Competitive tendering in resource allocation

Efficiently functioning markets provide a way to allocate scarce resources to their highest value use, promoting the economic welfare of society. Not all goods and services are traded in a market though, with some resource allocation and service delivery decisions by Government historically not subject to competition. Nevertheless, in these cases competitive market pressures can be applied by introducing contestability in the allocation of the good or service.

The market for exploration permits for natural resources such as coal, gas or minerals, provides an example where competitive tendering, including a cash bidding component, has been used to allocate exploration rights. This policy has recently been introduced in Queensland. This article examines some of the issues associated with the use of markets to allocate exploration rights.

Exploration rights have been historically allocated using one (or a combination of) the following approaches:

• ‘first come first served’ – a licence is allocated to the first explorer to apply, provided certain conditions relating to financial and technical capability are met;
• work program bidding – a licence is allocated to the applicant whose proposed program for the exploration activity best meets Government policy/regulatory objectives; and/or
• cash bidding – explorers are invited to bid an amount for an exploration licence.

Cash bidding introduces a price element to contestability for the allocation of exploration rights, with the bid amount being based on the bidder’s valuation of the expected returns from exploration, allowing for risk. One of the aims of this is to ensure society receives an appropriate return on the value of its non-renewable resources.

The aim of any allocation mechanism should be to achieve the most efficient level of exploration activity. Competitive tendering, including the option of a cash bidding component, will promote economic efficiency by facilitating the exploration right being allocated to the party that places the highest value on it.

In some cases, factors other than price will also play a part in the allocation decision – for example, a government may have other objectives relating to the timing and nature of resource exploration and development activity. Clarity and transparency about Government objectives and decision-making criteria will support the efficient allocation of exploration rights as well as the integrity of the process.

A key issue for policy makers is to decide what land to release for exploration activity and which allocation mechanism is most appropriate for the right to explore on that land.

A land release framework needs to take into account alternative land uses and community costs and benefits. In terms of the allocation mechanism for exploration rights, a range of factors will need to be considered, including, for example, the riskiness of the exploration activity and the expected number of interested parties. Cash bidding will likely be most effective for land that is known to be highly ‘prospective’ as a better informed market will give bidders greater confidence to submit a cash bid. For more risky ‘greenfields’ areas or where the expected benefit is unlikely to justify the cost of a competitive bidding process, other allocation mechanisms may be more appropriate.

Some concerns raised about cash bidding include that it may distort exploration activity for the most prospective land in favour of larger explorers and that it diverts funds that would otherwise be used for exploration activity. On the other hand, work program bidding may distort the nature and extent of exploration activity. This highlights that the allocation mechanism can affect exploration incentives and that the choice of mechanism will depend on the circumstances of each case and government objectives.

‘Winner’s curse’ is another consideration with this type of allocation mechanism. This is where the winning bidder, on average, overpays, given that bidders do not know the item’s market value when they bid. This risk can be minimised by bidders being well informed about expected returns from the asset. Applying cash bidding to highly prospective land facilitates this outcome.

While there are important issues relating to transparent and robust governance frameworks that need to be considered, cash bidding for exploration rights provides an interesting example of the use of markets to help achieve efficient allocation of the right to explore natural resources.

This approach could potentially be extended to other State assets, such as access to timber reserves or ‘conservation auctions’ for environmental projects. Contestability in service delivery is a key theme of many of the Queensland Commission of Audit recommendations.