs to conduct a wide-ranging review. However, that should not detract from the importance of developing ‘a fair field and no favours’ if public service markets are to be sustained.

Kevin Beeston Chairman Serco Group plc

2 A fair field and no favours

Executive summary Competitive neutrality is a simple concept: it involves a commitment to fair markets and maintains that there should be a level playing field between public, private and voluntary providers of goods and services. It is not concerned with opening up new markets, but with ensuring there is a level playing field in existing ones. Competitive neutrality is most often concerned with the advantages enjoyed by public undertakings, but the principle is just as applicable to the disadvantages suffered by government enterprises. And with the increasing involvement of social enterprises in the provision of public services, it is also concerned with the disadvantages suffered (and the unfair advantages enjoyed) by them. Why does it matter? Because where public, private or voluntary sector providers compete with an unfair advantage, public spending will be redirected away from the most efficient producers, resulting in a decline in social savings. The beneficiaries of unfair competitions will win a disproportionate number of tenders, undermining the credibility of the process and leading to less competitive markets. And if private and voluntary providers are not convinced of the fairness and sustainability of public service markets, then they will be averse to innovating with new technologies and new service models. UK governments have long been concerned with fair competition, but competitive neutrality has become a greater challenge in recent years as public enterprises have been given more freedom to compete in the marketplace, as state undertakings have been partially privatised, as public monopolies across Europe have been liberalised and as private and voluntary providers have been encouraged to compete for the provision of public services. Competitive neutrality is not concerned with whether or not public services are liberalised, privatised, commercialised or market-tested. But when government does undertake these reforms, competitive neutrality policy insists competition should be conducted in a way that is fair to all concerned. While the basic concept is relatively simple and largely unassailable, in practice it turns out to be a complex area of policy. Policy instruments that seemed to address the issue in its entirety – competition law and procurement processes – address only part of the problem. This report is based on a review of existing European and UK law and policy, developments in several overseas jurisdictions, academic

analysis, conversations with legal advisers specialising in competition and procurement law and interviews with industry associations and senior executives from a number of UK companies delivering services in a wide range of sectors, from defence to social services. Developing a comprehensive framework The concept of increasing diversity in public service provision, and the increase in competition associated with a truly mixed economy are welcome. But in the absence of a clear policy on competitive neutrality, there is a risk these markets may never fully mature. Based on the evidence that has emerged from this brief study of the market, the government might consider conducting an inquiry into competitive neutrality, starting with fundamental principles and looking at the suitability of the policy instruments currently being used. The intention might be to publish a comprehensive and coherent policy framework, addressing local and devolved services as well as central government. The government’s Competition Forum could play a major role in commissioning such a project. RECOMMENDATION 1 The government might consider developing a comprehensive policy framework on competitive neutrality. This should include a clear commitment to the underlying principle of a level playing field between public, private and voluntary sectors.

Procurement law European procurement policy is directly concerned with ensuring that public undertakings engaged in bidding for services do not benefit from distortions in the design and conduct of competitive tenders. However, broad exhortations to fairness are not enough to ensure competitive neutrality in practice. The government needs to spell out what competitive neutrality means in relation to procurement. The basic elements of a competitively neutral procurement policy would include the following: • Sequential competition: The structure of the competitive process should not give any class of bidders an unfair advantage • Access to bid resources: The government must ensure in-house teams are not given a competitive advantage or disadvantage by being over or under-resourced

A fair field and no favours 3

• Access to privileged information: External bidders should be provided with the same access as the incumbent’s bid team • Separation of purchaser and provider: Purchasing and provision functions should be separated to avoid a conflict of interest on the part of the procuring agency • Minimum savings threshold: In some overseas jurisdictions, governments have mandated that private sector bids must be lower than the public sector cost by some specified amount (usually 5% or 10%). Statutory thresholds are transparent but they are a deliberate breach of competitive neutrality conditions • Approach to cost comparisons: Different costing approaches, for example in the treatment of indirect costs, may favour the public or private sectors differently • Transition costs: One-off costs associated with the transition from traditional to contract management should be allocated to the reform process overall and not to any particular bid • Monitoring costs: Likewise, contract administration and monitoring costs are attributable to the performance management model and should not be charged to private bidders alone • Contractual arrangements: Where an in-house team wins a competition, it should be subject to contract-like arrangements which specify the conditions under which the service is to be managed and monitored • Provisions for monitoring and reporting: In-house providers should be subject to formal contractual performance regimes in the same way as external contractors, and there should be a similar level of rigour and independence in monitoring and reporting • Penalties for failure: In-house contractors should carry the penalties for poor performance, and implicit government underwriting of the associated costs needs to be built into bid evaluation.

RECOMMENDATION 2 The government might consider spelling out the detailed elements of a competitively neutral procurement policy, ensuring processes are fair, costing issues are addressed in an even-handed way and contract administration is non-discriminatory.

Competition law UK policy directives typically refer procuring authorities to European and domestic competition law, with the warning they can be taken to court for failures to comply. But the authority of competition regulators is limited. This is largely because of the limitations of competition law in regulating public bodies engaged in procurement and partly because of the reluctance of parties to complain. RECOMMENDATION 3 As part of a wider review of competitive neutrality policy, the Office of Fair Trading (OFT) might explore ways in which the scrutiny of public service markets using competition law can be enhanced.

Taxation and regulation There are major inconsistencies in the way in which government regulation and corporation tax, business rates and VAT apply to public, private and voluntary providers. The competition effects of the current tax laws (and VAT in particular) need to be addressed as a matter of priority: • Tax neutrality: Taxation arrangements should be neutral across different classes of provider. In some situations, this may require the creation of an artificial ‘taxation equivalence regime’, whereby a charge equal to the tax liability is imposed • Regulatory neutrality: Public enterprises should be subject to the same regulatory environment as their private and voluntary sector competitors, including laws on environmental regulation, health & safety regulation and anti-competition practices. RECOMMENDATION 4

A procurement that is procedurally fair may still advantage or disadvantage firms from a particular sector and positive intervention may be required to ensure a level playing field. The evidence suggests many UK firms are reluctant to lodge formal complaints, and reliance on retrospective enforcement will not be enough.

The government might address the taxation and regulation of different providers. Because of its complexity, a separate review of VAT and its application to the public-private interface may need to be considered.

4 A fair field and no favours

Structure and governance There are already extensive provisions in UK law and policy dealing with the competitive advantages potentially enjoyed by public bodies by virtue of government ownership or control. But they are by no means coherent, complete or easily accessed, and are better suited to addressing competition in the wider marketplace than they are in dealing with the contest between providers bidding for public service contracts. Moreover, the provisions relating to local government trading bodies are not as complete as those applicable to central government.

• Dealing with tied clientele: Where public enterprises enjoy a monopoly in their traditional markets, and compete with the private sector for opportunities elsewhere in the public sector, care must be taken to ensure they do not use the assured income from their tied clientele to underwrite business risks in new markets.

RECOMMENDATION 5

RECOMMENDATION 6

The government may wish to review the rules governing the establishment and management of public sector trading activities – both in central and local government.

There is also a growing number of trusts, social enterprises and public-private hybrids that may benefit from a close relationship with government, from tax concessions or implicit guarantees where existing policy prescriptions do not reach.

A government inquiry into competitive neutrality might investigate its application to quasi-public bodies enjoying the benefit of government patronage, tax concessions, implicit guarantees or other unfair competitive advantages.

Such rules might include the following: • Full cost pricing: Public bodies should charge the full cost for any services sold into a competitive market • Debt neutrality: Where public undertakings are able to borrow at a preferential rate because of an implicit government guarantee, then some form of correction must be made to ensure a level playing field. Some overseas governments also adopt a ‘capital structure policy’ to ensure balance sheets have an appropriate mix of debt and equity • Rate of return requirements: Public enterprises in competition with the private sector should be required to earn commercial returns that are at least sufficient to justify the long-term retention of assets in the business • Dividend equivalence: Once appropriate capital structures and rates of return have been set, public undertakings should be expected to return to government dividends that broadly reflect private sector practice • Transparency of social policy: Social programmes should be funded in a transparent way, and any such funding should not compromise the underlying commerciality of government businesses • Equal access to government data: Information that may not be available to third parties in the same form and at the same time as it is made available to government should not be used by a public undertaking operating in a commercial market

Enforcement and policy reform Relying on enforcement of general rules after the event will not be enough. UK companies are reluctant to launch legal challenges or lodge formal protests, with cost an additional problem for small and medium enterprises. An informal complaints procedure would offer an opportunity for ongoing review of policy implementation in this area. RECOMMENDATION 7 & 8 While the legal avenues available under competition and procurement law should not be replaced, the government could introduce a less formal administrative complaints procedure. Investigations could allow scope for policy recommendations, to which government should be obliged to respond. In some large-scale and well-developed public service markets, consideration might be given to appointing an economic regulator with specific responsibility for that sector.

Summary The UK government’s commitment to introduce a mixed economy is welcome. If this policy is implemented effectively, we have no doubt that it will contribute to better outcomes for consumers. But unless the government ensures a fair field and no favours – and reassures private and voluntary providers that it understands their concerns – then attempts to introduce greater diversity and contestability into public service provision could fall short of its ideals.

A fair field and no favours 5

1. Competitive neutrality matters What is competitive neutrality? The principle of competitive neutrality is a simple one: it is the concept that competition should be fair between different classes of market participants so that there is a level playing field between public, private and voluntary providers of goods and services. In the industrialised economies, this has acquired increasing significance in recent decades as government enterprises have been given greater freedom to compete in the marketplace, as public undertakings have been partially privatised, and as private and voluntary providers have been encouraged to compete for the provision of public services that were traditionally a public monopoly.* For historical reasons, competitive neutrality is most often concerned with the structural and statutory advantages enjoyed by public sector undertakings, but the principle is just as applicable to private and voluntary enterprises. In dealing with this issue recently, the OECD identified a number of different sources of competitive advantage for public sector businesses: • Advantages and disadvantages that arise from their governance and regulatory arrangements. The OECD includes regulation, taxation and the cost of capital in this category • Legal or practical exemption from competition law • Subsidies from government to fund public service obligations, if used to cross-subsidise commercial activities • Advantages from lax public procurement rules, where public sector providers are allowed to set prices below full cost • Power to collect data for public purposes, where the public sector entity can use that data on terms more favourable than those available to the private sector.1 It must be stressed that competitive neutrality policy has nothing to say about the decision to privatise, commercialise, liberalise or market-test public services.† It has nothing to say on the question of whether or not public services ought

to be provided through a public monopoly. But once the decision has been made to create a mixed economy, where public, private and voluntary sectors are in competition, competitive neutrality policy insists a level playing field should be maintained. Why does this matter? Because where government enterprises compete in the marketplace with an unfair advantage, they will take business and jobs from more efficient organisations. Unfair competitive advantages redirect spending away from the most efficient producers, contributing to a decline in social savings. Where government is seeking to liberalise markets that were traditionally the subject of public (or private) monopoly, an unfair market will weaken competition and deny benefits to consumers. And where public, private and voluntary organisations compete for government contracts, the beneficiaries of any unfair advantages will win a disproportionate number of competitions. This will undermine the credibility of the procurement process and lead to thinner markets. Where public services have been totally privatised, issues of competitive neutrality may still arise where there is core infrastructure with a natural monopoly or where former monopolies retain a dominant position in the market. These issues can usually be addressed through competition law or sector-specific regulation and are not dealt with in this report. But where public, private and voluntary sectors compete – particularly in bidding for the delivery of public services – then a purely regulatory approach is not so effective. In order to ensure there is a level playing field, government may need to undertake fundamental restructuring of the market framework, the regulatory system and/or the public sector provider itself. Government may find it necessary, for example, to make changes to taxation law or the rules on public access to data held by public authorities. In the case of public bodies with competitive disadvantages, government may need to make fundamental changes to governance structures and financial policies. Public sector agencies are often faced with onerous accountability and reporting requirements. They are sometimes required to deliver excessive dividend payments in order to meet the financial

* ‘Public undertakings’, ‘government enterprises’, ‘public sector businesses’ and similar terms are used interchangeably in this report to refer to public sector bodies that engage in commercial activities. †

In this report, ‘privatisation’ refers to the transfer of equity in public enterprises to private firms or individuals; ‘commercialisation’ to expansion of the freedom of public undertakings to compete in the marketplace; ‘liberalisation’ to the deregulation of public sector monopolies, allowing private organisations to compete; and ‘market testing’ to the exposure of public services previously provided exclusively by government to competition and contracting.

6 A fair field and no favours

demands of central government. And they are sometimes required to deliver social policies that are not directly related to their commercial objectives, without explicit compensation from government. These disadvantages cannot be addressed through competition law or procurement policy alone. Competitive neutrality can be delivered in a number of ways: through provisions of competition law proscribing anticompetitive practices, through taxation law and charities law, through guidelines regulating the establishment of public enterprises and the manner in which their trading powers will be exercised, and through the structure of procurement practices. Guaranteeing a level playing field between public, private and voluntary sectors is a complex matter, and unless care is taken with the design of the framework, significant distortions can remain. How has the UK addressed competitive neutrality? Although it has not established a comprehensive policy framework, the UK does have a strong commitment to competitive neutrality. In part this arises out of European competition and procurement law, but provisions have also been introduced into domestic law and practice. The law relating to VAT has been structured to pursue a level playing field between the business undertakings of central and local governments and their private sector competitors. And when new public undertakings are being established, or when trading powers are being extended, Treasury guidelines cover many of the elements of competitive neutrality. But this report reveals that a fragmented approach to competitive neutrality has resulted in significant anomalies, so that public, private and voluntary providers continue to experience major advantages and disadvantages. There are many different reasons why these anomalies occur. In part it is because competition law was not constructed to deal with the unique issues that emerge when public sector monopolies are being liberalised. In part these anomalies arise from the difficulty which private providers have in obtaining firm evidence about the internal conduct of public procurements. In part it is because private companies are reluctant to launch legal actions or formal protests against a government customer. The present structure of VAT is unable to cope with the ambiguity of the boundary line between public and private sectors. The uncertain position of voluntary providers engaged in large-scale commercial activities (particularly those enjoying charitable status) is another anomaly. These

ambiguities often arise in emerging public service markets, where procurement from external providers has begun but there is not yet widespread understanding of the underlying principles of competition policy. A significant number of anomalies have been identified throughout this report, but the following examples illustrate the scale and scope of the current competitive neutrality problem in the United Kingdom: Limits of competition law Over a period of several decades, the independent sector has become increasingly involved in the provision of residential and nursing home care in Britain and Northern Ireland. Government social service agencies have purchased accommodation from independent providers at the same time as they have provided accommodation through (publicly-owned) statutory homes. In 2000, a private social care provider named BetterCare complained to the Office of Fair Trading (OFT) that the North & West Belfast Health & Social Services Trust was abusing its dominant market position in paying significantly higher prices to its own homes than it was paying to independent providers. BetterCare complained that the Trust was refusing to take account of cost-of-living increases and that (among other things) it was able to offer higher salaries and attract better-trained staff. Similar complaints were made about Bedfordshire County Council. After three years of legal debate, the OFT ruled that it lacked jurisdiction to regulate the Northern Ireland Department of Health, Social Services and Public Safety, which set the rates for independent providers, since it did not fall within the scope of the Competition Act (as the Trust had no responsibility for setting the rates, it could not have committed an abuse).2 Since that time, the Consumers’ Association has raised the abuse of market dominance by public authorities with the OFT, but the OFT regards the BetterCare decision, together with other relevant case law, as grounds for concluding that the Competition Act is unlikely to apply to a public sector body engaged in purchasing goods or services but not providing goods or services itself in the market.3 Liberalisation of traditional monopolies The European postal market is progressively being liberalised, enabling private mail companies such as TNT and Deutsche Post to enter the UK market. The Royal Mail enjoys market

A fair field and no favours 7

dominance arising from incumbency, which is being addressed by postal regulator Postcomm through a range of measures such as providing new entrants with access to different parts of the value chain, price control and greater transparency of the Royal Mail’s costs. But the Royal Mail also benefits from a number of other special privileges, such as exemption from VAT and some traffic regulations. And it suffers from a competitive disadvantage in not being able to recover input VAT charged by suppliers. Postcomm has recommended several possible solutions, including a uniform VAT rate of 5% to be applied to all postal services, but agreement has not yet been reached on a way forward.4 Part-privatisation of public enterprises Following partial privatisation of parts of the defence research laboratories several years ago, QinetiQ has continued to be 56% owned by the government. It is intended that the government will sell down its remaining interest in time. In the meantime, QinetiQ has participated in a number of competitions for public services. While there is no evidence that QinetiQ has enjoyed an unfair advantage, some of its competitors have expressed concern that the company might enjoy a favoured position. QinetiQ, on the other hand, believes the government’s desire to be perceived as impartial places the company at a competitive disadvantage. This is not to say there is not a level playing field when QinetiQ competes, but the fact that both sides are concerned about the fairness of the procurement process demonstrates the need for a clear and well-communicated statement of policy on competitive neutrality. Commercialisation of government businesses The director of the Foundation Trust Network recently protested that foundation hospitals are unable to bid for the operation of diagnostic treatment centres, arguing the case for a level playing field with the private sector.5 Since 1993, the Prison Service has been precluded from bidding for PFI prisons. And until the recent introduction of regulations under the Local Government Act 2003, local authorities in the UK were limited in their power to sell services to the market in competition with private providers. The intention is that high-performing local authorities will now be able to compete on a level playing field without the benefit of crosssubsidies or other competitive advantages. But the controls necessary to reassure competitors of a level playing field are weak. In spite of the complexity of the issues involved, there is no evidence that serious work has

been done to ensure the Prison Service will compete on a level playing field in the market testing of prisons. Nor has this issue been properly addressed in the design of foundation hospitals. The new local authority trading companies will fall within the new local government capital control system, but it is unclear whether they will benefit from guarantees (explicit or implicit) from their local councils. They also enjoy considerable freedom in the prices they can charge for their services. Even before the introduction of the new law, one of the county councils was extremely active in the use of its existing trading powers, establishing contract and property services divisions to bid for work with other local authorities. Suppliers have expressed concerns that the council has established a monopoly in some of its own services (such as highways maintenance), using this as a base from which to cross-subsidise bids with other local authorities. The lack of clear rules on competitive neutrality and the associated lack of transparency have made it difficult for potential competitors to feel reassured about the fairness of competition. Role of voluntary providers in public service markets The Association of Chief Executives of Voluntary Organisations (ACEVO) has protested that third sector organisations face a significant competitive disadvantage compared to both public and private sector providers in relation to VAT. The Social Enterprise Coalition also refers to the need for ‘a level playing field for social enterprises using different legal forms, both in terms of cost and effective regulation.’6 Public sector organisations are VAT-exempt: in most circumstances, private sector providers can recover the VAT they incur on inputs. This precludes voluntary organisations from competing to deliver public services on a level playing field. New concerns have been raised about the reclassification of childcare services for VAT purposes and the introduction of a new source of competitive disadvantage for the third sector. Ian Theodoreson, director of finance and corporate services at Barnado’s, has been quoted as saying: “This simply underlines the argument put by the sector for many years that there is no level playing field when it comes to VAT.”7 Simultaneously, private sector firms have complained about the competitive advantages enjoyed by some major charities in the provision of health and other social services. The concern has been raised that if there is not a clear separation

8 A fair field and no favours

between the trading arms of third sector providers and their parent organisations, then the potential exists for not-forprofit providers to have a significant competitive advantage in some situations, particularly in relation to corporation tax, rates and (in some situations) VAT. Why does competitive neutrality matter now? The examples above illuminate some of the cracks in the landscape. It is possible that in the past these cracks in the competitive neutrality framework did not particularly matter. But a number of policy changes have taken place, causing them to widen and deepen, and a fundamental reappraisal of this aspect of competition policy is required. • One of these policy changes has been the decision to partially privatise some state-owned enterprises. Where the government retains an interest in a commercial enterprise, even a minority interest, concerns will understandably arise that it might seek to protect its financial interest. This is of additional concern when the agency charged with managing the government’s investment in these enterprises (the Shareholder Executive in the Department of Trade and Industry has been given a target to increase shareholder value significantly). National Air Traffic Services and QinetiQ are prominent examples of partially privatised enterprises, although there are smaller joint ventures across government which raise similar issues. • The decision by the government to commercialise public undertakings, giving them greater freedom to compete in the marketplace is another such policy change. This has been evident in the ‘Selling into wider markets’ initiative, in the liberalisation of local authority trading powers and through the establishment of foundation hospitals in the NHS (which enjoy great commercial freedom, but not yet the freedom to trade). • Another manifestation of this trend is the emergence of public-private hybrids whose classification remains unclear. Leisure trusts and trust schools are examples of this phenomenon. So too are limited liability partnerships between public undertakings and private corporations, and former public undertakings that have been converted to charities and industrial and provident societies. A limited liability not-for-profit company established in late 2005 by NHS nurses and therapists to bid for NHS contracts appears to be another.8 • In some cases, the increased interface between public and private trading enterprises arises because of the

liberalisation of service sectors which were traditionally a state monopoly: telecommunications has been a significant area of market liberalisation in recent decades, and postal services provide a current example. There are several trends in international and European law and policy relating to the trade in services which could increase the significance of this interface further. • The creation of public service markets – where private and voluntary sector firms are asked to compete for the provision of services previously delivered exclusively by government – is another example. This is the area where competitive neutrality perhaps has greatest application in the UK economy at present because of the sophisticated public service markets that have developed here over the past twenty years. The government is committed to expanding the diversity of these markets, in part by encouraging the participation of more private providers, but also by facilitating the entry of voluntary providers and liberalising the rules governing trading by public undertakings. Plans to increase diversity in public service provision, and the increase in competition associated with a truly mixed economy are to be welcomed. But in the absence of a clear policy on competitive neutrality, there is a risk that these markets may never mature. If private companies and voluntary providers are not convinced of the fairness and the sustainability of these markets, they will under-invest in those capabilities that will enable them to make a positive contribution to public service improvement over the long term. In particular, they will under-invest in research and development and be averse to innovating with new technologies and new service models. Given the UK government’s current interest in using public sector procurement to encourage greater innovation in UK industry, this would be an unfortunate outcome. The childcare services case study demonstrates some of the difficulties that have emerged during a recent development in government policy. Case Study: Childcare services The UK government has announced a 10-year strategy for childcare, issued a draft statutory code on the entitlement to free nursery education and published a Childcare Bill. Among other things, these initiatives will place a new duty on local authorities to secure sufficient childcare provision to meet the needs of their areas.

A fair field and no favours 9

The new policy framework reflects concerns about competitive neutrality. One of the key principles of the ‘Draft Code of Practice on the Provision of Free Nursery Education Places for 3 and 4 Year Olds’, released in June 2005, is that ‘Local Authorities should fund both the maintained and private, voluntary and independent (PVI) sectors fairly, transparently and equitably’.9 Parents using their entitlement to early years education in the private and voluntary sector will be able to access this facility for the full 38 weeks it is available using nurseries and reception classes.10 Significant work has been undertaken in the Department for Education and Skills on the development of market-level institutions. But there is no clear government strategy on the development of greater diversity in provision and the benefits this can bring to children and parents. And government guidance on the involvement of private and voluntary providers lacks a mechanism for enforcement. Funding allocations are often short term and specifications are changed too frequently, which can make long-term partnering difficult – particularly for voluntary providers. The draft statutory code on nursery education does provide for rates for PVI providers to be set over three years, but this may be too short to stimulate real innovation. Public and PVI providers have been subject to different inspection regimes, and while this is being addressed in certain respects, staffing ratios and inspection costs will mean that there is still not a level playing field. Intervention in failing PVI providers will also be more stringent than with failing schools. The lack of cost transparency for public providers means that it is difficult for PVI providers to feel confident they are participating in fair competitions. The new policy proposes extended use of school facilities to provide additional childcare, particularly for three to four year-olds, and it is contemplated that capital funding will be provided to facilitate this expansion of capacity. This may have the effect of distorting the market and creating unfair advantages for schools. The explanations given for this policy are concerned with better utilisation of school facilities and the desire to concentrate and cluster expertise, particularly in after-school services for young children. But these outcomes could be achieved in ways that are neutral between the different classes of provider.

Current VAT rules mean the PVI providers are often at a competitive disadvantage compared to their public counterparts. Where public policy decisions are made to subsidise service provision, the allocation of the subsidy is not always made on a fair and transparent basis between different classes of provider.11 Summary Competitive neutrality matters. Research in the UK local government market in the 1990s found that private firms were sensitive to perceptions of competitive bias in government tendering: a belief that the odds were weighted in favour of in-house teams was reported as one of the major barriers to bidding.12 And the anecdotal evidence gathered from members of the CBI’s Public Services Strategy Board in the course of this project has revealed significant ongoing concern about the fairness of some public service markets. Yet as the government continues to develop a mixed economy in the delivery of public services, and as public, private and voluntary sectors are brought into competition with one another as never before, competitive neutrality will matter a great deal more. It is essential that the government addresses the serious anomalies which exist in the current competition neutrality policy framework. To fail to do so would be to undermine the competitiveness and, ultimately, the viability of these markets. The following sections explore the sources of competitive advantage and the policy instruments currently used to regulate it in the UK, in order to understand the complexity associated with ensuring a level playing field and the reasons why we believe a more comprehensive policy framework is required.

10 A fair field and no favours

2. Ensuring fair procurement Around the world, competitive neutrality problems are addressed in a number of different ways, for example:

this principle is adopted in the UK’s draft Public Contracts Regulations 2006.

• Design and implementation of procurement policies

But the approach adopted by the Procurement Directive and the Public Contracts Regulations is to regulate the structure of the procurement process in an attempt to ensure all parties are treated equally. With one exception, the proposed regulations do not directly address the situation where public sector bidders have an unfair advantage by virtue of their structure or ownership. The exception is one permitting the contracting authority to reject an abnormally low offer on the grounds the tenderer has obtained state aid.14 Tenderers that have suffered harm (or risk doing so) as a result of flawed procurements are able to bring a legal action in the High Court or lodge a complaint with the European Commission.

• Ensuring public authorities are fully subject to competition law • Even-handedness in the taxation and regulation of different ownership structures • Policies on the structure and governance of public undertakings. Remedies can be applied either retrospectively, by establishing mechanisms for legal challenge or administrative protest by disgruntled parties, or prospectively, with government undertaking proactive reform of its structures and processes. In the market testing of public services, government must ensure not only that public undertakings enjoy no unfair advantage by virtue of their internal governance arrangements, but also that the competitive process itself does not favour an in-house team. This section considers provisions of UK procurement law and policy that might be construed as delivering competitive neutrality, and the reasons for concluding that they are incomplete. It then discusses elements of a competitive neutrality framework relevant to the procurement process, with examples illustrating current deficiencies. Procurement policy Regardless of whether European procurement directives apply, public authorities have an overriding obligation under the EC treaty not to discriminate against suppliers on the grounds of their nationality. The procurement directives date from the 1970s and as far as public service contracting is concerned, the principles laid down in those documents were reflected in UK law in the Public Services Contracts Regulations 1993. The preamble to the new EU Directive on the Coordination of Procedures for the Award of Public Works Contracts, Public Supply Contracts and Public Service Contracts provides that: ‘Member states should ensure that the participation of a body governed by public law as a tenderer in a procedure for the award of a public contract does not cause any distortion in relation to private tenderers.’13 The underlying principle of the directive is that contracting authorities are to treat tenderers equally and in a non-discriminatory way, and

Typically, UK guidance documents advise departments and agencies that they are subject to European and domestic law requiring procurement rules to be objective, transparent and non-discriminatory and obliging procurers to be fair in their treatment of bidders. Agencies are issued with a general warning that they can be taken to court for breaches of these rules.15 Office of Government Commerce (OGC) guidance on specification writing cautions not to include features that discriminate directly or indirectly for or against any supplier.16 For a variety of reasons, this approach is insufficient to ensure procurement processes are neutral as between public, private and voluntary sector providers. Competitive neutrality is a complex policy area, and in many cases ensuring non-discriminatory conduct will demand much more than a general exhortation to fairness. The government needs to spell out the causes of advantage and disadvantage, and the instruments that might be adopted by way of correction. Where some classes of bidder have a structural advantage because of ownership or governance, then a neutral process may not be enough to ensure a fair outcome. The government may need to take positive action to ensure public bodies do not enjoy an unfair advantage. Relying on retrospective remedies may not be enough if market participants are reluctant to complain. Indeed, there is considerable evidence that, in the UK at least, private sector firms are cautious about taking legal action or lodging formal complaints – particularly in public service markets where the government is the only customer.

A fair field and no favours 11

Research in the UK market in the mid-1990s found that half of all firms surveyed were unlikely to make a complaint against a local authority, and small to medium-sized firms were much less likely to do so than larger firms.17 Small businesses find the cost of making a complaint prohibitively expensive, both in terms of legal costs and the opportunity cost of senior management time. There is also recent evidence that British firms are reluctant to lodge such complaints in overseas markets. In 2004, the Chancellor and the trade secretary commissioned a review of UK business experience in competing for public contracts in other EU countries. The review, conducted by Alan Wood, chief executive of Siemens plc and supported by the OGC, concluded: ‘The consequences of challenging the award decisions of potential clients are seen by nearly all respondents to be extremely negative, likely to disrupt the commercial relationship and significantly damage any chance of winning future contracts.’ The manager of a small manufacturing firm told the Wood review: “I have to deal with these sorts of bodies all the time and if I get a reputation for being too aggressive, they (and others) will avoid even asking me again in future.”18 This is consistent with our experience in researching this report: companies were opposed to being identified by name, and in some cases did not even wish an anonymous account of an incident to be reported. In one particularly flagrant example of unfair competition, originally brought to our attention by a public official, a senior executive in the company said: “It’s sorted now, and I wouldn’t want to cause any trouble.”19 If the government cannot rely on disgruntled bidders to lodge a formal protest, the fairness (and thus the viability) of public service markets can be severely compromised by the time the government learns of it anecdotally. It is not enough to establish sound procurement rules: the government must actively encourage companies to report unfair practices, and it must take positive steps to ensure a level playing field exists. The notion that the government might need to be proactive in this area is not a radical proposition. The Wood Review concluded that the EU procurement rules ‘…do not of themselves lead to completely effective competition in public procurement’. Wood argued that the European Commission’s Internal Market Directorate should place

†

greater emphasis on assessing ‘…how procurement structures and practices affect the outcomes they are intended to achieve and the openness of the... market.’ He recommended that work should be undertaken on identifying, evaluating and benchmarking the structures, tools and techniques that would contribute most effectively to this outcome, publishing scorecards to raise the performance of member states.20 The government might consider adopting Wood’s approach in domestic law and policy, and consider establishing an informal complaints procedure which is capable of addressing broader structural and policy issues as well as strictly procedural concerns. Given the complexity of competitive neutrality policy, t vague ‘health warnings’ may be insufficient to ensure emerging public service markets are fair as between the different categories of ownership. A more comprehensive review of policies and procedures may be required. Procedural fairness Before considering the elements of a robust competitive neutrality framework, it is worth addressing another course of legal challenge disgruntled bidders might have available to them. Over the past two or three decades, courts in the common law jurisdictions – the United Kingdom, the United States, Canada, Australia and New Zealand – have increasingly intervened in procurements to ensure they are conducted fairly. To achieve this end, they have employed a range of legal instruments: contract, negligence, estoppel,‡ fair trading legislation and administrative law remedies. By far the most active area of judicial interpretation has involved the law of contract: the courts have concluded that, in some circumstances, the undertakings given by government bodies in the course of a procurement can give rise to a ‘process contract’, with a legally enforceable obligation to ensure competition is conducted fairly. British courts have concluded that the promises made by the procuring authority in the pre-award period can create a unilateral contract once a tenderer submits a compliant bid.21 Canadian courts have taken the view that there is a bilateral contract, with certain obligations enforceable on the tenderers as well.22 Anglo-American courts have concluded that these contracts contain an implied term to act fairly as between the parties, to treat each of the tenderers in the same way.23

The legal doctrine which prevents a person who has induced another to act upon a representation made by him or her from denying the truth of that representation.

12 A fair field and no favours

The potential for this doctrine of procedural fairness to address competitive neutrality issues is obvious, and guidance issued by the Treasury warns public authorities that they must have regard to this body of law in the design and conduct of their procurements.24 But the precise scope of the law of procedural fairness is unclear. To some extent, procuring authorities are able to contract their way out of a process contract, and in the US, for example, the courts have been reluctant to interfere unless the conduct is ‘arbitrary and capricious’. The availability of other legal devices such as negligence and estoppel is even less certain, and the courts have been increasingly reluctant to invoke administrative law remedies where governments are engaged in commercial activities such as the award of contracts. In the US, where bid protest law is more formalised, the success rate of protests is not high, and in the UK, as already noted, companies seem reluctant to launch protests at all. In short, the scope of this emerging law on procedural fairness and its potential application to competitive neutrality is far from clear.25 If, as already noted, competitive neutrality in procurement policy is not self-evident, policymakers need to spell out the detailed implications. The following analysis, based on a North American study of the issues, provides an analytical framework and a possible foundation for future policy development.26 Process issues Sequential competition In some governments, public sector organisations are given an opportunity to restructure and reform prior to being subjected to competition on the assumption that in-house teams need more time to become competitive. There is no inherent unfairness in such a policy unless an in-house team is given longer to respond to the tender specifications than private or voluntary bidders. Under a second type of arrangement, the in-house provider is given an opportunity to view proposals submitted by the private sector bidders before it submits its final bid. In both cases, the structure of the competitive process potentially gives the in-house team a competitive advantage. In some US jurisdictions, sequential competition of the former kind has been adopted as an explicit policy. Indeed, this appears to be the approach now being piloted by the US federal government, enabling agencies to establish high-

performing organisations (HPOs), which will be exempt from competitive sourcing studies for a trial period of time. Among other things, HPOs will have greater flexibility in personnel policies.27 Performance testing prior to market testing has occasionally been used in UK procurements, and while there is nothing inherently objectionable about such an approach, care is needed to ensure it does not distort the market. In some overseas jurisdictions, the threat of introducing competition into a particular sector has been used to secure union co-operation on an internal reform agenda. While this has proved to be highly effective, it does serve to undermine market confidence.28 Example: UK prisons In an attempt to introduce greater contestability into UK prisons management, the Home Office developed a programme for market testing existing prisons. The first tranche – three prisons on the Isle of Sheppey – was announced in March 2005. Two months later, the competition was suspended, in order to give the Prison Service time to initiate reforms. The question of whether market testing would continue was still being considered at the time this report was written. This reversion to performance testing part-way through a competitive process might give the in-house team an unfair advantage if the competition is later restarted. Where significant reviews are undertaken to assist in the formulation of the business case (or, previously, the public sector comparator), this could inadvertently create a kind of sequential competition. Example: PFI A major PFI project in the UK was abandoned in 2004 at a late stage in procurement. There was concern among bidders that part of the reason it was abandoned was the extensive work undertaken on modernising part of the service, lessons that were used in the development of the public sector comparator. While it was unintended, the public sector comparator, which had been based on different specifications, functioned as a kind of shadow in-house bid. The Scottish Executive has embraced the second form of sequential competition as a matter of explicit policy. Under a protocol signed in 2002 between the Scottish Executive and the Scottish Trades Union Congress, in PFI procurements the in-house team is permitted to submit a late bid once it has viewed the other bidders’ proposals.

A fair field and no favours 13

Example: Scottish PPPs In a guidance note on public sector involvement in PPPs, the Financial Partnerships Unit in Scotland has declared that in-house providers of facilities management (FM) services will be ‘…given the opportunity to refine their submission following receipt of the bidders’ ITN [invitation to negotiation] submissions.’ This is part of a best value process, which allows FM services to be carved out of the PPP contract if the in-house provider is able to submit a superior proposal at this stage. This model has already been used in some school PPPs, and at the time of writing it was being applied for the first time to a major hospital PPP. While the guidance stresses the importance of avoiding a conflict of interest, the only advice it offers in relation to the inherent unfairness of this model is that it should be clearly declared in the tender documentation. Companies are studying this model closely.29 Access to bid resources Bid costs can be substantial and the public sector should ensure in-house teams are properly resourced, including access to external consultants if required. On the other hand, private contractors face significant resource constraints and are obliged to adapt their bid strategies accordingly. Government must ensure that in-house teams are not given a competitive advantage by being overresourced. How government rations the resources available for bidding in competitive markets is a difficult question that does not seem to have been addressed in policy documents or in the academic literature. Access to privileged information A different access problem arises from the competitive advantage possessed by the incumbent in terms of its detailed knowledge of internal systems and processes. This is also a problem with private sector incumbents during recompetitions. Some measure of ‘ring-fencing’ is required in such cases so that external bidders are provided with the same access as the incumbent’s bid team. In the UK, government agencies have demanded the imposition of ‘firewalls’ between bid teams and employees engaged in the ongoing delivery of a major public service. All bidders are given access to the data room on an equal basis, although this cannot always overcome the benefits of incumbency. Incumbents also face disadvantages, since their intimate understanding of the service in question makes it difficult

to think in a radically different way about alternative models. In some cases, access to inside information might constrain the flexibility of the incumbent. Separation of purchaser and provider In recent years, it has become commonplace to separate purchasing and provision functions to avoid a conflict of interest on the part of the procuring agency. In some cases, the use of ‘firewalls’ may be sufficient to avoid a conflict of interest. In recent reforms to US federal policy on competitive sourcing, the team which drafts the performance work statement for the tender must be distinct from the team formed to conduct the in-house bid. But in other cases, the separation of these functions into different departments and agencies might be required. In spite of having been a pioneer in developing the agency model of public administration, some parts of UK government have been slow to recognise the importance of segregating purchasing and provision functions. An official study of the local government market in the early 1990s found that 80% of companies disagreed with the proposition that competition between in-house teams and outside contracts was conducted fairly.30 We found evidence to suggest this is still a concern in some local authority markets, such as leisure and waste management. Example: The Office for Contracted Prisons The Home Office only separated the commissioning and provision functions of the prisons market in 2003, creating the Office for Contracted Prisons more than a decade after the first prison was competitively tendered. Throughout that period, the private sector remained concerned about a conflict between the role of the Prison Service as purchaser and its role as competitor, and those concerns were registered publicly at the time. The creation of the Office for Contracted Prisons served to improve market confidence. Example: Connexions Significant conflicts of interest have arisen in the development of the market for careers guidance to young people, particularly since the establishment of the Connexions Partnerships in 1999. The failure to adequately account for the role already played by private firms led to local authorities and the Connexions Service (through which these services are delivered) having a conflict of interest in their roles as commissioners and as providers. Throughout 2002 and 2003, private providers repeatedly requested that these issues be addressed at a central government level, with only limited success.

14 A fair field and no favours

In spite of a clear commitment in government policy statements to contestable markets in the emerging market for children’s services, private firms are already registering their concern about the lack of a clear separation of responsibility between purchaser and provider, particularly in the way in which it will incorporate Connexions Services. Difficulties have also appeared in the emerging market for health services due to a failure to clarify the distinct roles of the NHS trusts as providers of local health services and as administrators of the system as a whole. We recognise these difficulties have arisen because this market is still in the early stages of development, but this is when unfair advantages or disadvantages can have the greatest impact on competitiveness. Example: ISTCs In one region, the local acute trust strongly opposed the awarding of an independent sector treatment sector (ISTC) contract, demanding compensation for any loss of revenue from the main hospital. The project has since been abandoned and the preferred bidder is now seeking compensation for the bid costs. This suggests the Department of Health needs to clarify the design of the ISTC market so that NHS Trusts do not expect compensation for the impact of competition. Costing issues Minimum savings threshold In a number of US jurisdictions, governments have mandated that private sector bids must be lower than the public sector cost by a specified amount (usually 5% or 10%). Statutory thresholds are a deliberate breach of competitive neutrality conditions and appear to have been created entirely for political reasons. While they do amount to a breach of competitive neutrality, savings thresholds at least have the virtue of transparency. There are no known examples of this practice in the UK. Approach to cost comparisons Difficulties can arise in the costing of the public sector bids and benchmarks, particularly in the allocation of indirect costs. Different approaches to costing (fully allocated costs versus avoidable costs) will tend to favour the public and private sectors differently. Transition costs There are one-off costs associated with the transition from public to private management that have sometimes been

allocated to the private sector’s bid costs in comparing proposals. These include the costs of transferring government property to private ownership, redundancy costs (including accrued entitlements) and the costs associated with the competitive process itself. It is generally accepted that the costs associated with restructuring and competition should not be allocated to any particular bid. Arguably these are the costs of reform and while they must be weighed against the savings obtained from the reform process to determine the benefits overall, it would be wrong to allocate them to only some classes of bidders. There are also one-off costs associated with redundancies and the transfer of workers from public to private employment (and vice versa, in the case of rebids). Again, it is important to identify transition costs unique to the private sector. In the UK, these have been minimised through the TUPE regulations, which protect the rights of workers through the process of transfer and thus avoid the need for large redundancy payments. Monitoring costs Some governments also include contract administration and monitoring costs in the costing of private sector bids. Certainly this is a cost that must be weighed in deciding whether or not to adopt a more transparent and arms-length model of public sector management, but it is not a cost that should be charged to private bidders alone. Contract administration issues Contractual arrangements Where an in-house team wins a competition, it should be subjected to contract-like arrangements which specify the conditions under which the service is to be managed and monitored. We understand that some leisure trusts are trading without formal contracts or specifications with their local authorities: this throws into doubt the validity of the competitive process. Example: Changing prison contracts In the Prison Service, where prisons were subjected to market testing (including contracted prisons that came up for re-competition), service level agreements (SLAs) were introduced for the prisons won by in-house teams. But there has been little transparency in these arrangements, and the private sector remains unconvinced how strictly they have been enforced. One of the contracted prisons changed roles to become a women’s prison shortly after

A fair field and no favours 15

it was re-won by the Prison Service (and it is now being changed again to a male prison). This means that it is impossible to determine whether management delivered on its commitments. The specification and enforcement of ‘service level agreements’ with the Prison Service will need to be addressed as the Home Office again looks to the market testing of prisons.

Provisions for monitoring and reporting In-house providers should be subject to formal contractual performance regimes in the same way as external contractors and there should be a similar level of rigour and independence in the monitoring and reporting arrangements associated with such regimes. It does not appear that this policy has been widely adopted in the UK.

Where different classes of public service providers are offered fundamentally different contractual arrangements, this may have an impact on their commerciality and competitiveness. Differential payment arrangements are also capable of providing an unfair advantage.

Penalties for failure One area where it is extremely difficult to achieve neutrality is in the penalties for failure. While an in-house contractor may be financially penalised for poor performance, this cost is ultimately underwritten by the taxpayer rather than by investors and lending institutions. The differences in terms of the institutional incentives can be enormous: knowing that it does not face real commercial discipline, an in-house team may be inclined to bid more aggressively. This needs to be addressed in the financial structure of public undertakings and in the assessment of bids.

Example: Voluntary sector providers Voluntary providers have argued that the vast majority of their arrangements with the UK government for the delivery of public services are short term and highly insecure. In a recent report, the Association of Chief Executives of Voluntary Organisation (ACEVO) has claimed that ‘…the insecurity of relationships with government makes it especially difficult for the third sector to access start-up funding for new services. Trustees of smaller charities are often unwilling to take on the risks, both financial and reputational, inherent in public service delivery.’31 The impact of this insecurity has been recognised by the government for several years, although little appears to have changed as a result. To the extent that voluntary organisations are offered shorter contracts and suffer greater insecurity than the private sector, this sector is suffering an unfair disadvantage. Example: social housing The UK government recently opened up the annual subsidy for newly built social housing to non-registered social landlords. Developers, builders and public service providers can now bid against housing associations for the social housing grant. However, the Housing Corporation determined that private providers would only receive a single payment at the completion of the project (payments that can be worth tens of millions of pounds), while the housing associations – the historic recipients of the grants – would receive their payments in two stages. The cost of borrowing to cover the gap would have placed the private sector at a distinct disadvantage. Following pressure from private service providers, this has been addressed in part by the addition of a notional sum to the cost of housing association bids. While this corrects some of the competitive disadvantage, it does not remove the underlying distortion caused by different payment mechanisms.

Example: Nursery provision The UK government’s draft code of practice for the provision of free nursery education enables local authorities to demand repayment where providers fail to meet conditions. But without further reform, this will result in a competitive disadvantage for the private sector, since maintained schools providing free nursery education that are underperforming will not suffer a real financial penalty. Nor do public sector organisations face the same discipline in terms of reputational damage. The entire public sector bears the opprobrium of poor performance, rather than a discrete organisation where goodwill has real and substantial commercial value. Summary Procurement law has a major role to play in ensuring a level playing field in public service markets, and a great deal has been done in the UK to ensure competitive processes are fair. But it is a complex area of policy, and greater care could be exercised in the design of the competitive process, the costing methodologies and contract administration to ensure neither public, private nor voluntary sectors enjoy an unfair advantage.

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3. Regulating anti-competitive conduct Many of the encounters between public and private providers occur in the market at large, rather than just in the course of a procurement process. The UK government relies heavily on competition law to regulate anti-competitive conduct by public undertakings in these situations. Central and local government authorities are warned that competition law applies and that they must seek advice to ensure they comply. Competition law Article 81 of the EU Treaty prohibits agreements between undertakings which prevent, restrict or distort competition. Article 82 prohibits conduct by an undertaking which amounts to the abuse of a dominant market position. Article 86(1) imposes a specific obligation of member states not to enact or maintain any measure with regard to public undertakings that is contrary to the rules on competition. The treaty is primarily concerned with trade between member states, but Articles 81 and 82 were used as a model for provisions in the UK’s Competition Act 1998 (CA98). UK policy directives and guidance documents typically refer public sector agencies and authorities to European competition law and to the provisions of the Competition Act, warning about the distortion of competition and the abuse of a dominant market position. Departments and agencies are advised to take legal advice and consult the Office of Fair Trading (OFT) website.32 But when it comes to competitive neutrality problems, the authority of competition regulators is limited. Based on case law, the current policy of the OFT is that a public body engaged in procuring goods or services will not generally be considered an undertaking for the purposes of the Competition Act (and thus subject to its provisions): ‘For the time being, the OFT is unlikely, in the absence of exceptional circumstances, to take forward cases concerning public bodies which are engaged in a mixture of purchasing and direct provision of goods and services for non economic purposes, for example purposes which are purely social, environmental or national security related.’33 (As regards public bodies engaged in the delivery of goods or services in response to government procurements, the application of competition law is unclear. In 2002, the UK’s Competition Commission investigated a potential abuse of market power and significant reduction in competition following the merger of two private prison companies. While the investigation was fully justified, the combined operations

of the two businesses accounted for less than 8% of the UK prisons sector. Yet there does not appear to be any power for the Competition Commission to investigate HM Prison Service, which accounts for around 90% of the prisons sector, to ensure it competes on a level playing field when public and private sectors respond to a procurement.34 In any case, competition law has only limited application to public service markets, where competition is confined to periodic auctions for the right to manage a monopoly service for a period of years. The UK’s Competition Commission acknowledged this in its 2002 report on the prisons sector. It was recognised that one of the key tests used to define markets and monopolies has limited application to public service markets, ‘…where bidding competitions take place infrequently, prices are determined for the duration of the contracts and the competitions occur at one point in time.’35 The Competition Act is of only limited assistance where the fundamental driver of unfair advantage is the market framework (rather than the conduct of individual participants). This is recognised in a recent report by the OFT on the market for property searches, where local authorities have a monopoly on unrefined information and also compete against property search companies in retailing that information. The OFT concluded that until the framework of the market is restructured and local authorities have time to respond to its recommendations, it was unlikely that further action under the Competition Act would be an appropriate use of resources.36 UK government officials have previously recognised that the power of the OFT in relation to government bodies ‘…does not provide a suitable framework for dealing with broader competition problems that government involvement in commercial markets might often involve.’37 And the OECD Competition Committee recently acknowledged that ‘Many competitive neutrality issues would not be reached by competition law, either because the relevant government business activities do not have market power or the advantages they receive do not fall within the categories of market abuse that are covered by competition laws.’38 The reluctance of UK companies to lodge complaints against government undertakings, particularly in public service markets, means it may not be enough to rely on retrospective enforcement of competition rules. Responsibility for the enforcement of the competition provisions of the EU Treaty rests (in part) with individuals

A fair field and no favours 17

or firms who have submitted a tender and are able to launch a legal action in the High Court, if they have been harmed or if they are at risk of harm from the breach of these laws. In the UK, the OFT can also initiate action. There are a number of cases where European competition regulators have intervened to prevent anti-competitive activity by stateowned enterprises, either through the imposition of financial penalties or by directing the break-up of these enterprises, isolating those functions with a regulatory role or a natural monopoly element from those that are largely commercial in nature. But the case law typically deals with highly commercialised services such as telecommunications and postal services, rather than social services such as health or education.

Again, there is little evidence that private or voluntary providers in the UK will be willing to challenge under these provisions.

State aid Article 87(1) of the EC Treaty provides that financial assistance granted through state resources in a form that distorts or threatens to distort competition by favouring certain undertakings (insofar as it affects trade between member states), could constitute unlawful state aid. The elements of state aid include an economic advantage that would not otherwise have been obtained under normal market conditions, some element of selectivity in the application of such aid, and a distorting effect on competition. Where competition is open, transparent and non-discriminatory, state aid is unlikely to be an issue.39

Financial transparency The European Commission’s Financial Transparency Directive requires public bodies engaged in commercial activities, and with an annual turnover in excess of = C 40m, to maintain records and inform the Commission of support they receive from government. This directive covers large government business enterprises such as the Royal Mail and some public undertakings such as local authority enterprises. The UK has used existing government accounting systems to comply with this directive in the past.

The definition of state aid is broad enough to cover loans, loan guarantees, favourable taxation treatment and indemnities against trading losses. According to the Department of Trade and Industry (DTI), it might extend to contracts not open to competitive tendering. Compensation for the delivery of social policies (public service obligations) will not usually be caught by these provisions, and compensation for social housing and hospitals will in all cases be exempt.40 Non-budget measures (such as preferential regulatory arrangements) are not included, and for this reason, the state aid rules will not be of assistance where there are structural or governance advantages.41 The state aid rules can be invoked against the trading arms of local authorities that compete with an unfair advantage, and there is a provision in the draft Public Contracts Regulations 2006 permitting contracting authorities to reject abnormally low tenders where state aid is involved.42 The complaints procedure involves a notification to the European Commission, followed by formal investigation. The remedies include the repayment of such aid by the recipient. Alternatively, a complainant may pursue the matter in the High Court.

Member states are able to introduce their own provisions on state aid. The UK government has not yet chosen to do this, although provisions are taken into account in Treasury guidelines for public undertakings. Guidance provided to new trading local authority trading companies in the UK warns that consideration must be given to EU rules on state aid. But no detailed instructions are provided and other guidance documents recognise that the rules are complex and that it is often very difficult to establish whether the state aid requirements have been met.43

Amendments to this directive are currently in the consultation phase and it is probable that the existing administrative arrangements will not be adequate to comply with the new directive. It is expected these new provisions will be adopted into UK domestic law,44 although their applications are limited to the large public undertakings. Summary While competition law must remain a central element of competitive neutrality policy, it may not be enough. This has long been recognised in the large body of legislation, regulations and guidance notes promulgated over the years dealing with the constitution, regulation and taxation of the trading activities of various kinds of public undertakings.

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4. Neutrality between ownership structures There is a great deal of diversity in ownership structures throughout the industrialised economies, with co-operatives, non-profits and mutuals playing a significant role in certain sectors alongside corporations. There are sound economic reasons why particular ownership structures prosper in particular industry sectors and while different rules apply to these organisations differently, government needs to ensure that particular business models are not given an unfair advantage that will distort the market.45 The UK government has actively sought to increase the diversity of the organisations involved in public service delivery, encouraging private and non-profit providers to enter the market, creating new kinds of public and quasipublic undertakings (such as foundation hospitals, foundation schools and self-governing trust schools) and laying down regulatory frameworks for new forms of social enterprise (community interest companies, also known as public interest companies). Deliberately favouring classes of provider Public, private or voluntary providers have sometimes been explicitly precluded from bidding in particular markets. For example, the Prison Service was prevented from bidding for PFI prisons, and foundation hospitals are presently not permitted to compete for the provision of diagnostic treatment centres. Yet there appear to be situations where private providers have also been deliberately excluded from markets. The Education White Paper of October 2005 envisages the creation of not-for-profit trust schools, with restrictions on how private providers can participate. And at least one local authority has conducted a procurement for leisure management that was open only to non-profit distributing organisations. There may well be internal business reasons (such as the availability of capital and concerns about the management of financial risk) why the owners of public enterprises may not wish to bid for particular services. But this is different from a situation where public enterprises are excluded as a class. In the past, central agencies may have excluded public undertakings from competing for public services because of a concern that such bodies enjoy an unfair competitive advantage. The ideal solution lies in ensuring a level playing field, but where this is not possible, it may be necessary to exclude public undertakings from certain markets. Central government is now actively encouraging the involvement of voluntary providers in the public services sector. This additional diversity is welcome, but it would

be unfortunate if it were accompanied by the emergence of competitions that exclude private providers as a class (explicitly or implicitly). One of the consequences of deliberately favouring social enterprises will be the encouragement of joint ventures and hybrids. Private companies already function through trust arrangements in the local government sector and there is discussion of them joint venturing with social enterprises in bidding for future contracts. A few public-private joint ventures already exist in central and local government, and we received complaints about the unfair advantages they enjoyed. Innovation in organisation form is to be welcomed, but if it is driven by artificial restrictions on market entry or by tax advantages enjoyed by some of the partners, it could well result in inefficient structures that consume rather than contribute to social savings. There may be situations where the government might wish to limit the range of alternative providers invited to participate in some public service markets. However, any such exceptions should be based on principle rather than political expedience. We suggest that in these situations, the government should make its position clear well in advance of procurements, and that it should base its decision on clear criteria established well in advance. But having decided that public, private, voluntary or hybrid providers will be able to compete in a particular market, the government must ensure its regulatory and taxation policies do not discriminate for or against particular forms of ownership. Taxation neutrality There is general agreement in principle that taxation arrangements should be neutral across different classes of provider. In Europe, tax advantages may be treated as a form of state aid, and in general the UK government has sought to create a level playing field between the public and private sectors in this regard. One of the reasons why local authorities have been obliged to exercise their new trading powers through a corporate structure is the government’s desire to ensure any surpluses are subject to taxation. In cases where services are delivered by one level of government and taxes are levied by another, the pursuit of competitive neutrality may require the creation of an artificial ‘taxation equivalence regime’, whereby a charge equal to the tax liability is imposed by the level of government delivering the service. Tax neutrality can be an extremely complex area,

A fair field and no favours 19

since private providers are sometimes able to structure their arrangements so that taxation exposure is minimised. In Australia, the Tax Office has co-operated with state finance departments in establishing a regime broadly consistent with national companies taxation law and practice.46 In the UK, a light-handed approach has resulted in significant gaps in the framework. The government has been clear that community interest companies (the legislative framework for which has recently passed into law) will not enjoy tax incentives, since they will often be competing with commercial organisations. But it is also encouraging voluntary organisations to become more involved in public service provision, in spite of the fact that charities (both restructured in-house providers and traditional third-sector providers) enjoy significant advantages in relation to corporation tax and business rates. Business rates Some local authorities have established discretionary services such as leisure facilities as social enterprises, enabling them to take advantage of discretionary relief for national non-domestic rates (which in London can provide a significant benefit). Charities engaged in the provision of health services also benefit from rate exemptions and the National Day Nurseries Association has raised the impact of business rate increases as a significant issue in that sector.47 Example: Leisure services provision Leisure trusts are entitled to a statutory 80% relief on national non-domestic rates, with discretionary relief possible on the other 20%. In the case of private providers, any relief on business rates is entirely discretionary. One London local authority established a leisure trust in 1993, awarding a seven-year contract to manage its leisure services. The contract has since been renewed; the social enterprise in question has exported its services and now manages more than 40 leisure centres nationwide. Private providers have raised objections to competition from a class of provider with an unfair advantage.

local authority leisure centres and the provision of clinical healthcare. In the local authority leisure market, it is estimated that immunity from corporation tax has provided the leisure trusts with an unfair advantage of 3-4% of turnover. Similar estimates have been made of the advantages enjoyed by charitable providers in the healthcare market. In the course of this investigation, concerns were raised that joint ventures between private corporations and public undertakings or social enterprises might also benefit from the non-profit partner having a corporation tax exemption. Value Added Tax VAT is the source of a significant amount of distortion in different parts of the market and, in some circumstances, voluntary providers can be at a disadvantage compared to the private sector in this regard. European law seeks to ensure a level playing field between public and private sectors in the application of VAT. The first two paragraphs of Article 4(5) of the 6th VAT Directive of the European Commission provide that: • States, regional and local government authorities and other bodies governed by public law shall not be considered taxable persons in respect of activities or transactions in which they engage as public authorities, even where they collect dues, fees, contributions or payments in connection with these activities or transactions • However, when they engage in such activities or transactions, they shall be considered taxable persons in respect of these activities or transactions where treatment as non-taxable persons would lead to significant distortions of competition.48

One recent study of a borough to the north of London found that VAT and business rate relief accounted for almost 90% of the total annual savings offered to the local authority by the leisure trust.

A general exception was made for postal services (among others), which when the directive was introduced in 1977 were universally provided by way of public sector monopolies. With the liberalisation and privatisation of postal services across Europe, VAT exemption has become the source of competitive advantage as private sector providers, which do not enjoy this exemption, have entered the market. There is general recognition that this is an anomaly, but a universally acceptable solution has yet to be found.

Corporation tax Charities and some social enterprises are exempt from corporation tax, giving them a significant advantage over private providers in markets such as the management of

With the exception of anomalies of this kind, UK government accounting rules provide that VAT should be applied ‘…as far as possible, in the same way to government departments and other public sector bodies as to ordinary traders’. The

20 A fair field and no favours

underlying philosophy of Article 4(5) was that non-business activities of government should be outside the scope of VAT. This principle has been partly addressed in UK legislation. Section 41 of the VAT Act 1994 applies to central government and the NHS. Accepting the general immunity of non-business activities, this section provides that even where a supply by a government department does not amount to carrying on a business, but it appears to the Treasury that similar goods or services might be supplied by taxable persons in the course of their business, the Treasury may direct that the supply is liable to VAT.49 This section also provides a scheme for the refund of VAT incurred by central government and the NHS on services used to provide their statutory services. Over time a list of 75 ‘eligible services’ has developed which means that for services that are open to competition from and contracting with the private sector, a great deal has been done to achieve competitive neutrality. But, as noted below, significant anomalies still exist – particularly where public, private and voluntary providers deliver services direct to the public. Section 33 of the VAT Act 1994 applies to local authorities (and some other bodies) and provides for a refund of VAT inputs where the supply of goods or services is not for the purpose of any business carried on by that body. This approach has been adopted so that the introduction of VAT should not be a burden on local ratepayers. The Treasury has confined the application of section 33 to bodies which ‘…both carry out former local authority functions and have the power in law directly to precept on local taxation’. Regional Development Agencies, Development Corporations and Urban Regeneration Companies have not been able to acquire preferential VAT status. Non-departmental public bodies must comply with normal VAT provisions and if taxable business activities exceed the VAT registration limit, they must apply for registration. Yet in spite of attempts to achieve a level playing field between different classes of service provider, significant anomalies have remained and in some areas new sources of competitive advantage or disadvantage are still being created. Example: Leisure trusts In the leisure sector, private providers claim leisure trusts enjoy a significant competitive advantage because of their limited liability to VAT on outputs. In one case study, it was estimated the trust saving on VAT was as much as 6.2% of turnover.

Business/non-business activities Much of the difficulty arises from the changing boundary between business and non-business activities of government. In the case of central government and NHS services, the status of a service or activity is determined by Treasury directions dealing with taxation and eligible services. Those directions have often been changed over the years to reflect the moving boundary, although anomalies remain. In the case of local authorities, the boundary relies largely on judicial interpretation of Article 4(5). Traditionally in the UK this was based around a concept of a statutory monopoly, but this too has changed over time. One important indicator of the status of a service now will be whether or not the service is provided free at the point of delivery. Significant changes have taken place in recent decades in attitudes towards this boundary between core and non-core activities of government. Given the anomalies that have emerged, the piecemeal way in which these anomalies have been addressed, and the certainty of increasing complexity due to the UK government’s choice and contestability agendas, there appears to be a case for a fundamental reconsideration of policy in this area. Example: Social housing provision In the case of social housing, a number of different inconsistencies appear. Local authorities can claim a refund of VAT inputs while housing associations cannot. Accordingly, whereas local authorities can claim section 33 refunds on payments made to private sector contractors for repairs and maintenance, housing associations bear the VAT as an additional cost. Some legal advisers regard social housing as a statutory duty, but HM Revenue and Customs treats the section 33 refund as a concession rather than a legal entitlement, resulting in a different application to the two sectors as discussed above. Provision of services direct to the public Where the public and voluntary sectors provide services directly to the public and are funded through grant-like payments, public bodies enjoy a competitive advantage over charities because of their ability to claim a refund of VAT inputs. Charitable providers have the benefit of a welfare exemption in charging VAT outputs, but they are not able to reclaim VAT inputs. This has been a source of concern to charities for some years.

A fair field and no favours 21

The increased interface between public, private and voluntary sectors as a result of the contestability and choice agendas will make it more difficult to ensure a level playing field between these sectors. Example: Education services The provision of education services by public bodies is VAT exempt, which is an increasing source of anomaly between public and private sectors. When further education institutions provide training to businesses, they suffer a competitive disadvantage, since they cannot reclaim the VAT paid on inputs. Yet private providers in this sector (of which there are a growing number) are able to charge VAT on their outputs (and the businesses who purchase their services can claim a refund, so the playing field at that point in the market is levelled). But private providers are able to claim a refund on VAT inputs, giving them an edge over public providers. Some universities have established training companies to overcome this disparity, but they are subject to notification and examination by HM Revenue and Customs in order to prevent VAT avoidance. When further education institutions provide training direct to individual members of the general public (for example, in areas such as computer literacy training), they possess a competitive advantage, since private providers are obliged to charge VAT on their outputs which cannot be reclaimed by the users. Some private providers have established charities to provide training in these areas, seeking their compensation through dividends, but this too has been deemed VAT avoidance by HM Revenue and Customs, and is subject to notification. Similar problems occur where private hospitals provide services direct to private patients and are not able to recover VAT inputs. The disparity between NHS and private hospitals will become more significant as the ‘choice’ agenda develops. Exempt activities VAT incurred by local authorities in the provision of certain activities classified as exempt (such as nursery facilities and welfare services to individuals for whom the authority does not have a statutory responsibility) is recoverable. But if more than 5% of the total VAT the local authority pays on goods and services is attributable to exempt activities, its ability to claim the refund on all exempt activities is lost. The sudden-death nature of this threshold means local authorities pay significant attention to the ratio of exempt activities, and this often creates an incentive for them to

seek third-party provision of some services. Local government has been critical of the impact of the threshold as a barrier to local direct delivery, and in this sense the 5% partial exemption creates a competitive disadvantage for local government. Example: Childcare provision Under new childcare reforms, the UK government has proposed a significant increase in the number of nursery places. The provision of nursery education is an exempt activity generating income for local authorities, and given the scale of construction activity involved, there is potential for the new policy to create a problem with the partial exemption threshold. The Treasury recently announced that it is considering whether local authority childcare services should be reclassified as ‘non-business’. Since these would no longer be exempt activities, local authorities would be able to recover all of the VAT they incur. The artificial incentive to contract out would be removed. But this would create an uneven playing field in relation to charitable providers. Charities are exempt from VAT under education and welfare provisions, which means they cannot reclaim VAT inputs. ACEVO has protested that if the rules are changed in this way, voluntary organisations will face a 17.5% competitive disadvantage. Grant funding Where the funding arrangements between a public authority and a service provider are interpreted as grants rather than contractual payments, the service in question is classed as non-business and the VAT paid on inputs is not reclaimable by the service provider. In some circumstances, this can result in a competitive disadvantage for private providers, and in two recent decisions – on Scottish leisure services and advice and assistance to young people – revenue authorities have interpreted the law in such a way that otherwise similar services appear to be treated differently. Example: Scottish leisure services In a recent case in Scotland a VAT tribunal ruled that the funding provided by a local authority to three leisure trusts, set up as charitable trusts to operate local authority sport and leisure centres, was consideration in return for a supply and therefore not grant funding. Thus the payments were subject to standard rate VAT and VAT inputs were reclaimable (VAT paid by the local authority was refundable under section 33). The ability of local authorities in England and Wales to claim refunds under section 33 in this way is not as clear as in Scotland, where there is a statutory obligation on local authorities to provide leisure

22 A fair field and no favours

facilities. But based on earlier precedents, it is possible HM Revenue & Customs will apply this ruling in England and Wales in any case. This decision has, in part, removed a competitive advantage held by the private sector over some forms of public and voluntary provision. A charitable trust or other notfor-profit body will still have a percentage of VAT on inputs blocked as a result of exempt supplies of sporting services.

But the scale and the complexity of the distortions in the interface between public, private and voluntary sectors are such that they cannot fail to have significant anticompetitive effects. The distortions will become more acute in the near future as government continues its policy of creating a mixed economy in the delivery of core government services.

Case Study: Advice and assistance to young people A 2002 decision by HM Revenue and Customs ruled that funding paid by the Department for Education and Skills (DfES) for the provision of advice and assistance to young people by Connexions partnerships is in the nature of a grant rather than consideration for a service. Connexions is the UK government’s service for providing assistance to young people on careers, education, housing, health and social services. These services are delivered directly by local authorities as well as through public-private partnerships. Prior to 2002, the VAT charged by contract providers was reclaimable from HM Revenue and Customs, resulting in a level playing field between in-house and external provision.

Regulatory neutrality All public enterprises should be subject to the same regulatory environment as their private and voluntary sector competitors, including laws on environmental regulation, health & safety regulation and anti-competition practices. In the UK, business activities are subject to the Competition Act and European competition law, although a service level agreement between a government agency and a subsidiary in-house team will almost certainly be excluded. There are many public services where government agencies are not obliged to comply with the same health & safety regulations as the private sector.

HM Revenue and Customs ruled that Connexions Partnerships were grant-funded and thus the VAT incurred by Connexions Partnerships was no longer refundable. Until 2004, this anomaly was resolved by the allocation of additional funding by DfES. In February 2004, it was decided that this funding would no longer be provided, which led to in-house teams being given a 17.5% competitive advantage. Since that time, at least seven contracts for this service have been brought back in-house on contract expiry. It is unclear whether HM Revenue and Customs’ ruling would stand if challenged in a VAT tribunal, but to date no provider has had the incentive to make such a challenge. Voluntary providers As noted above, voluntary organisations have protested they face a competitive disadvantage in relation to VAT. Because of the services that they deliver and the donation and grantbased nature of much of their funding, voluntary providers are unable to reclaim VAT inputs. In most circumstances, this places them at a disadvantage compared to private sector providers. Market distortions caused by VAT treatment are not confined to the public-private boundary. An anomalous situation also exists in the treatment of support services by contractors in the financial services sector (banks, insurance companies and even betting companies), where VAT exemptions also apply.

The UK government has not developed a comprehensive policy in relation to regulatory equivalence, and the result is that private providers sometimes find themselves with more onerous regulatory regimes than public undertakings. In its regulatory impact assessment on the new local authority trading powers, the Office of the Deputy Prime Minister recognised the potential for a conflict of interest between local authorities’ power to regulate markets and their new rights to participate in them.50 Example: Hospital inspections In the UK healthcare sector, independent providers are inspected routinely by the Healthcare Commission, whereas it is only obliged to undertake an annual assessment of NHS organisations, which might not include an inspection. Around 10-20% of inspections of the independent sector are unannounced. The Healthcare Commission has recently begun spot checks to ensure compliance with core national standards at 120 NHS trust (covering 20% of the NHS as part of the first stage of the new annual health check programme. There is a proposal to introduce a comparable ratio of unannounced inspections for the NHS later in 2005. Independent healthcare providers pay around half the costs of inspection by the Healthcare Commission, and the government has announced that it is looking to full cost recovery by 2008. NHS organisations do not pay for inspection, although the Commission has been investigating arrangements under which charges might be introduced.

A fair field and no favours 23

Example: The Childcare Bill This problem with inconsistent inspection regimes also arises in the UK government’s Childcare Bill. The earlier consultation document proposed that the private, voluntary and independent providers of childcare and early years education should, over time, move from being subsidised for registration and inspection services to being charged the full cost. These providers will be in competition with schools in the state sector for providing early years education. But there appear to be no plans for charging schools for inspection, even though their services for three to five year-olds will be inspected on the same basis and to the same standards. The National Day Nurseries Association has called on the government to ensure equality of regulation and inspection across all childcare providers, including schools.51 There are some public undertakings where the personal liability of senior executives is less extensive than in the

private sector. This inconsistency has been addressed in the new provisions for local authority trading companies, although the position of the senior executives of some of the older trading structures is not as clear. In March 2005, the UK government released its draft legislation on corporate manslaughter. While the bill does apply to Crown bodies as well as the wider public sector, this was the subject of protracted debate. A clear policy on competitive neutrality would have clarified this issue from the outset. Summary There are clearly major inconsistencies in the way rules on tax and regulation apply to public, private, voluntary and independent sector providers. These must have an impact on the competitiveness of public service markets. An effective competitive neutrality policy requires the government to ensure – as a matter of priority – taxation and regulatory regimes operate in a way that does not advantage any one type of provider.

24 A fair field and no favours

5. Neutrality in structure and governance Government must regulate its own commercial undertakings to ensure they do not benefit from unfair structural and financial advantages. One of the ways in which governments exercise this control is by imposing a threshold test when the undertaking is created, or when it is given greater commercial freedom. Alternatively, governments can impose guidelines governing the management and accounting practices of these undertakings when they do compete in the marketplace. Existing oversight of commercial activities The government oversees the commercial activities of public undertakings in several ways: through policy and guidance documents relating to particular classes of organisation and through an overlapping range of guidance documents dealing with particular elements of policy (eg rates of return and fees and charges). Since neither approach is comprehensive, it is often difficult to establish whether a particular entity is operating on a level playing field, and in some cases there are significant gaps. Self-financing public corporations and public-private partnerships ‘Public corporation’ is an accounting classification which covers trading funds, non-departmental public bodies (NDPBs), NHS bodies, as well as statutory corporations, companies limited by shares or guarantees and joint ventures. They are also referred to as ‘government-controlled market bodies’, a ‘market body’ being one which derives at least 50% of its income from sales. The most commercial of these are half-a-dozen self-financing public corporations – including the Post Office, the BBC and partially-privatised entities such as QinetiQ and National Air Traffic Services. A number of public-private partnerships such as local improvement finance trusts (LIFTs) and joint ventures have also been established under the ‘Selling into wider markets’ initiative. The governance arrangements relating to these various entities are not easy to determine. Trading funds These are not separate legal entities, but rather the way in which the trading operations of departments and executive agencies are funded outside the system of departmental estimates. They are established where they have a genuine customer-supplier relationship and a reliable income stream with at least 50% of income from commercial activities (at present, there appear to be 20 such organisations in the UK). Statutory and administrative tests enable the Treasury and Parliament to exercise considerable control over the shape

of these institutions prior to establishment and these include a requirement that there is ‘as much competition as is feasible’. Trading funds are established with ‘public dividend capital’ (comparable to equity) and with deemed loan capital, but they are subject to statutory borrowing limits laid down in the orders by which they are established. They are required to break even from one year to another and will typically be obliged to meet a target rate of return on capital employed. Trading funds are subject to the Treasury’s Fees and charges guide, and the underlying principle is to ensure ‘…efficient resource allocation takes place within the public sector and between the public and private sectors’. They are able to make a profit where in competition with the private sector. Dividends and interest payments are required and they are normally expected to earn an average rate of return.52 Executive non-departmental public bodies (NDPBs) NDPBs are established to allow a service to be carried out at arm’s length from government (although ministers remain answerable to Parliament for their overall management). They can be created under their own legislation, under the Companies Act or under charities legislation. They are encouraged to exploit their assets commercially under the ‘Selling into wider markets’ policy. Most are funded through grants-in-aid, although some may be partly financed through fees and charges (in which case, pricing is subject to the ‘Fees and charges’ policy). NDPBs are encouraged to engage in public-private partnerships, although they will not normally be permitted to borrow from the private sector.53 NHS bodies This category includes NHS trusts and foundation trusts. The former are treated as part of central government in the national accounts, the latter as public corporations. Their governance arrangements are complex, and this will become increasingly important now that some of them are engaged in limited competition with independent sector treatment centres. ‘Selling into wider markets’ This central government initiative encourages departments, agencies and NDPBs to exploit their physical and nonphysical assets commercially (it does not apply to selffinancing public corporations). Bodies subject to the policy are governed by other legislation, policy and guidance relating to their commercial activities, although with the emphasis on market activity the government has laid down some additional provisions under the ‘wider markets’ policy umbrella. One of the core criteria of ‘wider markets’ activity is that the good or service is sold in a competitive market and customers are not tied to the public body concerned.

A fair field and no favours 25

There is the usual warning about the need for pricing to be fair and comply with competition law.54 Local government trading Recent guidance for the trading companies of UK local authorities provides detailed instructions on issues to be considered in establishing such a company, but a review of the structural and governance arrangements from the perspective of competitive neutrality is not one of them. Brief mention is made of competition law in relation to financial assistance from the local authority, but not in relation to pricing policies, debt guarantees and dividends. As with most other such guidance notes, there is a broad warning about the need to comply with competition law and provisions on state aid.55 Trusts These and similar bodies occupy a much more ambiguous position. Although formally separated from the sponsoring authority, they often have overlapping personnel and may benefit from implicit government guarantees and a tied clientele. At present, no policy or guidance deals with the competitive position of hybrids of this kind. There is no overarching policy framework which gives coherence to these measures from a competitive neutrality perspective. As will become apparent from the discussion that follows, this has resulted in significant gaps in the UK’s competitive neutrality regime. Other countries have developed comprehensive policy guidelines, usually as part of programmes to commercialise or corporatise major government business enterprises. The most comprehensive framework developed so far is that introduced by the Australian state and federal governments in the early 1990s as part of a commercialisation agenda, and the following discussion is based on the principles it used.56 Full cost pricing Pricing is of paramount importance in the pursuit of a level playing field because of the monopolies that have traditionally existed in many public service markets, the lack of accounting systems capable of revealing the true costs of delivery and the inherent advantages enjoyed by public undertakings because of government ownership. Where there is a competitive market, unless the public body in question has the capacity to influence prices, the government is mainly concerned with internal accounting issues. The UK Treasury publishes a ‘Fees and charges guide’ which requires ‘…commercial services where there is or may be

competition…to charge the market price – including a profit element where appropriate – in the interests of fair competition.’ The primary responsibility for supervising the departmental pricing policy lies with the finance director, although the Treasury can request reports on fees and charges.57 In markets where the public sector does have the capacity to influence prices, Treasury policy is that ‘…charges should be clearly related to the cost base, but should leave sufficient incentive for potential competitors to enter the market’. Departments and agencies are warned about the potential application of competition law relating to the abuse of market power, although under current OFT policy, this may not be relevant where prices are set by a state agency and not by the commercial undertaking itself. But where public and private sectors are competing in a tender for the provision of public services, particularly where those services are complex and not easily benchmarked, then the policies laid down in the ‘Fees and charges guide’ will be less useful. In tenders for public services, where in most cases there is no established market price, policies relating to the allocation of costs will be much more important than those relating to price. The general principle is that public bodies should charge the full cost for any services sold into a competitive market, although it is sometimes difficult to determine how it should be applied in practice. Treasury guidance states that no commercial service should be priced at less than its average variable cost or short-run marginal cost, but this provides little assistance as to the detail. The ‘Fees and charges guide’ does make reference to risk levels and rates of return and there is loose guidance on the recovery of operating deficits, but there is only limited assistance on the complex questions associated with costing public services that have traditionally been delivered as a monopoly. Example: The property information market A recent study by the OFT into the market for property information demonstrates the complexity associated with pricing public services where the organisation in question has a monopoly and lacks basic accounting information. For example, less than one third of local authorities identified the costs of processing unrefined information separately in their accounts, suggesting they lacked an accounting system capable of ensuring a level playing field. The OFT found local authorities lacked clear guidance as to how they should calculate costs and set their prices for unrefined information.58

26 A fair field and no favours

While some public bodies in some circumstances are expected to take out commercial insurance cover, there is uncertainty about the treatment of insurance costs where government self-insures. Government policy provides that notional insurance premiums should be assessed in setting fees and charges, which should remove any advantages of government self-insurance. This will be of importance, for example, in any future market testing of prison management, insurance costs having become a significant issue in this sector in recent years. But it is unclear from the available guidance whether this is merely an accounting policy or whether public bodies actually deduct a notional premium payment.59 The treatment of pensions is another area where there is concern about the lack of a level playing field. Example: NHS pensions in Scotland The Scottish Executive has determined that private sector companies bidding to provide services to public hospitals must commit to pensions contributions consistent with NHS terms and conditions (that is, GAD-certified pensions). This is aimed at ensuring a level playing field between public and private sectors. But NHS boards (the Scottish equivalent of NHS trusts) are charged a much lower rate for the contribution to the final salary pension, which means they will actually have a competitive advantage. In the case of local government, the guidance on pricing is even less specific. Under new rules, local authorities have greater freedom in the trading of discretionary services. While the Local Government Act 2003 imposes a duty to ensure income from charges does not exceed the costs of provision, the guidance is very loose – for example in relation to the time period over which this rule is to be averaged. Detailed directions and guidance on competitive neutrality are not provided.60 Debt neutrality Where services are provided by an enterprise that is government owned or controlled, there is an assumption on the part of private lenders that those loans will be underwritten by the taxpayer. This means public undertakings will be able to borrow at a preferential rate which would constitute a form of state aid in the EU. The Treasury requires that, in the interest of creating a level playing field, public sector bodies facing direct private sector competition are exposed to the same commercial borrowing rates as their private sector counterparts. This is meant to have regard to implicit guarantees and applies to public corporations operating in competitive markets, trading funds and some NDPBs.61

UK local authorities are able to provide financial assistance to trading subsidiaries either directly or in the form of performance guarantees, as long as the assistance is likely to promote the economic, social and/or environmental wellbeing of the area. While state aid rules will apply in some situations, there is concern among private sector competitors at their ineffectiveness in dealing with implicit performance guarantees – particularly in relation to armslength undertakings, joint ventures and hybrids. Example: Leisure trusts Private companies in the leisure sector have expressed concern at contracts being awarded to leisure trusts without a trading record or a strong balance sheet. When a leisure trust fails (as several have), the costs (including pension fund deficits) are underwritten by local council taxpayers. This raises questions as to whether some public enterprises are trading with an implicit guarantee of taxpayer funding. Some overseas governments also adopt a ‘capital structure policy’ to ensure balance sheets have an appropriate mix of debt and equity. Rate of return requirements Public enterprises in competition with the private sector are generally expected to earn commercial returns at least sufficient to justify the long-term retention of assets in the business. The UK has a clear policy on the rate of return to be applied to departments, agencies, trading funds, non-departmental public bodies and NHS Trusts. In the case of commercial services, the rate of return will range from 5.5% to 15%, depending on the level of risk. Departments make their own assessment of the appropriate rate for each undertaking or activity, but they are expected to take into account the market price set by competing private firms and the level of risk associated with the activity, so this has become an important tool for regulating the commercial behaviour of a significant number of government business undertakings. This policy does not apply to self-financing public corporations or local authorities. And it is principally concerned with well-developed retail markets with repeated transactions between buyers and sellers, rather than emerging public service markets characterised by periodic auctions.62 Dividend equivalence Once appropriate capital structures and rates of return have been set, public undertakings are expected to return dividends that broadly reflect private sector practice.

A fair field and no favours 27

This has proven to be a difficult policy to implement, since in some overseas governments business undertakings have been levied an annual dividend charge regardless of the underlying performance of the business. This places public enterprises at a competitive disadvantage. In the UK, trading funds are expected to pay a dividend on their equity (long referred to as their ‘public dividend capital’). Legislation passed in 1973 contemplated negotiation over the payment of dividends, but it appears that since the introduction of resource budgeting, interest and dividends are paid at a rate equivalent to the cost of capital borne by the parent department.63 Transparency of social policy There is general recognition that social programmes should be funded in a transparent way and any such funding should not compromise the underlying commerciality of government businesses. In the European Union, it is possible that the financing of social policies could fall under the umbrella of state aid. The Office of Fair Trading recently reported that even in payments to private businesses, ‘…public subsidies have the potential to distort competition’. It concluded that there was ‘scope to improve national level guidance’. We argue this advice is even more applicable to the subsidies paid to commercial public sector undertakings for the delivery of social outcomes. Example: Targeted childcare Under the UK government’s proposed new regime for childcare, services may be targeted at families with low incomes. In order to achieve this, local authorities may in certain circumstances have to rebate some of the fees or subsidise the providers. As long as the subsidy is provided on a transparent basis, and all potential providers have equal access, there is no reason why targeted care of this kind needs to be inconsistent with competitive neutrality. Equal access to government data Information that may not be available to third parties in the same form as it is to government – such as personal files, property information or geological data – should not be used by a public undertaking operating in a commercial market. There is an EU directive which deals with the re-use of public sector information which may cover this field.64 But ensuring a level playing field in terms of access to information can be a difficult process.

Example: Property information A recent OFT study on property searches recognised that delays in obtaining appointments to access unrefined property information and restrictions on the number of searches that may be made at each visit could create a competitive advantage if local authorities were not restricting their own services in a similar way.65 This is an aspect of competitive neutrality that has not been addressed comprehensively in the UK, although there is a policy on the pricing of government information and the OFT is currently conducting another study on the commercial use of public information. Among other things, this study is addressing ‘…whether public sector information holders (PSIHs) have an unfair advantage selling on information in competition with companies who are reliant on the PSIH for that raw data in the first place.’66 It is unclear whether the scope of the OFT inquiry will address the following situation (and others like it) that were brought to our attention. Example: Access to client databases A joint venture between a private firm and a government agency was given exclusive access to a confidential database containing the details of potential clients. A private sector competitor was denied the same access. This case arose during the early stages of a new market and access by the joint venture was terminated once a protest was registered. But the failure to address this issue at the outset may have given the joint venture a competitive edge at a crucial stage in the development of the market and confirms the need for a clear statement of policy in this area. Dealing with tied clientele Where public enterprises enjoy a monopoly in their traditional markets, and compete with the private sector for opportunities elsewhere in the public sector, it is possible they might use the assured income from their tied clientele in order to underwrite business risks in these new markets. The Office of the Deputy Prime Minister has recognised that one of the potential negative effects of the new local authority trading powers is that councils might take unfair advantage of their access to an existing customer base.67 Summary While the UK government has published extensive guidance in relation to some aspects of the structure and governance of public bodies engaged in market activities, significant gaps remain.

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6. International developments in law and policy While the principle of a level playing field between the public and private sectors has long been recognised, it has been of increasing importance in recent decades because of the emergence of a mixed economy in public services. In one way or another, most countries in the industrialised world have been seeking to engage the private and voluntary sectors more closely.

‘The Treaty provides for strict neutrality. It is irrelevant under Community law whether providers of services of general interest are public or private: they are subject to the same rights and obligations.’71 According to the OECD, several European jurisdictions have placed a priority on addressing competitive neutrality – in particular the Netherlands, Finland and Sweden.72

In 2004, a roundtable on market activities, organised by the Competition Committee of the OECD, investigated the concept of competitive neutrality in some detail, looking at the different approaches being adopted in different countries. The roundtable had been requested by the Netherlands and supported by the UK and Australia.68 While different countries are approaching the issue in different ways, the roundtable confirmed this is an issue of international concern.

Asia In Japan, a high-level committee appointed by the Prime Minister in 2004 investigated the adoption of a framework for market testing public services. Its proposal included the establishment of a monitoring system to ensure ‘…equal-footing between the public and private sectors’. Consideration was given to an independent organisation to monitor the implementation of this policy ‘…to ensure transparency, neutrality and fairness’.73

USA The US federal government has addressed ‘sector neutral competition’ in its recent reforms of competitive sourcing. A ‘Commercial Activities Panel’ established by the US Congress in 2001 reported that both federal employees and private firms had criticised the competitive procurement process as unequal and unfair. In the panel’s view both sectors should be treated alike, and where fundamental differences remained a policy of fair treatment was prescribed.69 Subsequent policy directives issued by the Office of Management and Budget have removed many of the remaining advantages and disadvantages for government agencies. For example, a longstanding statement that government would not compete with the private sector was removed from the policy. In-house teams were also given the authority to challenge contract award decisions. At the same time, reforms were made to ensure that in-house bids reflect the full cost of performance, and some transition costs (such as security clearances) were omitted from contractors’ prices.70 The European Union The great importance placed on competition policy in the European Union has resulted in the concept of a level playing field being given greater attention. Article 86(1) of the EU Treaty imposes an obligation on member states to ensure public undertakings are treated neutrally as compared to other undertakings. Indeed, in dealing with services of general economic interest the European Commission has used the language of competitive neutrality since at least 2001. The 2004 White Paper on Services of General Interest stated the position under European law as follows:

At least one of the provincial administrations in China is looking at Australia’s competitive neutrality framework, recognising that with such a dominant state sector, they will need to reassure domestic and international corporations on the issue of competitive neutrality if they hope to develop robust and competitive markets.74 Australia The term ‘competitive neutrality’ was first used in Australia and New Zealand in the late 1980s as governments started commercialising state-owned enterprises. The policy was originally concerned with removing the impediments to trading by government business enterprises, while ensuring these entities were not left with competitive advantages when they came to compete in the marketplace. It is for this reason that the key Australian policy documents state: • Competitive neutrality requires that government business activities should not enjoy net competitive advantages over their private sector competitors simply by virtue of public sector ownership • The implementation of competitive neutrality policy arrangements is intended to remove resource allocation distortions arising out of public ownership of significant business activities and to improve competitive processes.75 In the early 1990s, the Australian governments collectively developed a National Competition Policy, of which competitive neutrality was a significant element. In addition to laying down a clear statement of agreed principles and methodologies, this policy framework established an

A fair field and no favours 29

administrative complaints procedure, enabling aggrieved third parties to challenge government decisions. The OECD has concluded :’Overall, the implementation of competitive neutrality reforms in Australia is considered a success.’76 Significantly, Australia’s competitive neutrality policy did not mandate the creation of public service markets through competitive tendering or voucher schemes. It did however say: ‘…if governments do choose to adopt these delivery mechanisms, with the involvement of a government service provider, then competitive neutrality arrangements will apply to the government service provider.’77 In fact, because the Australian governments did not become actively engaged in the development of complex public service markets at that time, they did not adapt these principles to the somewhat different circumstances which operate in those markets. This appears to have first been done in the late 1990s by two North American authors.78 The Netherlands In the 1980s – around the same time as the Australian states were beginning to develop their thinking around competitive neutrality – the government of the Netherlands was grappling with its ‘market and government’ problem. It was found that government agencies were trading more frequently in the market in an attempt to meet funding shortfalls and they often did so with an unfair advantage. Over a five-year period from 1998, the Ministry of Economic Affairs received around 250 complaints of unfair trading and the Dutch Competition Authority around 100 such complaints. This probably understates the scale of the problem because of a reluctance to report. Since 1998, a range of solutions has been attempted. In 1998, the Prime Minister introduced rules of conduct for government trading activities, including cost allocation and the imposition of taxation and profit increments, but these were limited to central government agencies and provided no means of redress for affected third parties. A ‘Market and Government Bill’ was introduced into parliament in 2001 and sought to regulate the entry of public bodies into the market. This law would have required such bodies to conduct a formal assessment of the likely impact on the market itself and on the interests of private enterprises, of a public body entering the market. Provision was made for objections and appeals. The bill was withdrawn in 2004 due to criticism over lack of clarity and the risk of over-regulation.

A new ‘Market and Government Bill’ has since been proposed which seeks to regulate the way in which public bodies conduct themselves in the marketplace. It will impose rules of conduct as part of the Dutch Competition Act, including prohibitions on cross-subsidisation, the exclusive use of data, combining economic and administrative activities that ought to be separated, and preferential treatment for public enterprises.79 Summary Worldwide, there has been increasing recognition of the need to provide for sector-neutral competition, with a number of countries developing explicit policy statements. Australia and the Netherlands have built the most comprehensive policy regimes thus far, in both cases arising out of controversies surrounding the commercialisation of public sector undertaking in the late 1980s.

30 A fair field and no favours

7. A comprehensive approach to competitive neutrality The commitment of the UK government to fair and competitive markets is not to be questioned. In recent years, as the scale and the complexity of the interface between public, private and voluntary sectors has increased, it has undertaken a range of additional measures in an effort to ensure a level playing field. A Competition Forum established in central government to address cross-cutting issues has commissioned work on several public service markets.80 An interdepartmental ‘programme board’, chaired by the Office of Government Commerce, is currently looking at increasing competition and improving capacity planning in public sector markets. Significant work has been put into improving the procurement skills of public officials, including questions of market design. Regulatory impact assessments on new regulations likely to impact on private or voluntary bodies routinely include a competition assessment (except where such a proposal only affects public services). The Office of Fair Trading (OFT) has recently undertaken work on the impact of government procurement on competition.81 The OFT also has powers under the Enterprise Act to conduct market studies where it suspects features of the market are limiting competition – this includes the investigation of the impact of government regulation. An investigation is presently underway into the commercial use of public information, including the question of unfair advantage. These powers under the Enterprise Act are a possible vehicle whereby the government might investigate the dimensions of a competitive neutrality framework and its application to UK law and policy. But in the absence of a comprehensive policy framework, with common principles applied consistently across the entire spectrum of ownership models and a cheap and equitable means of dealing with complaints, the UK will continue to lack true competitive neutrality and the government will fail to reassure the market that a level playing field exists. The case studies and examples throughout this report provide clear evidence that much remains to be done. A formal policy framework While the basic concept of competitive neutrality is relatively simple and largely unassailable, this report has established that in practice it turns out to be a complex area of policy. Policy instruments that seemed to address the issue in its entirety – competition law and procurement processes – address only part of the problem. And while the UK

government has laid down rules and regulations aimed at removing the competitive advantages of public undertakings, closer analysis reveals that this regulatory framework is far from complete. If this has been a problem in the past, it will be more so in the years ahead as the interface between public, private and voluntary providers develops in scale and complexity. If the government wishes to ensure a fair field and no favours between different classes of provider and to provide reassurance that markets are competitively neutral, it must take steps now to develop a formal policy framework on competitive neutrality. The starting point for such a policy regime should be a statement of principle. This would be more detailed than the principles that underlie traditional competition and procurement policy, but high-level commitment to the underlying principle is essential to market confidence and would act as the foundation for a more comprehensive statement of policy. The OECD has recognised the importance of such a high-level commitment to the principle of competitive neutrality and a clear statement of policy to the success of these reforms in Australia.82 The complexity of the issues identified in this report, suggests that there is scope for a high-level investigation of the existing policy instruments currently being relied on to deliver a level playing field and their effectiveness when measured against the fundamental principles. The work of the Commercial Activities Panel in the US federal government provides a possible precedent for such a study. The Competition Forum, a quarterly meeting of senior officials established to promote competition policy and address implementation issues across government, would be the obvious sponsor for such a study. It recently funded research, commissioned through the Department of Trade and Industry and undertaken by economic consultants, into the UK prisons and social housing markets. The OFT might also be used to undertake such a review. One of the five priority themes in its Annual Plan for 2005-06 is the ‘…interaction between government and markets – eg through public procurement, regulation and public sector bodies competing with the private sector’. Objective 7 of the plan includes as one of its deliverables, to ‘…promote continuing improvement in quality of Other Government Departments’ (OGD) competition assessments by scrutinising regulatory impact assessments, providing

A fair field and no favours 31

drafting advice and educating OGDs on assessing competition impacts.’83 Finally, the government might consider publishing a comprehensive and coherent policy, covering the full range of instruments available, to ensure a level playing field between public, private and voluntary sectors. The policy should cover local and other devolved services as well as central government.

RECOMMENDATION 2 The government might consider articulating the detailed elements of a competitively neutral procurement policy, ensuring processes are fair, costing issues are addressed in an even-handed way and contract administration is non-discriminatory.

Many of the elements of such a policy are spelled out in this report.

RECOMMENDATION 1 The government might consider developing a comprehensive policy framework on competitive neutrality. This should include a clear commitment to the underlying principles of competitive neutrality, address the full range of policy instruments necessary to ensure a level playing field and cover local and devolved services as well as central government.

One way of implementing a comprehensive policy framework would be to publish guidance on competitive neutrality for central and local government agencies, and to give such guidance legal force through promulgation as a statutory code of practice. While this might be the appropriate course in some sectors, given the scope of competitive neutrality policy and the range of existing policy instruments which already cover this ground (in part), it may not offer a solution overall. Procurement policy European procurement policy is directly concerned with ensuring public sector organisations do not benefit from distortions in the design and conduct of competitive tenders for public goods and services. Bidders should be treated ‘equally and non-discriminatorily’. But this approach is not enough to address all of the competitive advantages and disadvantages enjoyed by the providers from different sectors. In particular: • Given the complexity of this area, broad exhortations to fairness are insufficient. The government needs to spell out what competitive neutrality means in relation to procurement • A procurement process which is procedurally fair may still advantage (or disadvantage) a particular ownership structure. Positive action may be required to ensure a level playing field, particularly in addressing the structural advantages of public undertakings.

Competition policy UK policy directives refer procuring authorities to European and domestic competition law, with the warning they can be taken to court for failures to comply with provisions on nondiscrimination and abuse of market power. But the authority of competition regulators is limited by the structure of public service markets: • The current policy of the OFT is that a public body engaged in procuring goods or services will not generally be considered an undertaking for the purposes of the Competition Act (and thus subject to its provisions) • Competition policy is unclear in its application to public undertakings engaged in the delivery of goods or services in response to government procurements • In any case, competition law has only limited application to public service markets, where competition is confined to periodic auctions for the right to manage a monopoly service for a period of years • The OFT recognises that the Competition Act is of limited assistance where the fundamental driver of unfair advantage is the market framework (rather than the conduct of individual participants) • The reluctance of UK companies to make complaints against government undertakings, particularly in public service procurements, means that it may not be enough to rely on retrospective enforcement of competition rules. The current state of EC case law and the Competition Act mean that there is very little that the OFT can do by itself to extend the application of competition law. But it is capable of using its powers under the Enterprise Act to conduct market studies where it suspects that features of the market are limiting competition.

32 A fair field and no favours

RECOMMENDATION 3 As part of a wider review of competitive neutrality policy, the OFT might explore ways to enhance the scrutiny of public service markets using competition law.

Regulation of market sectors In general, government should not create markets which consciously exclude or deliberately favour particular classes of provider. One of the consequences of artificial restrictions on market entry is that it may result in the development of inefficient structures that consume rather than contribute to social savings. We recognise, however, that there may be circumstances where government may wish to exclude public, private or voluntary providers, as a class, from a market. These circumstances should be rare: government should make its position clear in advance and it should do so according to clearly stated principles. Concerns have been raised in this report about the lack of a level playing field in the regulation of different classes of provider. We have also documented major inconsistencies in the way in which corporations tax, business rates and VAT apply to public, private and voluntary providers. Given the likely increase in the scale and complexity of the interface between public, private and voluntary sectors, the competition effects of the current VAT laws, in particular, might be addressed as a matter of priority. RECOMMENDATION 4 The government might address the taxation and regulation of different providers. Because of its complexity, a separate review of VAT and its application to the public-private interface may need to be considered.

Structure and governance of public undertakings There are already extensive provisions in UK law and policy dealing with the competitive advantages potentially enjoyed by public bodies by virtue of government ownership or control. But these are by no means coherent, complete or easily accessed, and are better suited to addressing competition in the wider marketplace than they are in dealing with the contest between providers bidding for public service contracts. Moreover, provisions relating to local government trading bodies are not as complete as those for central government.

There are also a number of public-private hybrids (such as leisure trusts, joint ventures and former public undertakings organised as charities and industrial and provident societies) that may be effectively controlled by government or which may benefit from tax concessions or implicit guarantees, where existing policy prescriptions do not reach. RECOMMENDATION 5 The government may wish to review the rules governing the establishment and management of public sector trading activities, both in central and local government, to ensure they are coherent, comprehensive and easily understood in delivering a level playing field.

RECOMMENDATION 6 A government inquiry into competitive neutrality might investigateits application to quasi-public bodies enjoying the benefit of government patronage, tax concessions, implicit guarantees or other unfair competitive advantages.

Enforcement and ongoing reform Reliance on enforcement of general rules after the event may not be sufficient where the problem is that government is both a competitor and the regulator. As noted earlier, there is reluctance among UK companies to launch legal challenges or to lodge formal protests and this is more of a problem for small and medium enterprises. This suggests the need for a complaints procedure which is less confrontational and onerous than the formal avenues presently available to disgruntled parties under competition and procurement law and through the case law on procedural fairness. Consideration should be given to enabling concerns to be registered in the course of a procurement, rather than waiting until a preferred bidder has been appointed. Complaints could be investigated by an existing agency of government, a government-wide body or an industry regulator established for the sector in question, or by investigators appointed to inquire into the complaint. There would be benefit in empowering such investigators to make recommendations on policy reform, rather than just making findings on the merits of a particular case. There are several precedents for these arrangements:

A fair field and no favours 33

Australia In addition to legal challenges under the Trade Practices Act and formal complaints about access to essential infrastructure through the Australian Competition and Consumer Commission, Australian governments have each established a system of administrative oversight to monitor compliance and to receive and address complaints about competitive neutrality. In general, Australian governments have established independent complaints mechanisms, although some states require the complainant to first register their concerns with the government entity in question.84 The New South Wales government, for example, established two complaints procedures, one through the State Contracts Control Board (SCCB) to deal with procurements, and another through the Independent Pricing and Regulatory Tribunal (IPART) for all others. The SCCB and IPART conduct investigations and make findings and recommendations, including ‘…the need for changes to the conduct of the relevant government business to ensure future compliance’ and ‘…any consequent policy changes that should be considered by the minister or government’.85 By way of illustration, Australian jurisdictions have heard complaints in relation to meteorological services, counterterrorist first response services at airports and wildlife centres managed by the National Parks Service. In recent years, the Commonwealth Competitive Neutrality Complaints Office (to take only one example) has ruled that: • Once its tax-free status was withdrawn, ARRB Transport Research Limited – a public company limited by guarantee whose members were the governments of Australia and the Australian Local Government Association – was not operating in breach of competitive neutrality principles. But it was noted that the sustained failure to achieve an appropriate rate of return would represent a breach of competitive neutrality principles • The Australian Bureau of Meteorology’s valued-added services to aviation were a business activity and there was no case for excluding competition from the commercialised meteorological service of the New Zealand government • OzJobs, a business division of the government’s Employment National engaged in job placement, was not operating in breach of competitive neutrality principles.

UK precedent In the mid-1990s, the Department of the Environment established a complaints procedure to enable firms to register complaints about anti-competitive conduct on the part of local authorities in the implementation of compulsory competitive tendering (CCT). The Local Government Act 1988 had introduced the concept of anti-competitive conduct into local government tendering and granted powers to the Secretary of State to act against local authorities which did not comply with the competition rules. CCT suffered from serious deficiencies and we do not support such an approach to the market testing of public services. What are of interest are the provisions for monitoring and investigating complaints of anti-competitive conduct. The largest category of complaints related to decisions to award a contract to the in-house team on the grounds of anti-competitive behaviour. In 1995 alone there were 66 such complaints, which in seven cases led to directions from the Secretary of State. European precedent The Public Procurement Network (PPN) is a quick and informal procedure allowing suppliers who feel that they have been discriminated against in a procurement in another European country to seek clarification and resolution through an informal network of central government procurement officials. Complaints lodged through this process do not have the effect of suspending award procedures. The Office of Government Commerce is part of PPN and provides access to its services. Using a complaints procedure as a driver of ongoing policy reform within the UK is consistent with the recommendations of the Wood Review – that the Internal Market Directorate of the European Commission should place greater emphasis on assessing how procurement structures and practices affect the openness of the market, and that work should be undertaken on identifying, evaluating and benchmarking structures, tools and techniques. RECOMMENDATION 7 While the legal avenues available under competition and procurement law should not be replaced, the government might introduce a less formal administrative complaints procedure, enabling public, private and voluntary sector providers to challenge public and semi-public undertakings and/or public procurement processes on the basis of unfair competitive advantage. Investigations might address both the rights and wrongs of the particular case, and also allow scope for policy recommendations, to which the government should be obliged to respond.

34 A fair field and no favours

There are a number of ways for the government to ensure these investigations are undertaken. In markets with sufficient depth, there may well be merit in the government establishing an economic regulator concerned exclusively with the particular market (similar to the bodies appointed in the electricity, water, telecommunications and postal markets). But in smaller and developing markets, market-specific regulation will probably not be the appropriate course. RECOMMENDATION 8 In some large-scale and well-developed public service markets, consideration might be given to appointing a specific economic regulator confined to that sector.

Over time, the question of what institutional arrangements are best for implementing competitive neutrality policy could well change. It is possible that in the future, competition policy might assume a greater responsibility in ensuring a level playing field (although we do not believe that it will be sufficient in the short term). Whatever structures are adopted for the implementation of competitive neutrality policy, they should be reviewed on an ongoing basis. Moreover, given

the complex issues raised in this report, we do not believe these ongoing investigations should be regarded as a substitute for the fundamental policy review suggested in Recommendation 1. Conclusion The government’s commitment to introducing a mixed economy into the provision of many public services is welcome. If this policy is implemented effectively, we have no doubt it will contribute to better outcomes for end-users. But unless the issues raised in this report are addressed, private companies will under-invest in those capabilities necessary to make a positive contribution to public service improvement. Voluntary providers will also fail to develop the commercial skills that will enable them to compete effectively. Public undertakings will not be allowed to innovate because of concerns they will capture business unfairly from other providers. Unless the government ensures a fair field and no favours, current attempts to introduce greater diversity and contestability into public service provision could well fall short of its ideals.

A fair field and no favours 35

Endnotes Many of the background documents referred to in this report can be accessed through the Serco Institute’s Resource Centre at: http://www.serco.com/instituteresource/subjects/marketdev/competneut 1

Competition Committee, OECD, Regulating Market Activities by Public Sector, Proceedings of a Roundtable on Market Activities held in June 2004, DAF/COMP(2004)36, 1 February 2005, p7.

2

‘BetterCare Group Ltd’, Decision of the Office of Fair Trading, No. CA98/09/2003, 18 December 2003.

3

Office of Fair Trading, The Competition Act 1998 and Public Bodies, Policy Note 1/2004, OFT443, August 2004.

4

Postal Services Commission, Tackling Barriers to Entry in Postal Services, March 2005.

5

John Carvel, Recovery position, Guardian Society, 26 October 2005, p5

6

ACEVO, The ACEVO Manifesto for the Next General Election, September 2004; Social Enterprise Coalition, Information on SEC’s current projects, at www.socialenterprise.org.uk

7

Sector provision of childcare in danger after changes to VAT law, Third Sector, 6 April 2005 located at http://www.thirdsector.co.uk/charity_news/full_ news.cfm?ID=14219

8

Nicholas Timmins, Health staff form companies to sell services back, Financial Times, 15 November 2005, p5.

9

10

Department for Education and Skills, Consultation on Draft Code of Practice on the Provision of Free Nursery Education Places for 3 and 4 Year Olds, 20 June 2005, located at http://www.dfes.gov.uk/consultations/downloa dableDocs/ACF3836.doc. Department for Education and Skills, Childcare Bill Consultation, 15 July 2005, located at http://www.dfes.gov.uk/consultations/ downloadableDocs/Childcare%20Bill%20Con sultation.pdf

15

See for example, Treasury Taskforce, How to Follow EC Procurement Procedure and Advertise in the OJEC, Technical Note No.2, n.d., p9; Treasury Taskforce, How to Appoint and Work with a Preferred Bidder, Technical Note No.4, n.d., par.2.2.5; HM Treasury, Procurement Policy Guidelines, Government Accounting 2000, Annex 22.2, section 3; OGC, Tendering for Government Contracts: A Guide for Small Business, n.d., p2.

16

Office of Government Commerce, Successful Delivery Toolkit: Specification Writing, 18 July 2005, located at http://www.ogc.gov.uk/sdtoolkit/deliveryteam/ briefings/businesschange/specification_writin g.html

17

BMRB International Ltd, CCT: The Private Sector View. A report on a survey of private sector firms, London, Department of the Environment, 1995, p47.

18

Alan Wood, Investigating UK business experiences of competing for public contracts in other EU countries, a report to the Chancellor of the Exchequer and Secretary of State for Trade and Industry, Office of Government Commerce, November 2004, p46.

19

Conversation with the author, 28 October 2005.

20

Alan Wood, Investigating UK business experiences of competing for public contracts in other EU countries, A report to the Chancellor of the Exchequer and Secretary of State for Trade and Industry, Office of Government Commerce, November 2004, p57.

21

Blackpool and Fylde Aero Club v Blackpool Borough Council [1990] 1 WLR, 1195.

22

Ontario v Ron Engineering & Construction Eastern Ltd [1981] 1 SCR 111.

23

In New Zealand – Pratt Contractors Ltd v Palmerston North City Council [1995] 1 NZLR 469. In Australia - Hughes Aircraft Systems International v Airservices Australia (1997) 146 ALR 1.

11

See the CBI’s report, Children First: the power of choice in children’s services, due to be launched in February 2006.

24

HM Treasury, Procurement Policy Guidelines, Government Accounting 2000, Annex 22.2, section 3.2.d.

12

BMRB International Ltd, CCT: The Private Sector View. A report on a survey of private sector firms, London, Department of the Environment, 1995; BMRB International Ltd, CCT Non-bidders. A report on a survey of the views and awareness of non-bidding firms, London, Department of Transport, Local Government and the Regions, 1996.

25

For a useful discussion of the law in this area see Nicholas Seddon, Government Contracts (2nd ed), Leichhardt, NSW: The Federation Press, 1999, Chapters 7 & 8.

13

14

European Parliament and of the Council, Coordination of Procedures for the Award of Public Works Contracts, Public Supply Contracts and Public Service Contracts, Directive 2004/18/EC, 31 March 2004, Preamble Paragraph (4). Draft Public Contracts Regulations 2006, 30(8).

26

27

Adapted from Lawrence L. Martin, Developing a Level Playing Field for Public-Private Competition, PriceWaterhouseCoopers Endowment for the Business of Government, November 1999. Commercial Activities Panel, Improving the Sourcing Decisions of the Government, final report, Washington: US General Accounting Office, April 2002, pp11-12, 82-84. Pilots have recently been authorised in the Department of Defense.

28

See for example, Public Accounts Committee, Value for Money from NSW Correctional Services, Report No.13/53 (No.156), Legislative Assembly of the New South Wales Parliament, September 2005.

29

Scottish Executive Financial Partnerships Unit, Guidance Note on Public Sector Involvement in PPP Facilities Management (FM) Delivery, September 2003, pp11, 20-21.

30

BMRB International Ltd, CCT: The Private Sector View. A report on a survey of private sector firms, London, Department of the Environment, 1995, pp82-83, but see also pp33, 38, 49.

31

Nick Aldridge, Communities in Control: The new third sector agenda for public service reform, The Social Market Foundation, 2005, p95.

32

See for example, HM Treasury, Fees and Charges Guide, Final Revised Text, March 2004, sections 7.3, 7.4 & Annex E; HM Treasury, Charges for Information: When and How, July 2001, Annex 6; Office of the Deputy Prime Minister, General Power for Best Value Authorities to Charge for Discretionary Services – Guidance on the Power in the Local Government Act 2003, November 2003, p26; OGC, Tendering for Government Contracts: A Guide for Small Business, n.d., p2.

33

Office of Fair Trading, The Competition Act 1998 and Public Bodies, Policy Note 1/2004, OFT443, August 2004.

34

Competition Commission, Group 4 Falck A/S and The Wackenhut Corporation: A report on the merger situation, Cm 5624, October 2002, par. 5.11.

35

Ibid.

36

Office of Fair Trading, Property Searches: A Market Study, OFT810, September 2005, pars. 4.56-4.57.

37

Competition Committee, OECD, Regulating Market Activities by Public Sector, Proceedings of a Roundtable on Market Activities, held in June 2004, DAF/COMP(2004)36, 1 February 2005, p259.

38

Ibid. pp23-24.

39

European Commission, State Aid No. N 264/2002 – United Kingdom. London Underground Public Private Partnership, Brussels, 02.10.2002, par.79.

40

European Commission, Draft Decision on the Application of Article 86(2)… to state aid in the form of public service compensation…, July 2005.

41

Department of Trade and Industry, The State Aid Guide: Guidance for State Aid Practitioners, September 2005.

42

Draft Public Contracts Regulations 2006, 30(8).

36 A fair field and no favours

43

Office of the Deputy Prime Minister, General Power for Local Authorities to Trade in Function Related Activities Through a Company, July 2004, pp22, 25, 26, 39.

44

Department of Trade and Industry, Financial Transparency: Consultation on the Implementation of the European Directive…, 4 March 2005.

58

Henry Hansmann, The Ownership of Enterprise, Cambridge, Mass: The Belknap Press, 1996.

Office of Fair Trading, Property Searches: A Market Study, OFT810, September 2005, pars.1.32, 4.19-4.22.

59

HM Treasury, Government Accounting 2000, 30.3; HM Treasury, Fees and Charges and Other Accruals Based Accounts: Provisions, Contingent Liabilities and Contingent Assets (FRS 12), DAO(GEN) 6/99, 20 April 1999.

45

46

47

48

49

50

51

52

53

HM Treasury, Fees and Charges Recovery Policy, Annex 1 to DAO(GEN) 13/03, 15 September 2003; Competition Committee, OECD, Regulating Market Activities by Public Sector, Proceedings of a Roundtable on Market Activities, held in June 2004, DAF/COMP(2004)36, 1 February 2005, p258.

Australian Taxation Office, ‘Manual for the National Tax Equivalent Regime’, Version 4, February 2005. National Day Nurseries Association, Day nursery fees set to rise as business rates bite, Press Release, 10 November 2004. Sixth Council Directive of 17 May 1977 on the Harmonization of the Laws Relating to Turnover Taxes, 77/388/EEC, Article 4(5). The current list is published in the Treasury (Taxing) Directions – Value Added Tax Treasury (Taxing) Directions under Section 41(2), (5) and (6) of the Value Added Tax Act 1994 – Business Activities of Government Departments, 7 June 2002. Office of the Deputy Prime Minister, Regulatory Impact Assessment: Local Government (Best Value Authorities) (Power to Trade)(England) Order 2004, July 2004, p32.

60

61

62

Cabinet Office, Non Departmental Public Bodies: A Guide for Departments, September 2004; HM Treasury, Government Accounting 2000, Section 8; HM Treasury, Financial Memorandum for Executive NDPBs, 27 March 2003.

HM Treasury, Departmental Lending to Sponsored Bodies Operating in Competitive Markets, DAO(GEN) 13.04, 5 October 2004. HM Treasury, DAO(GEN) 13/03, 15 September 2003; HM Treasury, Fees and Charges Guide. Final Revised Text, March 2004, section 7.3 & Annex D; HM Treasury, Charges for Information: When and How, July 2001, Annex 8.

63

HM Treasury, Guide to the Establishment and Operation of Trading Funds, May 2004, p36.

64

Competition Committee, OECD, Regulating Market Activities by Public Sector, Proceedings of a Roundtable on Market Activities, held in June 2004, DAF/COMP(2004)36, 1 February 2005, p211.

National Day Nurseries Association, NDNA welcomes government U-turn on deregulation, Press Release, 2 November 2005. HM Treasury, Guide to the Establishment and Operation of Trading Funds, May 2004; HM Treasury, Government Accounting 2000, Section 7.

Office of the Deputy Prime Minister, General Power for Best Value Authorities to Charge for Discretionary Services – Guidance on the Power in the Local Government Act 2003, November 2003.

65

Office of Fair Trading, Property Searches: A Market Study, OFT810, September 2005, pars.4.17-4.18.

66

Office of Fair Trading, OFT to look at supply of public sector information, Press release 139/05, 28 July 2005.

67

Office of the Deputy Prime Minister, Regulatory Impact Assessment: Local Government (Best Value Authorities) (Power to Trade)(England) Order 2004, July 2004, p32.

68

Competition Committee, OECD, Regulating Market Activities by Public Sector, Proceedings of a Roundtable on Market Activities, held in June 2004, DAF/COMP(2004)36, 1 February 2005. Commercial Activities Panel, Improving the Sourcing Decisions of the Government, Final Report, Washington: US General Accounting Office, April 2002, p39.

54

HM Treasury, Selling into Wider Markets: A Policy Note for Public Bodies, December 2002.

55

Office of the Deputy Prime Minister, General Power for Local Authorities to Trade in Function Related Activities Through a Company, July 2004, pp22-23.

56

For example, see NSW Treasury, Guidelines for Pricing of User Charges, Sydney, January 2002; NSW Treasury, Tax Equivalence Regime for Government Businesses, Sydney, June 2003; and NSW Treasury, Government Guarantee Fee Policy for Government Businesses, Sydney, July 2004.

69

70

Office of Management and Budget, Circular No.A-76 (Revised), Washington, 29 May 2003.

HM Treasury, Fees and Charges Guide. Final Revised Text, March 2004, Chapter 7;

71

European Commission, White Paper on Services of General Interest, 12 May 2004, p23.

57

72

Competition Committee, OECD, Regulating Market Activities by Public Sector, Proceedings of a Roundtable on Market Activities, held in June 2004, DAF/COMP(2004)36, 1 February 2005.

73

Council for the Promotion of Regulatory Reform, Realization of a Private-Sector Led Economic Society through the Opening of Government-Driven Markets for Entry by the Private Sector, Outline of Interim Summary Report, 3 August 2004.

74

Personal communication with the author, May 2005.

75

Commonwealth of Australia, Commonwealth Competitive Neutrality Policy Statement, June 1996, p4.

76

Competition Committee, OECD, Regulating Market Activities by Public Sector, Proceedings of a Roundtable on Market Activities, held in June 2004, DAF/COMP(2004)36, 1 February 2005, p48.

77

Commonwealth of Australia, Commonwealth Competitive Neutrality Policy Statement, June 1996, p5.

78

William D. Eggers, Competitive Neutrality: Ensuring a Level Playing Field in Managed Competitions, Los Angeles: Reason Foundation, How-to Guide No.18, March 1998; Lawrence L. Martin, Developing a Level Playing Field for Public-Private Competition, PricewaterhouseCoopers Endowment for the Business of Government, November 1999.

79

Competition Committee, OECD, Regulating Market Activities by Public Sector, Proceedings of a Roundtable on Market Activities, held in June 2004, DAF/COMP(2004)36, 1 February 2005, pp205-213.

80

Department of Trade and Industry, Public Policy: Using Market-Based Approaches, DTI Economics Paper No.14, September 2005.

81

Office of Fair Trading, Assessing the Impact of Public Sector Procurement on Competition, Report prepared for the OFT by .econ, September 2004.

82

Competition Committee, OECD, Regulating Market Activities by Public Sector, Proceedings of a Roundtable on Market Activities, held in June 2004, DAF/COMP(2004)36, 1 February 2005, p49.

83

Office of Fair Trading, Annual Plan 2005-06, London: The Stationery Office, 2005, pp.6, 25.

84

Andrew Trembath, Competitive Neutrality: Scope for Enhancement, National Competition Council Staff Discussion Paper, Canberra: AusInfo, June 2002, section 6.

85

NSW Treasury, Policy Statement on the Application of Competitive Neutrality: Policy & Guidelines Paper, January 2002, Section 4.

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