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					                                  Teresa Stewart

Logging on: Victoria’s first online auction of native
timber
Victorian Department of Treasury and Finance

August 2006




Abstract
Market based instruments are gaining increasing profile in the management of
environmental resources. Economic theory suggests these have the potential to achieve
allocative efficiency and other public policy objectives more effectively, and at lower cost,
than traditional administrative approaches. Their success, however, depends on careful,
tailored economic design. Native timber is one area in which Government has
traditionally used administrative approaches to allocate scarce public resources. In March
2006, Victorian native timber was allocated for the first time using an online auction. This
marked a substantial shift in timber policy and a significant transition for both seller and
buyers. This paper explores the design decisions, tradeoffs and implementation
requirements that were involved in conducting the first VicForests online auction, and
evaluates initial outcomes. It concludes that using this competitive approach was broadly
successful in achieving policy objectives, particularly by comparison with the previous
administered price scheme.




Acknowledgements
The author would like to acknowledge the significant assistance provided by VicForests
and the Department of Primary Industries in the preparation of this paper.

The views expressed in this paper do not necessarily reflect the views of the Department
of Treasury and Finance or the Victorian Government.
1       A new approach to allocating native timber
VicForests undertook the first online auction of timber ever held in Australia in March
2006. Sawmillers around Victoria bid for hardwood timber harvested from State forests,
using a custom designed, online auction system. The auction was highly successful,
particularly by comparison with the previous administered price scheme.

The auction was a key milestone in the transition to a sustainable timber policy, initiated
by Our Forests Our Future (2002). It marks the winding up of administrative
approaches based on historical allocations and processes dating back decades. VicForests
will use this open, competitive approach to allocate new resources as they become
available, opening up access to this scarce resource and allowing a more efficient,
innovative timber industry to emerge.

This case study outlines the process of designing the auction system, working with
industry to support transition and describes the initial outcomes of the first online
VicForests auction. It highlights the many design decisions, tradeoffs and implementation
requirements that are involved in conducting a successful competitive allocation process.
Importantly, it demonstrates the feasibility and value of changing how Government
allocates natural resources, to achieve better outcomes for the whole community.

•   Section 2 briefly places the auction in context of the broader allocation problem,
    policy context and the role of VicForests in developing an auction for the sale of
    native timber, including auction objectives.

•   Section 3 discusses the design of an appropriate property right, allocation instrument,
    auction system and supporting processes.

•   Section 4 discusses the outcomes of the first auction of native timber, and identifies
    opportunities for further enhancing outcomes over time.


1.1 The challenge for Government

State forests, and the resources within them, belong to the Victorian community. They
produce commercial products (such as mining, timber and tourism), provide recreational
and cultural opportunities and play an important role in the health of other resources,
including clean air, water and biodiversity. The Victorian Government oversees the
management of State forests, with the objective of maximising the value to the whole
community from their use. This involves balancing alternative uses of forests and ensuring
that their use is sustainable.

The use of an auction, or a ‘competitive allocation approach’, signals a major change to the
way government manages an important natural resource. The VicForests online auction is
an important tool and milestone in a broader policy context. Constructing this broader
framework has involved:

•   Determining how much timber to allocate to different uses over time

    o     How much should be retained for the environment?


                                            -2-
    o    How much timber should be allocated for commercial uses?           What is a
         sustainable level of harvesting?

•   Determining how to allocate available timber resources among commercial users

    o    Who will gain access and at what price?

    o    How will this be determined?

•   Determining how the value of timber should be allocated between commercial users
    and the broader community

    o    What is an appropriate return to the community for harvested timber?

•   Managing the transition from an administrative to a competitive framework.

This paper focuses on the mechanism selected and implemented, or how timber is
allocated amongst commercial users.




                                          -3-
2          Background

2.1 Users of harvested native timber

Potential users of harvested native timber include existing industry participants and new
entrants from Victoria and interstate. Currently around forty firms buy native timber in
Victoria, predominately sawmillers and processors. These are located around the State,
reflecting the historical and current location of forest resources. Victorian sawmillers are a
diverse group, ranging from large commercial operations to small family businesses. These
operations receive and process harvested sawlogs in various ways. Higher grade sawlogs
are sawn, dried (typically air and kiln dried), reconditioned and finished into products
such as boards, floorboards, architraves and mouldings. Demand for these products, and
therefore for sawlogs, is primarily driven by building activity, particularly building
alterations and additions. Lower grade sawlogs are processed into pallet timbers.

The total number of firms processing native timber in Victoria is expected to decline over
time, as the sector responds to declining volumes of available timber, increasing
economies of scale in production and growing competition. Future users could also
include new operations located in Victoria, or in other states (notably New South Wales).


2.2 Available resource: How much timber is made available for harvesting?

Victoria has around 3.4 million hectares of State forest, located primarily in the North
East and East of the State. Around 20 per cent is potentially available for commercial
harvesting over an 80 to 100 year cycle. Over a fifteen year period, the Victorian
Government allocates around three per cent of State forest (or around 1.5 per cent of total
forested public land) for commercial harvesting. Approximately 0.2 per cent will be
harvested and eucalypt timber products allocated to the private sector for processing each
year, before being regenerated.

Victorian native timber is sold primarily as sawlogs and pulpwood. Sawlogs are sold by
grade, depending on diameter, length, defects and other features. These are suitable for
processing into boards for use in structural applications (for example, architectural beams)
and appearance products (such as flooring, furniture and joinery). Pulpwood refers to
lower quality logs generally not suitable for sawn processing and used to make wood pulp
for paper, or exported as hardwood chips. The first VicForests online auction allocated
hardwood sawlogs.


2.3 The allocation of native timber in Victoria: How is timber allocated amongst
          commercial users?

The allocation of native timber among commercial users has historically occurred through
an administrative process.1 Sawmills were issued licences to harvest specified volumes of
timber from particular areas of state forests. Volumes received were largely historically



1
    Or more recently, through sealed bid tenders


                                                   -4-
determined, and negotiated with little or no contestability for the resource. License
holders paid a fee on these licenses as well as royalties on sawlogs.2

Our Forests Our Future (2002) outlined a new framework for the sustainable future of
Victoria's native forests and the timber industry. A key component of this new framework
was a shift to open, market based pricing and allocation of timber.

This shift recognised the inadequacies of an administrative approach in achieving an
efficient allocation of resources. The main advantage of a competitive approach is its
ability to bring together information held by diffuse market participants, and use it to
allocate resources efficiently. For example, Government does not know how much native
timber is ‘worth’ to the many individual users who might value it. Through a competitive
bidding process, bidders who can create the greatest value from native timber will be
revealed and resources allocated to them. Auctions can also allocate resources more
quickly and transparently than alternative approaches, and produce better financial
outcomes for the seller.

VicForests was established to manage the sustainable harvest and commercial sale of
native timber. This separated the management of native forests, or decision about how
much timber is allocated to commercial uses (managed by the Department of
Sustainability and Environment) from the process of allocating timber between
commercial timber firms to maximise financial return.

2.3.1     The role of VicForests

The role of VicForests is to allocate available native timber to maximise commercial
return.3 It is required to harvest timber within sustainable limits, and in a way consistent
with other policies of the Victorian Government.

Under the Sustainable Forests (Timber) Act 2004 and Allocation to VicForests Order 2004,
VicForests is allocated timber within certain Forest Management Areas (FMAs)4 to harvest
and/or sell.5 VicForests can sell forward contracts for timber supply of up to ten years,
based on estimates of the volume and quality of timber which will be harvestable from
allocated stands.

Under its establishment order, VicForests was required to develop a competitive sales
system for timber resources.6 VicForests announced the Pricing and Allocation Model for
the Sale of Public Native Timber Resources in May 2005. This sales model confirmed that
VicForests would see forward timber supply contracts (of up to ten years) in open,
competitive auctions from 2005–06 onwards.


2
  Royalty rates incorporated various factors, including costs of production, the standard proportion of log that could be
utilised for timber of different species and grades, and market prices for different uses. These rates were set with an
objective of ensuring that ‘the sum of royalty and transport costs involved in placing a base grade of timber on a defined key
market [was] the same for all operations accessible to that market’ (Victorian Timber Industry Strategy, 1986).
3
  VicForests is a government business enterprise governed by an independent Board of Directors.
4
  The Forests (Timber Harvesting) Act 1990 divides Victoria into 14 FMAs. Lots were drawn from seven of these FMAs, in
the North East, South and West of the State, which individually contain areas of State forest ranging between approximately
57 000 and 580 000 ha.
5
  The Allocation Order defines the maximum harvestable area of forest stands in the 15-years of the order (2004 – 2019).
6
  State Owned Enterprises (State Body – VicForests) Order 2003


                                                            -5-
2.4 Auction objectives

In developing a competitive allocation system, VicForests sought to maximise the value of
harvested native timber resources. In doing so it implicitly pursued a number of
objectives, including:

•      Allocative efficiency: Ensuring that harvested timber ended up in the hands of the
       bidders who value it most highly. In this way, the resource is allocated to its most
       valuable uses and the total benefit to the community is maximised.
•      Sustainable competition: This objective is closely related to allocative efficiency. It
       requires that the allocation framework provides for ongoing competition for the
       resource over time, including fostering an industry with multiple, competitive
       players.
•      Industry participation: Facilitating the effective participation of a wide range of
       participants, including operators of various sizes and locations and new entrants.
       Working with industry to manage the transition to competition was also a key
       component of the Victorian Government policy move towards sustainable allocation
       of forest resources. This objective was subject to the management of other important
       risks, notably the need to ensure that winning bidders were ‘fit’—financially and
       operationally—to enter into supply contracts.
•      Revenue maximisation: Ensuring that the Victorian community realised a fair
       financial return for scarce native timber resources, or maximising the financial
       return on resources sold. This objective was subject to other objectives and relevant
       government policies (for example sustainable forests management).7
•      Process efficiency: Ensuring that the process efficiently allocated resources to those
       who valued them most highly, minimising associated administration and
       participation costs.
•      Transparency and fairness: Ensuring that resources were allocated in a way that was
       objective, fair and transparent. As well as supporting an efficient allocation, this is
       critical to the perceived fairness of the process. This perceived fairness underpins the
       support and confidence of participants, government and the broader community in
       the allocation system.

While it is useful to separate these objectives for discussion, they are interrelated and, in
some cases, somewhat contradictory. The appendix discusses these objectives, and links
between them, in detail. Table 2 summarises auction objectives and desired outcomes.




7
  Allocative efficiency and revenue maximisation are largely consistent, since in an efficient auction the bidder who values a
lot the most wins. They are not necessarily equivalent however: while allocative efficiency requires that resources be held
by the bidder who values them most highly, commercial return depends on the price at which this transfer occurs. The
latter is a question of how value, or ‘economic rent’, is distributed between the bidder and VicForests


                                                            -6-
Table 1 Objectives of the VicForests online auction

Objective       Desired outcome            Auction design should…

Allocative      The value of harvested     - Competitively determine prices
efficiency      native timber to the       - Allocate resources to the highest bidder
                Victorian community
                                           - Support broad and effective participation
                is maximised
                                           - Provide capacity      to   aggregate     the   resource
                                             effectively
                                           - Provide for sincere and productive bidding

Sustainable     The resource is subject    - Deter collusion      and    other      anti-competitive
competition     to ongoing                   behaviour
                competition over time      - Minimise scope for excessive market power
                                           - Support broad and effective participation
                                           - Provide appropriate security of tenure

Industry        Parties who value the      - Minimise direct costs of participation
participation   resource are able to       - Minimise costs of uncertainty
                contest it effectively
                Costs of transition are
                minimised

Revenue         Fair market value is       - Maximise financial return, subject to other
maximisation    realised for scarce          objectives and policies (e.g. sustainable harvest)
                resource.                  - Effectively manage other business risks

Process         Processes for allocating   - Provide for sincere and productive bidding
efficiency      the resources are          - Quickly and efficiently ‘discover’ market prices
                efficient
                                           - Minimise costs to the buyer
                                           - Minimise costs to the seller

Transparency    Government, industry       - Treat all bidders fairly and equitably
and fairness    and community              - Provide complete and clear information to all
                confident the                parties
                allocation process is
                                           - Allocate resources transparently
                fair
                                           - Provide a mechanism to resolve disputes




                                                -7-
3       Designing an effective auction for native timber
Public policy allocation problems do not typically lend themselves to simple or ‘off the
shelf’ allocation models. The process of designing a tailored allocation approach requires
consideration of a complex range of specific policy, economic and institutional
characteristics and development of a deliberate and tailored solution (or ‘economic
design’).

Deficiencies in economic design can result in outcomes which do not achieve, or which
even undermine, the objectives of the allocation. These may include an inefficient
allocation of resources, unfair or anti-competitive behaviour, forgone revenue and loss of
industry and public trust and confidence. For VicForests, this process included a number
of key elements:

•   Property right design: Defining ‘what’ would be sold
•   Instrument design: Designing the mechanism, or ‘how’ property rights would be sold
•   Auction infrastructure: Creating a system to implement the property right and
    instrument
•   Implementation processes: Creating processes to support development and
    implementation.

In each of these stages the objectives of the auction and other specifics of the policy
problem shaped the design choices made. While this paper focuses mainly on instrument
design, choices are in all of these areas discussed below.


3.1 What should Government sell? Property right design

Property rights provide the underpinning framework for an allocation of resources.
Designing a property right involves defining precisely what the government will sell (or
buy). Key elements of property right design for the auction of timber included:

•   Designing a generic property right, or the common structure of auction lots.

•   Developing the auction catalogue—determining the specific resource to be sold in the
    March and subsequent auction events.


3.1.1    Designing the structure of lots

Designing the form or structure of lots involved identifying the attributes which would
define lots, defining associated rights and obligations, and developing the legal institutions
to enforce them.

The defined attributes of a property right are important in shaping how participants value
the resource (see Box 1).




                                             -8-
    Box 1 Defining the attributes of the property right
    A property right refers to a bundle of legal rights or entitlements over the use of a
    resource. The types of property rights or entitlements conferred by government vary
    widely. For example the Victorian Government allocates rights to:
    •    Use public natural resources such as forests (and other public land), water, minerals
         and fish stocks
    •    Undertake certain activities, such as practicing particular professions (for example,
         medical practice), or providing services (for example, electricity generation, taxi
         services or liquor retailing)
    •    Provide goods or services to government, such as transport, stationary or uniforms.
    The attributes of a property right can be specified in many ways. Examples of common
    attributes include quality, quantity, location, tenure and transferability. These types of
    attributes can have an important impact on how the resource is valued, and how
    efficiently it is allocated.
    Bidders attach different valuations to different attributes of a resource, depending on
    their individual preferences and risk profiles. The way that these attributes are packaged
    and described consequently affects how bidders can realise (and judge) this value. In
    general, the described characteristics or specifications of the resource should include any
    attributes that bidders are likely to place differing valuations on, so that they can
    assemble and bid on resources that maximise their individual value. Similarly, lots are
    ideally constructed in small bundles (as is feasible, with regard to the costs of selling,
    buying and administering lots), to maximise the flexibility of bidders in accessing the
    resource they value.
    A key step in designing appropriate lots is consultation with industry and market
    participants to determine potential requirements. In doing so it is important that both
    the needs of existing customers and potential new entrants are considered. Section 3.4
    discusses the processes that supported this consultation.


The auction primarily allocated supply contracts for delivered logs.8 That is, the State
offered access to a quantity of harvested timber, with this access right defined by a
contract. Successful bidders purchased contracts for the supply of a specified volume and
type of timber logs, over a particular period. VicForests manages the harvesting of this
timber from State Forests, and its transportation to the ‘mill door’ of successful buyers.
This is in contrast to the previous operational model, which primarily sold timber at the
‘stump’. These stumpage sales involved VicForests selling an entitlement for buyers to
extract and transport specified timber from the forest.

The property right design has important implications for how a resource is allocated and
used, including the allocation of risk. For example, an alternative form of property right
would be to allocate access to a specified area of forest, leaving bidders to assess the likely
volume and quantity of yield prior to bidding. This would shift risk for variations in actual
harvest from the seller to the buyer, dealing with the resource ‘information problem’ (i.e.


8
    The majority of future sales of sawlogs under VicForests’ price allocation model will be mill door delivered sales.


                                                                -9-
difficult to know exactly what the resource yield will be) and distributing risk in a
different way.

VicForests mill door supply contracts are defined by supply zone, timber grade (quality)
and species, annual contract volume and contract length (or tenure). The specification of
FMA supply zone, species and grade was designed to be consistent with existing supply
contracts, to assist bidders in assessing the value of timber. Table 2 outlines attributes of
VicForests auction lots, and implications for how bidders generally value them.

Table 2 VicForests auction lot attributes and implications for value

 Specification   Details                    Implication for value
 Supply zone     Geographic area from       - Determines individual haulage costs for each bidder
                 which logs would be          for that lot.
                 provided, typically a      - Provides some information about likely species and
                 FMA.                         quality of timber.

 Timber          Group of Eucalypt          - Implications for the quality and potential value of
 Species         Species (Ash or Mixed        the timber:
                 Species)                      o Ash (alpine, mountain and shining gum) species
                                                 provide the most valuable timber.
                                               o Mixed species (mixture of stringybark eucalypts
                                                 with others, including gums, peppermint or
                                                 silver top) are of lesser value.

                 Species of Eucalypt        Some lots were additionally specified at species level
                                            (for example alpine ash, mountain ash, messmate or
                                            silver top).
 Timber          The grade of timber (B,    Logs are graded according to diameter, the presence of
 Grade           C, D or E)                 defects (for example, rot), colour, grain and
                                            straightness, which affect the value realised from the
                                            processed timber. B grade logs are of the highest
                                            quality and are the most highly sought after, while E
                                            grade logs have the lowest ‘recovery’.
 Contract        Volume of timber (gross    Contract volumes in the March auction varied from
 volume          m3) that will be           500 cubic metres up to 45 000 cubic metres.
                 supplied for that lot
 Contract        The entire period of the   Contract lengths varied between one and nine years.
 length          supply contract for that   While short term contracts may be valued as a means
                 lot                        to adjust short term operations, long term contracts are
                                            typically preferred, providing greater certainty to
                                            operators about future supply.
 Contract        The start and ending       Transition from the existing license system means that
 timing          years of the supply        bidders have existing entitlements that cease at
                 contract                   different times (up to 2015). Bidders attach value to
                                            supply contracts based in part on how they fit in with
                                            supply flows from these (and potentially other)
                                            sources.




                                               - 10 -
The specification of attributes of lots affected the value attached to them. Customer
feedback and the return realised on different lots demonstrated this influence. For
example, VicForests chose to specify the area from which timber would be supplied
mostly at a FMA level. This aggregation allowed VicForests to manage operational risks
associated with uncertainty in current resource data and changes in the resource over
time—that is, risks around whether VicForests would be able to meet future supply
contracts sold at auction. Existing bidders, however, had been accustomed to knowing
what district (a smaller area) timber would be harvested from and could arguably infer
more information about the likely quality of the product they would receive at this level.
Aggregating this information in a broader geographic region may have reduced the
information held by individual bidders about the value of given contracts, and could be
expected to discount their bids to account for this uncertainty.

Future specifications of lots could also incorporate other dimensions of log value.
Specified log radius (more specific than grade ranges), for example, would provide bidders
with more information about the likely ‘recovery’ of high value timber products from
logs. While adequate resource data was not available to incorporate this specification for
2006 auctions, VicForests may do so for future allocations. This is with a particular view
to facilitating access by interstate bidders.

3.1.2   Formalising property rights: contract design

Contract design provides the legal basis for property rights. All VicForests supply
contracts were governed by common Terms and Conditions, specified and provided to
bidders prior the auction. These outlined in detail the obligations and rights of the buyer
and VicForests, including supply and payment terms, liability, and safety and
environmental compliance standards. Key features of these contracts included the
requirement that timber processing occur in Australia (discussed in Section 0) and
provision for secondary trade.

Permitting the transfer of supply contracts creates a secondary market for the resource.


Box 2 A secondary market exists where previously assigned entitlements are traded—that
is, where property rights are purchased from other investors, rather than from the issuing
body (i.e. VicForests). A secondary market supports allocative efficiency by allowing for
corrections in the initial allocation of resources, and allowing resources to move as
circumstances and valuations change over time. The existence of a liquid secondary
market is often very important in shaping the risk associated with purchasing an
entitlement, and therefore how much bidders are willing to pay. (Black, 2002, p. 417)


The existing secondary market is essentially informal (largely bilateral negotiations
initiated through local contacts or advertising in local journals) and can be expected to be
inefficient relative to an open process with many bidders. VicForests will facilitate more
efficient secondary exchange in future by reselling resource on behalf of bidders, as part of
regular auction events.




                                            - 11 -
3.1.3        Developing an auction catalogue

The ‘auction catalogue’ specifies what resource, bundled into a number of separate auction
lots, will be allocated in a given auction event. Development of a catalogue for the first
auction involved developing a strategy for how VicForests would release available native
timber over time.

Within the parameters of the overall resource available (separately determined by the
Allocation Order and existing licence commitments), VicForests retains significant
discretion as to the ‘profile’ of supply contracts sold. Key issues in designing this profile
included the extent to which future supplies of timber would be ‘forward’ sold, and the
mix of short and long term contracts to be provided. Factors considered in determining an
appropriate profile of contracts included:

•        Need to manage VicForests supply risk: variability in estimated and actual volume
         and quality of timber harvested from allocated stands, which become increasingly
         pronounced as allocation and harvest times diverge
•        Strong industry preference for longer contracts and greater certainty about future
         resource availability
•        Providing for ongoing contestability for the resource, including facilitating access by
         new entrants, over time.

The model chosen by VicForests includes a mix of long and short tenure contracts, and
short term and long term (or forward) supply sales. The auction catalogue included 47 lots
and 174 100 cubic metres of timber. This relatively small volume, and the range of lots
offered (for example, one from every FMA) was designed as a ‘pilot’—an opportunity for
industry to participate in a real bidding process, but without the first auction outcome
being ‘make or break’ for any sawmills. Subsequent auctions (including events in May and
June 2006) were larger (more than half a million cubic metres each), with an “emphasis on
providing more security into the future” for industry.9


3.2 How should Government sell? Instrument design
Instrument design involves determining how a resource will be sold. For VicForests, this
involved determining what type of auction, or ‘auction architecture’, was most
appropriate. For example, an auction may be:
•       Open or sealed
•       Ascending (highest price accepted) or descending (lowest price accepted)
•       Sequential (one item sold at a time) or simultaneous (everything sold at once)
•       Combinatorial (package bids).

This choice will depend on the nature of the resource, the design of the property right,
characteristics of the market and policy objectives. Key features of the first VicForests
auction are summarised in Box 3. This Section describes selected elements of the
VicForests auction instrument further.


9
    David Pollard, VicForests Media release, 3 April 2006, Local winners in first online timber auction


                                                              - 12 -
     Box 3 Key characteristics of the VicForests Online Auction
     •   Open: All participants could see bids as they were submitted and fashioned their
         own bids accordingly.
     •   Ascending: Bids of increasing size were submitted until no bidders were willing to
         submit a higher bid and lots were awarded to the highest bidder.10
     •   Partially simultaneous: All lots were put up for bidding at the same time, but closed
         at different times.
     •   Non-continuous: Bidding took place in multiple, predetermined activity rounds,
         between which all bidding activity was suspended.
     •   Non-combinatorial: The first auction did not allow package bidding.
     •   Online: Bidding occurred via an electronic, online platform.

3.2.1      Open: all bids seen by all bidders

The VicForests online auction was open—all participants could see bids as they were
submitted, and fashioned their own bids accordingly. In a closed or ‘sealed’ auction,
bidders submit confidential bids and the winning bids are revealed at the end of the
auction.

This approach was designed to support allocative efficiency and revenue maximisation by
allowing bidders to learn about the valuations of other bidders during the auction,
increasing the certainty with which they could judge the value of different lots and giving
them greater confidence to bid aggressively up to their willingness to pay. By contrast, a
traditional sealed bid auction does not allow this learning to occur, and bidders are likely
to submit more cautious bids in order to mitigate the risk of overpaying (or ‘winner’s
curse’).11

An open auction also supports the achievement of process transparency, since the auction
rules clearly establish the basis on which lots will be awarded. By contrast, an
administrative process can involve assessment against multiple, subjective criteria. Section
4.6 discusses this further.


3.2.2      Partially simultaneous

Multiple lots of native timber, each with a separate price associated with it, were sold
simultaneously, with bidders able to bid on any of the items. Bidding activity on all lots
commenced at the same time and progressed in rounds until the auction closed.




10
   Auctions may also have a descending price format. In this case the auctioneer sets a high price and progressively reduces
it with the first bid winning.
11
   The Winner’s Curse refers to the likelihood that the highest bidder in an auction has overestimated the true value of the
item won. Where bidders place similar value on an item, but are individually uncertain of its value, and assuming that
bidders are, on average, estimating value correctly, the bidder with the highest value estimate is likely to have overpaid.
This risk induces rational bidders to discount (or ‘shade’) their bids (Chan et al, 2003, p.xi)


                                                           - 13 -
VicForests selected a simultaneous auction because the lots were variously
complementary or substitutable (see Box 4). This relationship between lots meant that
bidders needed information about the price of different lots at the same time, in order to
bid confidently for those that interested them.


Box 4 Substitutable and complementary lots
Two lots are substitutable where a bidder is, to some extent, indifferent between them:
the bidder could use either lot instead of the other. For example, a particular sawmill
might require a single lot of C grade timber, but be able to use any of the C grade timber
in the auction catalogue.
Lots are complementary where their value depends, to some extent, on packaging them
together. For example, a bidder might only be able to use a particular lot if they were able
to combine it with other lots of a certain size (to achieve economies of scale in processing)
or different grades or species.

Simultaneous sale allows bidders to observe this information and bid accordingly. For
example, for substitutable lots, simultaneous sale allows bidders to move their attention to
alternative lots if others become too expensive for them. By contrast, if lots were sold
sequentially the bidder would be forced to bid in each auction without knowing what
would happen in subsequent auctions. If the bidder bids aggressively on early lots they
risk paying too much, as later lots could be cheaper. Alternatively, if they let suitable
wood ‘go by’, they risk being outbid on later lots and ending up with none, despite having
been willing to pay more than early sale prices. Similarly, where lots are complementary,
in bidding on the first of these complementary lots the bidder faces the risk that they will
fail to win the other, and will be ‘stranded’ with resource of lesser value on its own.12

These uncertainties make bidding more difficult and risky. This can both undermine the
efficient allocation of resources and reduce revenue, as bidders discount their bids to
account for additional risk. A simultaneous auction mediates these uncertainties by
providing more market information to bidders to inform their bidding.


Box 5 Simultaneous auction and bidding complexity
Bidding complexity is a risk often perceived as associated with a large, simultaneous
auction. That is, bidders potentially have to respond to bidding activity on a large number
of lots with different characteristics, values, substitutes and complementarities, making
real time assessment of strategy difficult. In fact, experience from other applications
suggests that bidders will focus on only a subset of items, narrowing the set of lots a
bidder will have to watch. The auction design did include a number of measures to
mediate the risk of excessive complexity however.




12
   The secondary market, as discussed in Section 3.1.2, could be expected to move this allocation towards allocative
efficiency. Secondary markets can be inefficient: often being thin and unstable and with relatively high transactions costs
and uncertainties. For these reasons a secondary market is unlikely to address adequately major inefficiencies in the initial
allocation (Charles River Associates (Asia Pacific) Ltd, 2001, pp. 17-18).


                                                           - 14 -
First, pauses between activity rounds, during which all bidding was suspended, allowed
bidders to survey all activity and reassess their strategies.
Second, bidders registered for those lots they were interested in bidding for prior to
auction. Only these lots appeared on an individual bidder’s screen, reducing the amount
of information they had to interpret.
Finally, the online bidding system was designed to make it as easy as possible for bidders
to quickly assess the status of lots, through a colour coded dashboard (discussed in Section
3.3).

Unlike some simultaneous auctions, bidding activity did not remain open on all lots until
the end of the auction. Rather, lots were awarded to the lead bidder on that lot after one
activity round in which no counter bids were submitted. This format was selected to
ensure that the auction quickly progressed towards resolution.

Importantly, this approach limited the extent to which the auction was simultaneous.
Bidders could not substitute among lots once they were awarded. For example, if outbid
on their most preferred lots, a bidder could not redirect their bidding to less preferred,
cheaper lots if those items (having had no bids for one round) had already been awarded.
In this way, this approach selected by VicForests represents a balance between the
preference to award lots quickly and the objectives of allocative efficiency and revenue
maximisation.

3.2.3   No combination bidding

A simultaneous auction does not completely resolve the risk of ‘stranding’ where there are
complementarities between lots. The capacity for bidders to move between bidding on
different lots gives them some flexibility to bid simultaneously on lots to aggregate
complementary packages. However, it does not entirely remove the risk that a bidder will
end up winning some but not all of the required items. This uncertainty makes bidders
less likely to bid aggressively, and implies that allocative efficiency could be enhanced if
bidders were allowed to bid a single price on one or more packages of assets.


The ‘exposure’ or ‘stranding’ problem refers to the risk that a bidder will win some, but
not all, of the lots they need to achieve the package value, ending up stranded with items
that are not individually valuable (or as valuable).

Combinatorial auctions can resolve this risk. Combinatorial auction (or package or ‘smart’
auctions) are simultaneous auctions in which bidders can submit a single bid for the
collection of goods, services or resources they wish to buy, rather than submitting bids on
each item separately. The auction system computes the set of these combinations or
packages that maximises value (for example, revenue) to the auctioneer in real time. A
combinatorial auction was used by the Victorian Department of Primary Industries to
allocate new Crown leases for aquaculture fisheries reserves in Port Phillip Bay in June
2006 (see Box 6).




                                           - 15 -
The first VicForests Auction did not use a combinatorial format. This was due in part to
the additional complexity for the system (computation) and for bidders. A partial package
feature was used for a second auction. This is discussed further in Section 4.1.3.


Box 6 Combinatorial auction of aquaculture fisheries reserves
In June 2006 the Victorian Government offered eighteen Crown site leases for
aquaculture for sale, located in across Port Phillip Bay and Western Port.
Bidders participated over the internet, using an electronic bidding system designed by
Professor Charles Plott of the California Institute of Technology. The system allowed
bidders to place bids on packages, or ‘combinations’, of items. These were ‘all or nothing’
bids—the bidder either won the entire combination of items at the nominated price, or
they won none.
The auction system incorporated this combinatorial feature due to perceived synergies
between the sites. By organising portfolios of sites, with specific profiles of characteristics
such as tide, nutrients, predators, wind, distance to port and production levels bidders
could maximise the value of the sites to their business. For example, additional value
could come from diversifying business risks (for example, the risk of loss through disease
or inclement weather) or achieving production thresholds that minimise their costs
(economies of scale).
Bidders were able to create combinations at any time during the auction. Other bidders
could see these as they were created and, through bid signals, coordinate to compete with
large package bids.


3.2.4     Reserve prices set and disclosed

Bidding started at a reserve price for each lot set by VicForests prior to the auction. If no
bids were received at this reserve the price would automatically and progressively reduce
down to a floor price. Reserve prices are a key means by which VicForests could ensure
that it collected a reasonable share of the value of the resource (or achieved the objective
of revenue maximisation). By having a reserve price for an item, bidding competition is
increased and VicForests captures some of the benefit that would otherwise go to the
winning bidder (Chan et al, 2003, p.21). It also improves the pace of the auction, reducing
process costs for seller and bidders.

Importantly, a reserve price also indicated VicForests’ minimum willingness to sell. This is
significant both in terms of covering costs associated with harvest, haulage and
administration, and to express community values attached to the allocation of a scarce
resource—harvesting and selling native timber for next to nothing was unlikely to be
acceptable.13 VicForests set reserve prices relatively low; mitigating the risk that
excessively high starting price would discourage participation and block an otherwise
profitable sale.




13
   Where there are significant uncertainties about the value of a resource, for example, an new resource (such as radio
spectrum), a reserve price may also provide additional information to participants about its likely value


                                                        - 16 -
3.2.5     Fixed auction close

Bidding was structured into ten, prescheduled activity rounds (two each day for five
days). Between activity rounds all bidding activity was suspended. These breaks were
intended to allow bidders to analyse bidding activity on different lots, and to adjust their
bidding strategy accordingly. The perceived complexity associated with bidding on
multiple heterogeneous lots in a simultaneous auction (discussed in Box 5) was a key
factor in the inclusion of this measure.

Like the activity rounds, the end of the auction was scheduled prior to the
commencement of bidding. While there was some provision for the triggering of an
extension to the tenth and final activity round only one such extension could occur, and
this period lasted for a set period. 14 At the end of the final activity round, plus this
specified extension period (if triggered) the auction finished. An alternative to a ‘fixed
end’ would be to have the close of the auction partially or entirely dependent on bidding
activity. For example, many auctions have used auto-extend options, which keep the
auction open for a specified period after the submission of a bid (See Box 7). A fixed
auction close was selected to provide certainty about the resolution of the auction, for
both seller and bidders.

A risk associated with an ascending bid auction with a fixed end is that bidders adopt a
‘wait and see’ approach, not bidding competitively until the final stages of the auction.
This compromises the revelation of price information throughout the auction and
increases the potential of congestion and ‘sniping’ near the end of the auction. Sniping
occurs where bidders enter a high bid as close as possible to the end of the auction, in the
hope that others will not get the chance to counterbid before the auction closes.

 Box 7 Common examples of different closing rules

 •      EBay.com: This well known auction site uses a pre-scheduled or fixed closing rule.
        Sellers nominate a listing end date and time, and all valid bids before this time are
        accepted. As a result EBay bidders commonly try to ‘snipe’ each other, submitting
        bids in the last seconds of the auction so that other bidders have no time to
        counterbid.

 •      TradeMe.co.nz: Unlike EBay, this New Zealand based auction site allows sellers to
        select an ‘auto extend’ option. In an auto extend auction any bids placed in the last
        two minutes of the auction will extend the closing time for two minutes. That is, the
        auction will not close until two minutes have passed with no bids being submitted.
        This prevents bidders being outbid without having opportunity to respond with a
        counterbid.


3.2.6     Activity rule

To try and account for this ‘wait and see’ behaviour, the VicForests auction used an
activity rule. This required bidders to bid in every activity round to remain eligible to bid,


14
   In the case that a ceiling bid was submitted in the final round. Bidders had the option of nominated ‘ceiling bids’ on any
lot in any of the activity rounds – these would be automatically submitted at the end of the round if above the target bid.


                                                           - 17 -
making it more likely that the market would approach the true willingness to pay of the
highest bidder during the auction. It does not entirely mediate this problem however—
sniping could still be a problem at the close of the final round or extension period.

A key disadvantage associated with the activity rule is that it limits the extent to which
bidders can move their bidding focus among different lots as the auction progressed (as
they were not eligible to bid for a lot for which they have not been consistently active). It
also risked leaving bidders overexposed at the end of the auction. For example, if a bidder
wished to secure one of two substitutable lots, the activity rule provides incentive to start
bidding on both, to ‘keep their options open’ in the case that they were knocked out of
bidding for one. If that did not occur however (for example, if competition was
unexpectedly low) the bidder could end up purchasing more than they intended. To
reduce these effects, as bidders were knocked out of bidding for some lots they would be
‘reactivated’ on other lots which had not yet been awarded. To some extent, this allowed
bidders to shift bidding to less preferred lots as they dropped out of competition for
others. This feature was limited to lots which remained open, and depended on ‘lot
preferences’, nominated by bidders prior to the auction, which determined which lots
were reactivated for a given bidder.

3.2.7   Eligibility to participate restricted

Potential bidders were required to be ‘qualified’ prior to participating in the VicForests
auction. This is a common measure taken to mitigate business risks associated with
allocating contracts at auction, notably the need to ensure that winning bidders were
‘fit’—financially and operationally—to enter into supply contracts with VicForests. This
qualification process included an assessment of financial viability (by an independent
assessment agency) and any conflicts of interest. The qualification process also required
potential bidders to agree to the terms and conditions of the auction and any resulting
contracts.

Other Victorian Policy requirements also governed eligibility to participate, including
requirements that:

•   Timber sold under the new allocation framework be processed in Australia
•   Direct recipients of the Voluntary Licence Reduction Packages be excluded from
    participating in VicForests’ auctions until July 2007
•   Improvements in Occupational Health and Safety systems be realised across the
    industry.

The VicForests auction did not impose security deposits or similar formal financial
barriers to participation.
While widespread or significant default would undermine the allocative efficiency and
future credibility of the auction system, this risk was balanced against the risk that
security deposits set even at a relatively low level (and refunded post auction) could
present significant barriers to participation for small bidders. In addition, the longstanding
relationships VicForests had with the majority of potential bidders (including existing
supply contracts) provided the organisation with confidence that bidding activity would
be genuine.


                                                - 18 -
Some bidders were required to submit immediate deposits on forward contracts won at
auction. VicForests determined these deposits based on a proportion of the value of
contracts won, and the assessed credit worthiness of the bidder (as identified during the
qualification process). The majority of bidders were not required to provide a deposit.


3.3 Auction infrastructure

A customised system, or auction ‘infrastructure’, was necessary to implement the auction
instrument described above. Key to this infrastructure was the design of an online auction
platform, through which bidders interacted electronically.

3.3.1   Online, real time bidding

Bidding occurred via an electronic, online platform which allowed bidders to view
available lots (and their details), view the status of lots at any point during the auction and
to submit bids. An online system facilitated participation by allowing bidders to log on
from anywhere in the world, using any computer with internet access and a standard
internet server, while electronic bidding allowed information (bids) to be transmitted to
all bidders in real time. By contrast, an open bidding process conducted by mail involves
lengthy delays while the auctioneer receives and processes bids, and publishes round
results.

3.3.2   Hosted, secure system

While VicForests specified the format and rules for the auction a specialist online auction
provider undertook the actual running of the auction event. VicForests specified
parameters such as auction timing, reserve prices and reductions and bid increments prior
to the auction. Once the auction commenced it had no further discretion to amend these
settings. This feature was important to the perceived transparency of the auction.
The auction provider issued all (qualified) bidders with a unique user names and password
to access the system with prior to the auction. While bidders were issued with a single
account, they were permitted to have multiple people or terminals logged into this
account at any given time during the auction. While this gave rise to an added security
risk—bidders were bound by any bids submitted using their account—industry
consultation indicated that the opportunity to have other parties (e.g. business
accountant) simultaneously monitoring activity was important, particularly for smaller
businesses, and those in more remote areas where the risk of disconnection was greater.
Bidder identities were not displayed to other bidders. For example, when a bidder viewed
the ‘bid history’ for any lot, they would be able to see when new leading bids were
submitted, and this affected their target bid. They could not view who had submitted a
bid (unless it was their own bid) or, where there were multiple bids, how many different
bidders were active. This measure was intended to make collusion and predation more
difficult.

3.3.3   Customised bidder page

Substantial development work was invested in designing a ‘bidder interface’ that would
provide the information required by bidders to effectively pursue their bidding strategies,
while remaining accessible or ‘user friendly’. Central to this design was a colour coded


                                             - 19 -
panel or ‘dashboard’ which allows bidders to rapidly assess real time information by lot,
including the status of the lot and the minimum bid the bidder would have to make to
lead competition for the lot.
An individual portfolio page enabled bidders to view their total volume and financial
commitments (based on lots awarded to them and those on which they were the lead
bidder) at any point during the auction, and to download this to a spreadsheet program for
further analysis.

3.4     Implementation processes

A number of key processes supported the design processes described above. These were
important in informing the design process and making implementation effective.

3.4.1    Information exchange and industry consultation

This information exchange includes provision of information to potential participants,
engaging industry in informing design issues and marketing and promotion.
The provision of clear and accessible information about the auction and resource is
important in facilitating the participation of a wide range of participants. In particular, it
is critical that clear and complete information about the resource being sold is provided to
all potential participants, to allow them to accurately evaluate its value. This information
allows participants, particularly new entrants, to reduce information asymmetries relative
to those with more existing knowledge of the resource (for example, incumbent
customers). It is also necessary to provide adequate time to allow participants adequate
time to undertake ‘due diligence’, evaluating the value of the resource and formulating
their bidding strategies.
Information exchange also includes engaging participants in the specification of property
rights and design of the auction system and processes. This information allows
government to better understand and realise the value of the resource. Consultation with
industry, through the relevant industry body (Victorian Association of Forest Industries)
and customer forums was central to development of the VicForests Auction system.
Industry was provided the opportunity to comment on the online auction system, the
auction catalogue and auction rules as they were developed, and these were variously
amended in response to this feedback.
Marketing and promotion creates awareness of the opportunity presented by an auction
event, supporting wide participation. It provides a vehicle for the information exchange
described above. VicForests advertised preliminary workshops in a wide range of
publications, including industry journals, regional newspapers and a national newspaper.
Subsequent information, including processes for bidder qualification, auction scheduling
and rules, and the auction catalogue were available via the VicForests internet site.

3.4.2    Information and training

VicForests provided an extensive program of training and information to support the
participation of potential bidders. This training was designed to help industry participants
access the information they needed to judge the value of the resource, plan their
participation in the auction and effectively use the auction system to execute their bidding
strategies. This included:



                                            - 20 -
•   Training sessions on system use, using computer laboratories to support instruction
    (conducted in regions) and provision of a comprehensive, illustrated user guide to the
    bidding system (made available on internet site)
•   Training sessions on formulating bidding strategies
•   Conduct of multiple ‘mock’ or simulation auctions, in which potential bidders were
    issued with mock auction profiles and had the opportunity to practice bidding against
    other bidders and progressing through the various rounds of the auction
•   Provision of a help desk service to answer questions during registration and auction
    periods.
Training sessions were conducted in regional Victoria (typically one in each of the key
regions of Gippsland, East Gippsland and North East Victoria) to allow operators located
around the State to attend.
VicForests scheduled supplementary training (including mock auctions) in response to
customer feedback that they required further guidance on the implications of auction
rules and practice on the system. Participants also had access to VicForests sales staff,
including regionally based staff that provided further coaching to individuals.

3.4.3   Multidisciplinary expert input

VicForests employed skills from a range of disciplines in designing and implementing an
auction mechanism appropriate to this industry. This included:
•   Resource expertise: extensive input of regional sales staff and forest management and
    harvesting information in informing property right design and implementation.
•   System design: contracting of an online auction specialist to build and operate a
    customised auction system
•   Legal expertise: in house and external input to auction rules and auction terms and
    conditions.

Each of these elements was critical to the development of a workable auction.




                                           - 21 -
4       Does it work? Auction outcomes
The results of the first online auction of Victorian native timber were broadly positive. It
is difficult to assess performance conclusively, particularly given the small size of the
auction and long term nature of some impacts. Comparing even these short term
outcomes to the previous administrative approach, or to a sealed bid auction (of the sort
previously conducted by VicForests), indicates that adopting an open, competitive process
substantially enhanced policy outcomes.15


4.1 Allocative efficiency

4.1.1     Competitive determination of prices

Lots ranged widely in the degree of competition evident, but for at least a majority,
bidding was competitive. The number of bids received for a lot varied from zero (for the
single lot which remained unsold) to 43 (for an Ash, mixed grade lot of 4000 cubic
metres). More than fifty per cent of lots received twenty bids or more. Fifty per cent of
the lots had five or more bidders submit bids, while ten lots (22 per cent of lots), however,
had two or less bidders. Four lots had only one bidder and sold at the reserve price. While
the allocation of these latter lots is not necessarily inefficient, there may be scope to
facilitate greater competition for lots of this type, for example by modifying the attributes
of the lot (for example, size or contract tenure). Alternative allocation systems (e.g. sealed
bid auctions) may also be more appropriate for selling resource where competition is thin.

 Ongoing industry consultation will inform such changes. By comparison, the system of
administered licences provided for little or no contestability or ‘market signals’ in placing
values on scarce natural resources, with allocation largely historically determined and
prices negotiated centrally.16

In the longer term, and as larger quantities of resource are allocated using this approach,
the movement of resources, including increasing scale of production or the emergence of
specialist producers, exit or consolidation of existing players and the entry of new
participants may all be broad indicators of enhanced allocative efficiency. The incidence
of secondary trades may also provide an indication of inefficiencies in the initial
allocation, although these may also be an efficient market response to changes in
valuations or circumstances over time.




15 This discussion relates to the March 2006 VicForests auction, the first ever online auction for native timber conducted in
Australia. This relatively small allocation was followed by a larger auction in late May, using a similar format and system. In
discussing these results, it is noteworthy that the relatively small size of the March auction may limit the extent to which
results (such as prices realised) can be extrapolated to subsequent auctions. Moreover, the industry is currently marked by
significant overcapacity (relative to resource availability), suggesting that competition and prices may mediate somewhat as
the industry consolidates.
16
   The lot which did not receive any bids was for E grade, mixed species wood from East Gippsland. The market for timber
of this type is currently shallow, and the sale of the other lot of this type is likely to have met existing demand.


                                                            - 22 -
4.1.2   Allocating resources to the highest bidder

Within the scope of those bidders eligible to participate in the auction, there is little
evidence that resources were not allocated to those willing to pay the highest prices.
VicForests received no formal grievances or feedback to indicate that bidders would have
been prepared to pay more for any lot than was paid by the winning bidder. Evidence on
the incidence of ‘winner’s curse’, or over-valuing of lots, is less clear. While there was no
immediate default on contracts, the viability of successful bidders may only become
evident over time. There was some suggestion that values reflected the marginal value of
wood when used to supplement existing, administratively priced supply contracts, and
…”not necessarily a reflection of the intrinsic commercial value of this wood” (Hopkins, P
2006 ‘Timber sale gets strong price growth’, The Age, May 15, 2006, p.1). Assessment of
these issues will similarly be possible in time, particularly as price information from
subsequent auctions becomes available.

Encouragingly, there has been no feedback to indicate that reliability of internet access
prevented any bidders from participating successfully from their regional locations, a key
concern for VicForests and stakeholders.

Opportunity may exist to further enhance allocative efficiency by refining auction rules
over time. Existing activity and closing rules limit the ability of bidders to substitute
between lots, potentially preventing them from placing bids they would have been
prepared to make and reducing allocative efficiency. For example, a bidder outbid on
highly contested lots after early rounds of the auction could find that cheaper alternatives
have already been awarded, preventing them from submitting higher bids on those lots.
Recent developments in auction design have made it feasible for auctions to be run in a
single, continuous bidding period, with all lots open until all lots close. For example, see
Box 6. The application of these developments could well produce even better auction
outcomes in future.

There is some evidence that sniping may have been an issue for those lots still open in the
tenth and final round. Bids were submitted in the last thirty seconds of scheduled bidding
for six of the ten lots still open in this round, implying that the allocation of these lots
could have been based on who was fastest in bidding in the final seconds, rather than
willingness to pay. An alternate closing rule, which kept the auction open until no bids
were submitted for a specified period (for example, five minutes), could be explored as a
way of removing the incentives for sniping.

Experimental economics could make a valuable contribution to the consideration of these
types of issues. Experimental economics refers to techniques which allow property rights
and allocation instruments to be simulated in a laboratory setting, so that the effectiveness
of different setting may be tested and the best possible model applied in the ‘real world’
policy setting. Victoria has a small but growing capacity in experimental economics.
Several Victorian Government departments are contributing to this building this capacity,
with a view to using these innovative tools to inform future policy approaches.




                                            - 23 -
Box 8 Experimental economics and the design of auctions
Experimental economics refers to the conduct of policy ‘experiments in a laboratory
setting. Policy ‘markets’—property rights and allocation mechanisms—are simulated
using computer programs and the internet. Subjects (often students) sit at computer
terminals and participate in different simulations, with real monetary rewards. Different
settings (e.g. auction rules) are tested to reveal which are the most effective in achieving
desired outcomes.
The logic for experimenting with different policy options and settings is the same as using
experiments to learn about any other science. Experiments are used because naturally
occurring phenomena, involve complex interactions which are difficult to predict using
theory alone. Experimentation provides more information about how theoretical
frameworks like auctions will operate in practice, giving government more confidence
that it will achieve its objectives and avoid negative outcomes.

4.1.3   Allowing efficient aggregation of resources

The constraints on flexibility discussed above may also affect the extent to which bidders
were able to assemble useful packages of lots. As discussed earlier, it is possible there are
synergies between different lots of timber. That is, a bidder might get greater value, and
be willing to pay more, if they are able to secure certain packages of items. New
combinatorial auction models, which allow bidders to submit ‘all or nothing’ bids on
packages of items in real time, may provide options for generating and capturing greater
value in future VicForests auctions. Feedback from industry stakeholders indicate that a
number of participants do perceive significant synergies between lots, suggesting that a
combinatorial format may be a useful approach. (A subsequent VicForests auction did
used a type of combinatorial feature).

It is important to note however, that the allocation of a continuous stream of resource
over time mediates the cost of ‘stranding risk’. That is, losing in one auction is less likely
to be critical the viability of a business, since timber auctions will be held on a regular
basis (potentially two large auctions per year). This could make the package problem less
important, subject to the strength of ‘portfolio’ effects of interdependencies between lots
in a given allocation. This issue could be examined further.

Finally, feedback from a number of participants during the auction indicates some
confusion about the operation of the auction rules and the auction system, particularly
with regard to the activity rule. This confusion could have prevented bidders placing bids.
This aside, the number of bidders who had such issues was relatively small, given the
number and diversity of participants, and the measures in place to assist bidders
(including a live help desk) appear to have functioned very effectively. Section 4.2
discusses broad and effective participation and sincere and productive bidding.




                                            - 24 -
4.2 Sustainable competition

4.2.1   Deterring collusion and other anti-competitive behaviour

Collusion is typically difficult to identify conclusively, particularly where there is little
historical market price information with which to compare auction outcomes. VicForests
recognised the risk of collusion: the timber industry is small and participants are clustered
around small regional communities, with interaction an important part of business and
social life. Collusion becomes less likely, however, as competition for a resource increases.
Given the level of competition evident for the majority of the VicForests lots, and the
considerable increase on administrative and reserve prices achieved, there is no clear
evidence of bidders colluding in the first auction.

4.2.2   Minimise scope for excessive market power

VicForests identified the possibility that a single processor could establish excessive
market power and undermine future competition for the resource as a significant risk of a
competitive approach. Measures were considered to mitigate this perceived risk, including
placing limits on the total proportion of the auction catalogue that could be bid upon or
won by a single bidder. These measures were rejected on the basis that risk was not
significant (especially given the small size of the March auction), and that such measures
were likely to distort the auction outcome. The results of the first auction appear to
support this risk assessment. No single bidder successfully secured more than 30 per cent
of the total auction volume, and 50 per cent or 18 bidders were successful in winning at
least one lot. Successful bidders included small, medium and large operations. This result
was in contrast to concern that an auction bidding process would see small bidders unable
to compete against larger companies in securing resource.

Compared with an administrative system, the new auction system increases the capacity
of processors to compete in a number of ways. First, it provides opportunity for businesses
to contest resources based on the value they can create from its use. For example, a small,
productive operator could have opportunity to access resources previously locked up in
historically determined allocations, and expand their business. An auction based system
could similarly provide new opportunities for those operators choosing to specialise in a
selected area, such as processing low grade and small logs or specialty timbers, allowing
them to purchase precisely the resources they require.

Second, market based pricing removes existing cross subsidies across operators with
respect to the geographic location of the resource. This allows operators, including small
operators, to exploit the comparative advantage they have in accessing resources located
close to their processing locations (that is, they pay less haulage costs). For example, local
timber processors won all timber lots from East Gippsland. Local operators also won the
majority of lots from the North East (VicForests, 2006).

4.2.3   Supporting broad and effective participation

A key advantage of an open auction system over a sealed bid or administrative approach is
its ability to facilitate participation beyond existing participants. It does this by sharing


                                            - 25 -
information about value which would otherwise be held by diffuse incumbent
participants. For example, in a sealed bid auction, existing participants will have greater
information about the historical and market values of the resource. The only participants
in the first VicForests auction, however, were existing Victorian operators. There are a
number of factors that could partially explain this observation:

•   Transport costs may make the purchase and processing of logs interstate unviable. The
    market based price of Victorian native logs may also be higher than interstate
    resources, which remain administratively determined.
•   The relatively small size of the March auction may have been insufficient to interest
    new operators, including institutional investors. As greater quantities of resource are
    sold via a competitive approach new entry may become more viable.
•   The property right may not have been structured in a way suited to new investors. For
    example, institutional investors may seek longer contract tenure, while interstate
    mills may require specification of other attributes of quality (for example, log
    diameter) to inform their evaluations of value. VicForests is exploring ways to
    incorporate such requirements, where possible, for future auctions.
•   The Victorian Government requires that all timber sold be processed in Australia.
    This excluded companies who expressed interest in purchasing the timber for export
    from contesting the resource. Applications for qualification and other feedback to
    VicForests indicate that interest in securing resource for this purpose did exist,
    suggesting that this restriction may have reduced allocative efficiency and revenue
    realised in this auction. Of course, this observation does not attempt to capture the
    broader impacts and objectives to which this requirement relates.

As discussed in other sections, the trade off made in imposing such restrictions on
participation is likely to be some reduction in participation and potentially, allocative
efficiency and revenue.


4.3 Industry participation

Considerable effort was devoted to ensuring that participants were able to participate
effectively in the online auction, including a comprehensive training program and custom
designed, online bidding platform. This was a significant challenge as VicForests
customers are a diverse group, ranging from highly professional, well resourced businesses
to small family operations, sometimes with very limited familiarity with information
technology and internet use. Feedback from participants indicated that the training
sessions provided were useful and the auction system well designed to provide bidders
with all the information they needed in an accessible format. Wide participation in
auction bidding suggests that these measures were successful in giving bidders the skills
and support they needed to participate effectively, with only one participant reporting to
VicForests that they would not participate because they were uncomfortable with the
auction system. Winning bidders included participants who had very limited experience
using computers before the training process began. As discussed above, however, calls to
the help desk indicate that some bidders did not completely understand the auction
system or auction rules, and this may have impeded their ability to bid. Further discussion
of how the design supported participation is included under the discussion of sustainable
competition below.


                                           - 26 -
4.3.1   Minimise direct costs of participation

Qualification, registration and bidding processes appear to have functioned well, and not
imposed excessive costs on participants. Unlike similar auctions, VicForests did not
require an upfront security deposit from bidders, or charge a fee for participating.
Participants did face some expense in using the new auction system, including:

•   Learning to use the auction system: for example, time and travel expense involved in
    attending training
•   Equipping themselves to use the online system: for example, computer equipment and
    internet connection
•   Administrative requirements: for example, providing financial and other information
    to VicForests
•   Developing auction strategy: for example, seeking business advice, time in considering
    strategy
•   Bidding: for example, time spent monitoring bidding, considering strategy and
    entering bids.

There are two important issues to consider in evaluating these costs. First, some key costs,
such as learning to use the system (and to an extent, administrative requirements), are
primarily ‘start up’ costs which will decline markedly for most participants in subsequent
auctions. Other costs, such as strategic business advice and computer systems, are likely to
have been incurred in time anyway, and arguably are valuable in accelerating the
modernisation and productivity of the industry. Secondly, these costs should be compared
with those involved in preparing a sealed bid, or renegotiating an administered licence
with Government. Both processes required significant investments of time by individual
operators, albeit over a longer time period. By comparison, an open auction process
requires intensive attention, but over a much short period of time.

4.3.2   Minimise costs of uncertainty

Changes in the auction system and auction rules in the months prior to the auction may
have increased participant uncertainty and the costs of participating (for example, as
strategies had to be reformulated in response to changing rules). Increased stability may
enhance the ability of bidders to use the system, and increase their confidence in the
fairness and transparency of the allocation. For example, in the development of an online
auction for Victorian aquaculture sites, the auction system and all auction rules were
finalised before any training was undertaken. This allowed participants to become
accustomed to the system over a period of time, and have a good understanding of how
the auction event would operate.

It is important to note that these changes to the VicForests system were in part due to
customer feedback, including feedback on how to make the system and processes more
accessible. Other rules, such as the use of a combinatorial feature, were amended to
facilitate transition over a number of auction events. Importantly, such changes are
unlikely to be as marked in future auctions, as both buyers and the seller become more
familiar with the process and transition is completed. Moreover, this responsiveness and
industry engagement was a key element of VicForests’ approach to developing the new


                                            - 27 -
competitive allocation framework. However, it is worth noting that the possibility of rule
changes may create incentives for participants to lobby for rule changes which would
advantage them.


4.4 Revenue maximisation

4.4.1         Maximising financial return

The March auction was extremely successful in maximising revenue relative to an
administrated licence system. Total auction value was $16.3 million (over the entire
period of the contracts), including a total return to VicForests (revenue less
administration, projected harvest and haulage costs) of $9.4 million. Importantly, this
return represented an increase in return of more than the previous system of administered
licences. Figure 1 shows this additional revenue as it will accrue to VicForests (over the
period of various contracts).

Figure 1 Additional annual income (over comparative existing administered prices)

          $900.00


          $800.00


          $700.00                                                                                     10%
                                                                                                      90%

          $600.00


          $500.00
  '000s




          $400.00


          $300.00


          $200.00


          $100.00


            $0.00
                    2005-06   2006-07   2007-08   2008-09   2009-10   2010-11   2011-12   2012-13   2013-14   2014-15


Source: VicForests, 2006
Note: Contract terms and conditions provide for 10% variation in the volumes taken (and paid for) by customers. The blue
bar above represents the minimum additional revenue associated with auctioned contracts

All but one of the lots in the auction catalogue sold, with prices on average approximately
40 per cent higher than administered prices. Figure 2 shows the extent to which auction
prices exceeded comparable administered prices. Eight of the 47 lots sold for prices below
their current administered prices, mostly mixed and lower grade timber. Prices for highest
grade wood (B grade Ash) increased on average by approximately 56 per cent, and by as
much as 104 per cent.

The additional revenue realised by the auction is likely to be the product of two effects:




                                                             - 28 -
•     Greater allocative efficiency creating greater total value from the resource: the auction
      allocated resource to those able to create the most value from it (and therefore willing
      to pay the most). Measures to enhance allocative efficiency further, as discussed
      above, would therefore be expected to positively impact upon revenue also.
•     VicForests capturing a greater share of the value (or ‘rent’) from allocation of the
      resource: greater contestability pushes up the prices paid by resource users,
      transferring more of the rent or ‘profit’ made on use of the resource from the
      purchaser to VicForests (and therefore the broader community). Ongoing
      consideration of measures such as reserve prices will be important to achieving this
      objective in future auctions.

Most obviously, this ‘value’ can be financial in nature—as a result of competitive
pressures, buyers in an allocative process are forced to reveal the maximum ‘price’ they
are willing to pay; and sellers, in a procuring process, are forced to reveal the minimum
‘price’ they are prepared to accept.

As discussed in Section 3.2.4, reserve prices were set relatively low. The fact that all but
one lot received bids indicates that reserve prices (excluding the unsold lot) were not
excessively high.

Figure 2 Auction prices: Percentage change on comparable administered prices

    120%


    100%


    80%


    60%


    40%


    20%


     0%


    -20%
                                               Lot no.
    -40%

Source: VicForests, 2006


4.5 Process efficiency

4.5.1      Provide for sincere and productive bidding

Auction rules were designed to ensure bids submitted were genuine, including requiring
that bidders signed up to contract terms and conditions prior to bidding, making it clear
that all bids were legally binding offers and not allowing bid withdrawal. VicForests also
used security deposits to mitigate the risk of contract withdrawal. As discussed above,
there were no immediate defaults on contracts won at the auction. Given that many of the



                                              - 29 -
contracts do not commence for some years, however, it is not possible to evaluate this
conclusively.

There may be opportunities to simplify the auction rules for future events (for example,
considering different options for activity rounds and the closing rule). This could
potentially reduce the possibility that bidders could identify ‘loopholes’ in the rules to
distort auction outcomes.

4.5.2   Efficiently discovering market prices

The auction, as scheduled, ran for five days, and allocated all but one of the 47 lots on
offer. A significant proportion of lots were awarded before the end of the auction
however—around thirty per cent reaching their final sale price by the end of the second
day of bidding. Sealed bid allocations run previously by VicForests also included around
five working days for the evaluation of bids, but without the interaction which takes place
in an open auction (That is, bidders lodged one bid and waited for results. They had no
opportunity to respond to the bids of others).
While this suggests an auction approach was more efficient in determining an allocation,
more recent auction models suggest that there may be opportunity to reduce the length of
the auction in future. Continuous auctions, without structured rounds or activity pauses
and with auction length determined by bidding activity (auction closes after certain
period with no bids) have been successfully run with large numbers of lots, and completed
in a single day.

4.5.3   Minimise costs to the seller

A common concern associated with the implementation of a ‘live’ or open auction system
relates to the cost to the seller of developing and administering such a model, relative to
the additional value it might generate and alternative allocation approaches (costs to
bidders was discussed above). Administrative and sealed bid approaches are likely to
appear easier to adopt an open ascending format, and may be less resource intensive in the
short term. This assessment presents a number of issues however:
•   While the costs of developing an auction system are significant in early development
    and piloting stages, these can be expected to decline markedly for subsequent events.
    For example, the cost to VicForests of running a reasonably large auction in
    subsequent years declines to around 25 per cent of the cost of developing the system,
    training bidders and running the initial auction event.
•   The direct costs of employing an administrative approach are frequently higher than
    expected when aggregated and compared with a competitive approach. For example, it
    is estimated that the renegotiation of administered licences involved the equivalent of
    around two weeks of fulltime work by VicForests officers, for each of the 45 odd
    customers holding such licences (around 22 months FTE).
•   The implicit costs of administrative and sealed bid approaches are likely to include
    inefficiency and reduced revenue, and reduced transparency in allocation.




                                           - 30 -
4.6 Process transparency
An additional benefit of open, competitive approaches is the enhanced transparency they
bring to the allocation process. In an auction, government must be explicit about its
criteria (embodied in auction rules) for allocation. Auction bidding processes provide a
record of competition and allocation: the winning bidder is known and losing bidders can
identify why they did not win. This record can be audited to confirm that rules were
followed and all participants treated fairly.
The stability of auction rules and procedures is one area in which transparency could be
expected to be enhanced for future auctions. As discussed above, rule and timeframe
changes prior to the auction potentially increased uncertainty of participants. Part of the
reason for these changes, of course, was the process of open and responsive engagement of
industry in developing the auction system. VicForests received no formal grievances post
auction to indicate the rules did not treat all participants fairly and equitably although, as
discussed earlier, there may be scope to enhance the understanding of some participants of
how the rules work.
VicForests made materials detailing the rules and processes governing the property right
and auction event (including qualification and bidding) publicly available. This
transparency was of high priority to industry.

4.7 Other benefits
As well as the enhanced outcomes against the objectives described above, the auction is
likely to have resulted in other benefits. Many of these will emerge over time, as
transition to the new competitive allocation framework becomes embedded. For example,
new approaches to identifying sustainable yield undertaken to inform the allocation are
more robust than previous data. This will inform forward allocations, providing more
certainty for industry and other stakeholders. The market based approach has also
revealed information previously diffused across many individual operators, giving
government a better understanding of the resource (e.g. how value is affected by location)
which can inform future specification of property rights and allocations. Finally, a
competitive system creates a more transparent, consistent framework for industry to
interact with government. This changes the nature of this relationship, embodying the
separation of commercial and other policy objectives.

5    Future directions
The first VicForests auction provides a powerful example of how policy outcomes may be
enhanced using a competitive approach, even in an industry accustomed to administrative
allocation and with diverse participants. The intensive process of development
undertaken indicates that this can not be done rapidly however, and the design of
property right and mechanism must be tailored to the nature of the resource.
VicForests will continue to use online auctions to allocate native timber for processing.
Over time this will undoubtedly involve further enhancements to the allocation
framework. As discussed in this paper, opportunities exist to achieve even better outcomes
through refinements of the property right and allocation instrument. This continuous
improvement will be supported by ongoing engagement with industry and other
stakeholders, multidisciplinary expert input, and new developments in economics. In this

                                            - 31 -
way the allocation of native timber in Victoria will remain an innovative model,
providing valuable insights to a wide range of public policy problems.




                                      - 32 -
Appendix: Auction objectives

A.1 Allocative efficiency

Allocative efficiency requires that harvested timber ends up in the hands of those users
who value it most highly. In this way, the resource is allocated to its most valuable uses
and the total benefit to the community is maximised. In broad terms, allocative efficiency
requires that the allocation system provide for:

•    Broad and effective participation: all parties who could potentially use the resource
     (that is, they attach some value to having it) are able to participate in bidding
     (subject to the management of other risks). This is discussed further in industry
     participation.

•    Efficient specification and aggregation of the resource: bidders can identify the
     characteristics that are valuable to them in a resource and can organise the resource
     (for example, put together multiple lots with complementary characteristics) in a
     way which maximises their value.

•    Sincere and productive bidding: bids reflect the value bidders attach to the resource,
     rather than other strategies or ‘gaming’ to manipulate competition.

•    Competitive determination of final sale prices: the resource is awarded to the bidder
     with the highest (or most favourable) offer. Alternatively, no non-winning bidder
     would have been willing and able to pay more for a lot than the sale price.

Allocative efficiency also requires that the valuation of buyers reflects the full social value
of using a resource. Where significant externalities exist—costs or benefits not borne by
the individual buyer—these private valuations may substantially diverge from social costs
and benefits. This can result in inefficient outcomes. Externalities could include, for
example, the implications of harvesting for other uses of state forests. The policy
framework in which VicForests operates, however, specifies a volume of resource will be
made available for harvest uses. Given this, the role of this auction was to allocate the
resource as efficiently as possible within the context of this constraint.


A.2 Sustainable competition

The objective of sustainable competition is closely related to allocative efficiency,
requiring that the allocation framework provides for ongoing competition for the resource
over time. Fostering an industry with multiple, competitive players is central to this
objective. This highlights the importance of broad and effective participation, and the
need for the allocation system to:

•    Deter collusion and other anti-competitive behaviour
•    Minimise scope for market power that would substantially inhibit future
     competition
•    Support efficient investment in the industry by providing appropriate security and
     structure of property rights.

                                             - 33 -
A.3 Industry participation

In the timber industry ‘broad and effective participation’ could include operators of
various sizes and locations, different types of businesses and new entrants. Working with
industry to manage the transition to competition was also a key component of the
Victorian Government policy move towards sustainable allocation of forest resources.

Facilitating broad and effective participation requires the auction design to minimise the
costs to potential bidders of participating effectively. This includes:

•     Minimising the direct costs of participation (such as fees, equipment or time) to
      bidders
•     Minimising the costs of uncertainty:
      o      Providing transparent, fair and stable rules and processes
      o      Providing complete, useful and accessible information (and support services)
             about the resource and auction processes.

These costs are discussed further in process efficiency. Importantly, the objective of
facilitating industry participation was subject to the management of other important risks,
notably the need to ensure that winning bidders are ‘fit’—financially and operationally—
to enter into supply contracts with VicForests.


A.4 Revenue maximisation

The objective of revenue maximisation is an important one: ensuring that the Victorian
community realises a fair financial return for scarce native timber resources. This implies
that the allocation system should maximise the return on resources sold, subject to other
objectives and relevant government policies (for example, sustainable forests management
– see Box 9). VicForests ‘return’ on a given lot is the unit profit or ‘stumpage’ (sale price
less harvest, haulage and administration costs) multiplied by volume of timber.


Box 9 Sustainable Timber Harvesting

“Ensuring the sustainability of native timber harvesting in allocated areas is central to the
management role of VicForests. The Sustainable Forests (Timber) Act 2004 balances the
ongoing availability of native timber resources for a wide range of valuable timber
products with conservation and biodiversity values, recreational opportunities, and water
catchments, as well as the viability of the communities which make a living from the
forest estate.
“VicForests is committed to the achievement of forest management certification to the
Australian Forestry Standard by December 2006. Timber resources made available for sale
by VicForests will be certified in accordance with the application of the highest standards
of sustainable forest management.”
Source: VicForests (2005) Qualification process for participation in online auction OLA1–2006 and OLA2–2006, p.3


Allocative efficiency and revenue maximisation are largely consistent, since in an efficient
auction the bidder who values a lot (bundle of resource sold at auction) the most wins.


                                                         - 34 -
They are not necessarily equivalent however: while allocative efficiency requires that
resources be held by the bidder who values them most highly, return depends on the
price at which this transfer occurs. The latter is a question of how value, or ‘rent’, is
distributed between the bidder and the seller.

In order for a sale to occur, the value that this bidder can get from using the lot must be
enough to cover the bidder’s business costs in using the resource, and a ‘normal’ return on
that investment. Any additional value or profit the bidder could get from the resource will
be reflected in the bidder’s maximum willingness to pay (or maximum purchase price). In
order sell the good, the value must also exceed the cost of providing the good for sale, or
the Government’s willingness to sell (or minimum sale price). The price at which the
transfer occurs might be anywhere within this range, depending on the reserve price and
bidding competition (or the willingness to pay of other bidders).

As long as the winning bidder has a higher willingness to pay than other bidders (that is,
they can get more value out of using the resource than alternate users) however, allocative
efficiency will be achieved. The price of transfer will determine the relative profits of the
buyer and seller. In order to maximise revenue to the seller, the sale price must be as close
as possible to the winning bidder’s maximum willingness to pay.


A.5 Process efficiency

The objective of process efficiency is about achieving allocative efficiency in the least
costly way possible. In addition to many of the issues discussed above, this suggests that
the allocation system needs to:

•    ‘Discover’ prices quickly: provide a mechanism which progresses at an appropriate
     rate (while not compromising the ability of bidders to participate effectively) and
     quickly awards resources to those who value them the most
•    Minimise costs to the buyer: as discussed above
•    Minimise costs to the seller (administration costs)
•    Manage longer term business risks: This includes efficient strategies to mitigate the
     risk of default on forward contracts and other obligations.

A.6 Transparency and fairness

Resources need to be allocated in a way that is objective, fair and transparent. As well as
supporting an efficient allocation, this is critical to the perceived fairness of the process.
This perceived fairness underpins the support and confidence of participants, government
and the broader community in the allocation system. This implies that the allocation
framework should:

•    Have rules and processes that treat all participants fairly and equitably
•    Make available clear and complete information about the rules, processes, rights and
     obligations of all parties, and that these are relatively stable
•    Provide for transparency in allocation results (that is, losing bidders can identify why
     they did not win)


                                            - 35 -
•   Provide a mechanism to resolve disputes including possible or perceived conflicts of
    interest.




                                         - 36 -
References
Black (2002) Oxford Dictionary of Economics, University press, Oxford

BOMweb Pty Ltd (2006) Forests Auctions Online Auction System User Guide January
2006

Chan, C., Laplagne, P. and Appels, D. (2003) The role of auctions in allocating public
resources, Productivity Commission Staff Research Paper, Productivity Commission,
Melbourne.

Charles River Associates Asia Pacific Ltd (2001) Review of 2 GHz Radio Spectrum Auction
Submitted to Ministry of Economic Development New Zealand, Wellington

Hopkins, P 2006 ‘Timber sale gets strong price growth’, The Age, May 15, 2006

Our Forests Our Future: Victorian Government Policy Statement on Forests (2002)
Department of Natural Resources and Environment, East Melbourne.

State Owned Enterprises (State Body – VicForests) Order 2003

VicForests (2006) Auction Catalogue Online Auction 1-2006 (OLA1-2006) and Online
Auction 2-2006 (OLA2-2006)

VicForests (2006) Auction Rules for Online Auctions 2006 OLA1-2006 and OLA2-2006

VicForests (2006) Monday 3 April 2006 Media Release: Local winners in first online
timber auction

VicForests (2005) Qualification process for participation in online auction OLA1–2006
and OLA2–2006

VicForests (2005) Pricing and Allocation Model for the Sale of Public Native Timber
Resources

Victorian Government (1986) Victorian Timber Industry Strategy, Victorian Government
Printer, Melbourne




                                           - 37 -

				
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