Bridging the gap between energy market policy reform and real change

Matt Rennie, the leader of EY's Power and Utilities business has a great post on LinkedIn about why new players hesitate to enter reforming energy markets.

Early in the article he sets out the way in which reforms are usually intended to change a market:

• "Before reform, and energy market includes a small, closed pool of market participants doing business with each other.
• After reform, an energy market includes a large, open pool of market participants trading either bi-laterally within a tightly controlled legislative regime, or through an intermediary (e.g., a market or system operator)."

Matt writes about the challenges that governments face in translating policy reform into the the real change to the system that is the ultimate goal of the reform.

Those that read my post earlier this week may notice that, by making the link between policy reform and desired outcomes, Matt is aiming to help governments avoid Underpants Gnome thinking. 

Matt goes on to give three recommendations for governments that are seeking to make the link between reform and real change, which include:

• "Understand the motivation of incumbents and new players: This is the heart of the answer. As I’ve said in previous blogs, governments must put themselves in the shoes of market participants and understand what drives them. For incumbents, the focus is on grappling with fundamental cultural change brought by reform. New, private investors, meanwhile are looking for certainty regarding market conditions before making a commitment.
• Create an attractive investment environment: Awareness of these key drivers will allow governments to plan for a successful new market. Creating an attractive investment environment requires governments to be alert to the potential of incumbents engaging in problematic behaviours, including obstruction of retail markets, unreflective cost allocation and informational ring-fencing, as market opening draws nearer. Regulatory measures designed to target such conduct need to be put in place and, often, legal or ownership unbundling of the incumbent is required to address potential conflicts.  It is also important that transmission system operators send clear signals regarding where new capacity in needed and that generators can feel confident about the stability of future returns. Strong regulators and committed policy makers are necessary here. 
• Leverage existing market power and experience: Many governments, while planning a new, competitive generation market, miss the opportunity to leverage the power and experience of the incumbent utility. Many mechanisms that worked well in the old market can be adapted for the new one. For example, modified versions of IPP arrangements could allow developments already in progress to proceed with certainty, while also sowing the seeds for the merchant plants of tomorrow and allowing wholesale markets to develop slowly and sustainably.  Contrary to the views of most policy makers, new entrants see an important perpetual place for the stabilizing presence and influence of the incumbent, and an environment where a diversity of companies brings benefits that go beyond lower spot prices to include increased efficiency, innovation and employment opportunities."

You may note that these look more like general principles than concrete steps. This is because, in the real world, countries are so different that it's impossible to come up with a set of concrete steps that will apply in every country. When I am looking to advise governments on this sort of thing, I generally try and identify the general principles much like this, and use them to work together with the people on the ground to generate concrete steps that apply in their context.

Matt's article (linked here again in case you missed it above) does lay out quite nicely what "Phase 2" looks like in the real world of policy reform. Give it a read, and follow him on LinkedIn for more.

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Disclosure: I previously worked for EY, but have no ongoing affiliation, or financial interest in their business.

An Underpants Gnomes theory of the world

I was reading this article on Vox by Ezra Klein and I was absolutely floored by this line:

“A lot of pundits…have a sort of Underpants Gnomes theory of Marco Rubio’s chances. Step one is Rubio is the only acceptable nominee to Republican elites. Step two is ... something. And step three is Rubio wins the nomination.”

— Why one political scientist thinks Donald Trump might actually win, Ezra Klein

If you’re not familiar with the Underpants Gnomes, they were invented by the creators of South Park, and appeared in the episode Gnomes; which is helpfully summarised on the Wikipedia page.

In the episode the Underpants Gnomes have a plan to make profit which consists of three phases, set out in the screenshot below:

"Gnomes plan". Via Wikipedia - https://en.wikipedia.org/wiki/File:Gnomes_plan.png#/media/File:Gnomes_plan.png

If you can't see the image above it says:

Phase 1: Collect underpants

Phase 2: ?

Phase 3: Profit

Klein’s usage in his Vox article was the first time I had seen reference to an Underpants Gnomes theory of something, but, apparently its use in analysis of policy and political economy goes back quite a way. Forbes has a nice article that explains its applications to political economy.

Basically, the Underpants Gnomes have a view of the world that links the collection of underpants to profit via some mechanism that they can’t explain, and likely doesn’t exist. When I saw Klein use it, I was struck by how powerful and widely applicable the idea can be.

For example, in Indonesian infrastructure you see this kind of thinking.

Phase 1: Make a speech about how Indonesia needs USD 450 billion of infrastructure investment between 2015-2019.

Phase 2: ?

Phase 3: Indonesia gets all the infrastructure investment it needs

We have been in Phase 1 for the last three years, and haven’t yet seen any evidence that infrastructure investment is accelerating at the rate needed.

Another example could be from PPP.

Phase 1: Create PPP policy framework

Phase 2: ?

Phase 3: Indonesia has dozens of PPP projects

We have been in various stages of Phase 1 for a decade now, give or take…

I certainly don’t want to give the impression that Phase 2 in either of the above plans is easy! Most of my career has been spent trying to figure out exactly what they involve (after a decade, I do have some partial theories…).

The general point is that a plan needs to do more than identify a problem, and a desired outcome. To really effect change, you have to follow the thinking process all the way through.

I don’t know about you, but I plan to add this idea to my policy analysis toolkit! Now I just have to think about how I translate it into Indonesian for the first time I pull it out in a meeting with my government counterparts…

How much do you need to know about a field to give advice about it?

I enjoyed this article in the Harvard Business Review on leading people when they know more than you do. It makes the distinction between specialist leaders and generalist leaders. "A specialist manager knows what to do; the generalist manager knows who to call. The specialist leader tells her staff the answer, the generalist brings them together to collectively find the answer."

This got me thinking: this doesn't just apply to leadership of teams, but also to contributing to teams, dealing with clients or counterparts, and, really, any sort of endeavour when you have the option of interacting with other people to try to solve a problem.

When we are trying to solve a problem, even as a leader, there are points in time where we need to act like generalists and get people's inputs, and times we need to shut down the review process to focus on the task at hand. The generalist may be the superior manager for a broader range of tasks, but a generalist's success as a manager depends on the existence of specialists in their team that actually know the industry or technical skill required to get the work done. 

In the real world, as the authors hinted at, it's not as simple as "specialists are bad" and "generalists are good." The authors were responding to the very common problem of specialists struggling to make the transition to being generalists. In fact, there also exist generalists that struggle with a lack of specialist skills.

A common concept that is used as an ideal for consultants by many big firms is that of the T-shaped professional. You can read the Wikipedia page or google for more info, but the figure below illustrates the knowledge of a pure specialist, a pure generalist, and a t-shaped professional.

All of the knowledge maps above have the same area. Someone that is smarter or works harder to learn can increase their area, in terms of depth and breadth, but most of us are never going to fill in the square entirely. 

And that's ok. In fact when a client hires you to do something for them, it's not usually because you know their industry better than them, it's because you can do something they can't and it's cheaper/better/faster to hire you in to do this one thing than it is to try to develop the capacity to do it in-house. 

A lot of professional services firms tend to have a comparative advantage in knowledge of particular techniques, that can be applied across a fairly wide range of industries. For example, tax planning, financial modelling, business strategy, legal drafting, technical writing, project management, and so on. 

The best consultants I know are very clear with their clients in what they know, and where the limits of their knowledge lie. This helps both client and consultant work best together to identify potential blind spots that one or both parties may have, to focus attention there, and have the best chance at coming to the right decision. 

The key thing that creates value in team building is complementarity of skill sets. The problem for pure generalists is that when they're working within a single domain, a lot of their knowledge is either not related to the domain, or duplicated by others in a team. A pure specialist, at least can add a lot of value if deployed correctly. 

 So, to answer the question I pose in my title: how much do you need to know about a field to give advice about it?

The HBR article's answer is something like: Not much. You're a generalist manager, don't waste your time duplicating knowledge that exists elsewhere because you don't want to look ignorant and ask a question. Rely on your specialist minions to deliver and get out of their way!

I think that's pretty solid advice, but I might add that you need to learn as much as you need to know how to leverage your specialist knowledge  in the field. If you are truly the "leader without expertise" that the HBR article mentions in its opening paragraphs, then you'd better develop some expertise soon, or you're probably not long for leadership!

So, in conclusion: know thyself! Are you a specialist that needs to generalise, or a generalist that needs to specialise? The right answer will depend on you, your personality, your abilities, and the career and life you envision for yourself. Finding the right balance for you will give you the best chance at developing a satisfying career working with, and managing others.

Palapa Ring: the biggest news in Indonesian PPP that no one is talking about

With little fanfare, over the past few months Indonesia’s Ministry of Communications and Information Technology (MCIT) has been making solid progress in developing and procuring what is, arguably, the most exciting project in the history of Indonesia’s PPP program. As I tweeted last week, I think this is the biggest, best news story in Indonesian PPP that no one is talking about.

In this article I’ll explain what I think makes it so exciting, and why I think this project could be transformative for Indonesia’s PPP agenda.

This is a good project

At time of writing, your only sources for information about the project is BAPPENAS's PKPS website. They published both the announcement of the pre-qualification process, and the announcement of the pre-qualified parties.

The project aims to procure a PPP contrator to construct and operate three fibre-optic backbone networks divided into three packets serving, respectively, the west, central and east of Indonesia. The total capital cost of all three is estimated to be on the order of USD 250 million.

The prequalified parties differ slightly between packets (check out the announcement for specifics), but include: 

1. PT. iForte Solusi Infotek 
2. PT.Indosat, Tbk  
3. Konsorsium Mora Telematika Indonesia - Ketrosden Triasmitra 
4. Konsorsium Super Sistem Ultima - Huawei 
5. PT.Telekomunikasi Indonesia, Tbk 
6. PT. XL Axiata, Tbk
7. Konsorsium Pandawa Lima
8. Konsorsium PT.Matra Mandiri Prima - PT. Hitachi High Technologies Indonesia - PT.Partibandar Utama 

Update: By time of posting, there have been a few articles written. Including this quite good one, that even talks about the project structure including a subsidy. It also promises that the RFP would be out this month, which seems very ambitious. Watch this space!

Following the checklist I set out in my Prakarsa article, the project is looking pretty good so far.

Criteria	Status
Appropriate risk models
USD tariffs for the private party	???
A track record as a reliable offtaker and reasonable contractual counterpart
Ability and willingness to hire professional advisers	???
A willingness to let private parties compete on a level playing field with SOEs
Sufficient authority and a track record of solving problems

Appropriate risk models: The private party will be remunerated on an availability basis, meaning the government will be bearing demand risk and will have full control over user-charges. There may come a time in future where it may be appropriate to allocate demand risk to the private party, and allow them to levy user charges directly at regulated prices, but that is a substantially more complicated proposition than the proposed project. Keeping it simple for now is a good thing.

I also understand that the Ministry of Finance and IIGF having taken some steps towards approving guarantees for the project. This will also be seen positively by investors.

USD tariffs: I don’t know whether the private party will be remunerated in USD, IDR or a mix, but either way, the parties that are prequalified do a lot of Indonesian business, so are the type that could probably find a way to be comfortable with whatever tariff is proposed. When I find out the answer to this question, I will update the article.

A track record: MCIT has never done a PPP project before, and, to my knowledge, they have never signed a contract remotely with the same tenor of this one. But then, they have regulated and overseen an industry that has delivered almost IDR 600 trillion (USD 44 billion) of private investment in Indonesian infrastructure between 1995 and 2012 (in 2015 IDR, using the investment deflator). Obviously, they're doing something right, and private investors are relatively comfortable with the regulatory environment.

Source data from World Bank Technical Note: Estimating Infrastructure Investment and Capital Stock in Indonesia (forthcoming), presentation by the author.

Professional advisers: I don’t know who is advising the government on this project, but from what I have seen so far, they seem to know what they are doing.

Level playing field with SOEs: It may be too soon to say for sure, but the fact that Indosat and Telkom are competing against each other through the tender process makes me think that it would be less likely that one or the other would be advantaged relative to other bidders.

Sufficient authority: I had the good fortune to meet Minister Rudiantara last week at Indonesia Australia Business Week, and he spoke of his strong support for the project. Sadly, support up to the top level of government has not been a feature of many PPP projects in Indonesia’s history. This senior support will make it much easier to address problems as they arise.

Other good stuff: In addition to all of those advantages I list above, much of the alignment is undersea, so land acquisition and resettlement (major drivers of problems in other projects) will be relatively simpler.

All of these things add up to a project that I think has a good chance at being Indonesia’s first PPP project to reach operations*.

Indonesian PPP desperately needs a win on the board

Indonesia needs a replicable model that can deliver dozens of projects per year transparently and efficiently. Yet, that pipeline of dozens of projects doesn’t follow until 4-5 years after the delivery of the first project. Indonesia’s pipeline of PPP projects has been 4-5 years away for the last 10 years!

Those of us that have been working in the field since Indonesian PPP’s coming out party in 2005 at the first Indonesian Infrastructure Summit have been shouting about it for so long that we now lack credibility. We lack credibility with the private sector, who are sick of coming to hear about projects that never get tendered, or whose tenders get cancelled without explanation. We also lack credibility with government contracting agencies, who see PPP as a failed model because of its lack of success to date.

Think about it, if I’m a Bupati with a water project, why I would send my project down the PPP road, when I can see that Lampung, Umbulan, and Jatiluhur have been stalled, barely moving for years? What would make me think I would have a better chance of getting through?

Delivering a PPP project could flip the narrative. Once investors can see that there are good projects that provide appropriate returns, and contracting agencies see that the model can work to deliver infrastructure, transfer risk, and provide value for money, the world will beat a path to Indonesia’s door. But, unless to do deliver a project, we’ll stay 4-5 years away from a real PPP pipeline forever!

So, what now?

Solid fundamentals, and the desperate need for a project are often, sadly, not enough to get a project over the line. Infrastructure projects are complex, and diligence, and strong leadership will be needed to see the Palapa Ring project through the remainder of the tender process, to issuance of the RFP, to award, financial close, construction, commissioning, through to operations.

The Indonesian government as a whole, and MCIT more specifically deserve credit for creating a good project and getting it this far. I have been somewhat mystified by the lack of coverage so far. Going forward, I hope to see the media playing their role in reporting on, and monitoring this project, to make sure it stays on the straight-and-narrow, and creating a sense of urgency for its delivery in government.

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*I very much hope Central Java Power Plant, Lampung Bulk Water Supply Project, or Umbulan Bulk Water Supply Project prove me wrong, but I wouldn’t put much money on it, given how long they have been stalled.

Indonesia doesn’t need to look far to see what a successful PPP program looks like

I wrote earlier this week about how a significant pipeline of PPP projects doesn’t follow until 4-5 years after the delivery of the first. There is a country, right on Indonesia’s doorstep that demonstrates this effect exactly: the Philippines.

The graph below shows the Philippines' astounding progress in just 4 years.

Source: Philippines PPP Center, presented by the author

The Philippines signed the CA for their first project under their PPP framework in 2012: the Daang Hari-SLEX Link Road (Muntinlupa-Cavite Expressway) Project, worth just USD 45 million. Since then, the pipeline has grown such that they intend to sign 5 projects by the end of the year, worth over USD 3 billion. Beyond those signed this year, the PPP center has 43 projects in their pipeline and, given their track record, there is no reason to believe they will not deliver a good chunk of them over the coming years.

Outside of telecommunications (a bit of a special case), and PLN (which seems to have the model down), the only private investment in Indonesian public infrastructure in the past 5 years has been on toll roads whose concessions were signed in the 1990s! No credible pipeline of projects currently exists that can deliver the volume of infrastructure investment that Indonesia’s economy requires, and its citizens demand.

As I said on Monday, a really significant pipeline of PPP projects for Indonesia is probably 4-5 years away, much as it has been for the last 10 years! We need to take action now to deliver Indonesia’s first PPP project, or our significant pipeline of projects will stay 4-5 years away forever!

Private participation in Indonesia's water sector still lacks legal certainty

I blogged two weeks ago about the launch of the Pekanbaru Water Supply PPP project pre-qualification process. The launch of the transaction process took a lot of Indonesian infrastructure watchers by surprise as, according to most interpretations of the current legal framework, private participation in the water sector is currently illegal.

Back in February, Indonesia's constitutional court struck down as law 7/2004 on Water Resources as unconstitutional, effectively returning regulation of the water sector to law 11/1974 on Irrigation, which does not permit private participation in the sector. I'm no lawyer, but people who should know have told me that, effectively, this means any proposed water PPP project is on hold until the law is replaced.

The lack of legal certainty has been used as an excuse for the lack of progress on the procurement of the long delayed Umbulan and Lampung water projects, both of which began procurement many years ago.

There have been recent media reports that the signing of the draft governmental regulation on water resources (an interim measure while the new law is prepared) is imminent. I haven't seen a draft, but  private operators voiced their concerns with the draft that was put to them back in June. 

I hope the launch of a new PPP project in the water sector is a sign that the new governmental regulation is indeed imminent, and that it is drafted in a way that allows private sector operators to participate and improve water service to Indonesia's citizens.

The importance of disclosure in major infrastructure projects

I enjoyed this article by Marcos Siqueira, from the World Bank's Handshake Journal on public private partnerships, titled "What if we disclosed everything? Reactions to a radical proposal".

He sets out a really nice argument for transparency in public contracting, especially in developing countries that have governance concerns.

“The crude truth is that opaque PPP policies serve a lot of interests, but almost none of them benefit service users or taxpayers. Here are some of the key points on transparency in PPPs, from my perspective:

First, much of the developing world faces complex governance challenges. Fairness issues haunt the day-to-day life of procurement processes. PPPs are very big projects, subject to sophisticated risk allocation mechanisms, and governments do not always have the capacity to fully understand the consequences of the contracts, which only increases the level of illegitimate interests surrounding projects. Therefore, in my opinion, unfortunately opacity is the best way to protect those interests.

Second, opacity feeds inefficiency, even when no explicit governance issues are present. The long-term nature of PPP contracts make managers want to protect themselves. After all, valid information can be a very powerful tool for users to push for contractually determined service levels to be effectively delivered, and for the government to use its regulatory tools to monitor costs and quality. I understand why contract regulators and private sector infrastructure operators prefer that service users do not have adequate information: they feel less pressure.

Third, opacity stimulates opportunistic behaviors, both of government and of the private sector. I have noticed around the world that parties often enter into agreements knowing all too well they will break it (or try to change it) as soon as they can. Opacity helps keep watchdogs at a safe distance, and creates an adequate environment for discretionary changes to a contract that might push it away from its original objectives. So the more opaque the practices, the more difficult it is to enforce a contract in the long run.”

— Marcos Siqueira, What if we disclosed everything? Reactions to a radical proposal.

He goes on to say that "From my perspective, a full, radical, proactive transparency policy is the single best and least-expensive strategy to reduce the influence of those interests in the PPP project cycle. The transparency policy (see examples from PPPIRC) should include, at least, the unrestricted disclosure of:

• Unredacted contracts
• Associated financial deals
• Unredacted bids
• Unredacted amendments
• Performance reports
• Financial data of the project company
• Fiscal commitments and risks"

But this is far from something that World Bankers and international policy advisers like myself try and impose on developing countries alone. At least in my case, my home jurisdiction practices what I preach.

Since 2007, the Victorian Department of Treasury and Finance has been publishing project summaries of every PPP project they enter into. And, in many cases, they even publish the unredacted contracts, as suggested by Siqueira. 

If you are interested in seeing what a real project agreement looks like, I do recommend taking a look through some of the contracts on the Victorian websites. Interesting ones for me are the City Link Concession Deed, and the sale deeds of all of our old power plants; which incidentally, worked out pretty well for the government, given the disruptions created by rooftop solar, among other technological changes...

After you've had a look at the concession deeds, most of which are well over 100 pages, you'll appreciate the effort made in producing project summary documents, which lay out most of the relevant information from the agreements, plus a lot more relevant information in a much more reader-friendly way.

The Victorian Desalination Project is a nice case study that shows how a government goes through the process of confirming that the project is needed, and that the private option creates value relative to the public option. The project summary document reports it was estimated that the winning bidder's price saved the government almost a billion dollars in present value terms.

The State Government of Victoria, through Partnerships Victoria was at the vanguard of developing manuals and training materials that form a lot of what is considered "international best practice" in managing private participation in public service provision. In some cases, developing countries adopted what they understood to be "international best practice" without understanding that they lacked certain key capacities or institutions to implement them. A lack of regulatory capacity is one key constraint for developing countries in particular.

Indonesia is still a reasonable distance from the State Government of Victoria's model of transparency. If you google around, you can find some excerpted or redacted power purchase contracts for PLN, but not much else is publicly available. 

Like Siqueira, I struggle to see the public interest in keeping such contracts confidential. As he notes: "I have been challenged that there are legitimate commercial secrecy concerns that indicate the need to keep information away from the public’s eye. My view on this is that the same lack of transparency required to keep commercial secrecy also serves to hide fairness issues during procurement, protects inefficient organizations from scrutiny, and creates difficulties for contract enforcement."

While many have learnt the hard way to be wary of swallowing developed country best-practice whole, enhanced transparency is hard to argue against in almost any jurisdiction. Indeed, it is arguably more critical in places like Indonesia.

Belajar dari praktik terbaik di Indonesia: cara memajukan KPS di Indonesia

Indonesia Infrastructure Initiative (IndII) baru saja menerbitkan edisi Prakarsa terbaru. Dalam edisi tersebut ada sebuah karangan dari saya yang menunjukkan apa yang dapat kita pelajari dari PT PLN (Persero) untuk sukseskan agenda kerjasama pemerintah swasta (KPS) di infrastruktur di Indonesia.

Saya lampirkan karangan saya dibawah. Bagi mereka yang ingin membaca edisi Prakarsa secara keseluruhan, yang berfokus kepada keterlibatan sektor swasta dalam infrastruktur di Indonesia, lanjut saja ke situs IndII. Edisi Prakarsa dapat dibaca dalam Bahasa Inggris dan Bahasa Indonesia.

Learning From Indonesian Best Practice: A Way Forward for Public Private Partnerships in Indonesia

The Indonesia Infrastructure Initiative (IndII) just published their latest issue of  their journal Prakarsa, which includes an article I wrote on how those that want to see Indonesian PPP projects succeed need to learn from PLN's example.

I have embedded the article below, for those that want to read it here. For those that want to read the whole edition, focusing on private participation in infrastructure in Indonesia, please head to the IndII site, where you can read it in English or Indonesian.

Pre-qualification opened for Pekanbaru water supply project (though briefly)

The Directorate for PPP Promotion under BAPPENAS reports on their website that pre-qualification is open for parties that want to register their interest in participating in the tender process for the Pekanbaru water supply project. The full announcement is available here.

According to the announcement, the project anticipated to be worth just under IDR 1.4 trillion, or just over USD 100 million, and is being tendered under Indonesia's unsolicited PPP project framework.

The unsolicited project framework is summarised briefly in Indonesia's latest PPP book, and in more detail in chapter VII of Presidential Regulation 38/2015 concerning cooperation between government and business entities in the provision of infrastructure, but essentially, it means that some private party proposed this project and the tender is being run to subject the proposing party to some degree of competition.

Perpres 38/2015 allows for three ways to compensate the proposing party for their "intellectual property" and initiative in proposing the project:

1. 10% advantage in the evaluation process;
2. A right-to-match the price of the winning bidder; or
3. To get paid out the value of their intellectual property by the winning bidder.

It's not clear from the announcement which of these is being proposed for the Pekanbaru project, but many potential investors I have spoken to over the years have expressed a lack of enthusiasm for entering a tender process where another party has an advantage.

Participating in a tender process through to the end can easily cost on the order of USD 5 million, and as I have noted in other posts, profit margins are thin in competitively tendered infrastructure projects. If one party has a 10% advantage, or a right to match, they will almost certainly win the tender process. In such a situation, most investors will save their time and money, and not bother participating in a tender like the ones envisioned for this project.

Beyond the regulatory challenges, there are other reasons to think that this tender may not be the most competitive. Interested parties have only one week to register their interest and receive the pre-qualification documentation, from the 26th to the 30th of October. And, they need to register their interest in person in Pekanbaru between the hours of 10:00 and 14:00. The announcement on the PKPS website is the only one I can find, and as far as I can tell it only went live on the afternoon of Tuesday the 27th of October.

So, if you are an investor interested in Indonesian water projects and would like to give this a go, you'd better get moving quick!

And/or, in future, set up an email alert for changes on the PKPS website...

These survey results on risk tolerance in Indonesia are literally shaking my faith in rationality

Ry4ns4n, a friend and lecturer at Universitas Gadjah Mada, created and posted the infographic above a few months ago, which sets out some fascinating information on risk tolerance in Indonesia in a really readable way (if you happen to be able to read Indonesian).

The infographic above claims that 39% of men and 46% of women are classed as risk averse, which is categorised as people that would choose IDR 800,000 (guaranteed) over gambling between receiving IDR 800,000 and IDR 1,600,000.

This type of question is common in behavioural economics and studies of risk tolerance, but usually it’s of the form: which would you choose, a box with USD 10,000, or a box with a 10% chance of USD 100,000 and a 90% chance of nothing. In this sort of example, the expected value of the boxes is the same, but people often answer differently depending on their risk tolerance. In my experience polling people (which I’ve done rather a lot, because I have run quite a few trainings on this subject), the vast majority of people will take the guaranteed money, trading off the chance of more money for certainty.

In my example, you’re choosing between a sure thing, and something with potential upside and downside. In Ry4ns4n’s example, in fact, there’s no downside. You either receive IDR 800,000, or a chance at more with no downside. Who would take such an offer?

When I saw the infographic, I was convinced Ry4ns4n had made a mistake in interpreting the data, or the question. First off, I thought, there's no way such a large proportion of Indonesians would have answered that question that way? Then, secondly, why would you even put together a survey and ask this question that, surely, everyone would answer one way.

I pressed him, “surely you’ve got this wrong. The question makes no sense.” But he was firm that he was accurately interpreting and representing the data.

Still disbelieving, I went to the source, the fourth Indonesian Family Life Survey (IFLS), put together by the RAND Corporation.

If you’ve never seen the IFLS data set and you’re interested in, well, really, any sort of data driven analysis in Indonesia, you really, really should check it out. Respondents answer literally thousands of questions about everything from how many children they have, to how often they work, whether they can identify misspelled words, complete maths or logic problems, their incomes and expenditure, and—of key interest to me—risk tolerance; among many other topics. My guess would be, almost no matter what your field, there are probably a few questions relating to it in the IFLS.

The relevant question is question SI01 from Book 3A, and reads as follows:

Indonesian

English

Pertanyaan Misalkan Ibu/Bapak/Sdr ditawari dua pilihan untuk memperoleh pendapatan. Pada pilihan pertama, Ibu/Bapak/Sdr dijamin akan mendapatkan Rp 800 ribu per bulan. Pada pilihan kedua, Ibu/Bapak/Sdr dijamin akan mendapatkan Rp 1,6 juta per bulan atau Rp 800 ribu per bulan, masing-masing dengan kesempatan yang sama. Pilihan mana yang Ibu/Bapak/Sdr akan ambil? Jawaban 1. Rp 800 ribu per bulan 2. Rp 1,6 juta atau Rp 800 ribu per bulan 8. TIDAK TAHU

Question Suppose you are offered two ways to earn some money. With option 1, you are guaranteed Rp 800 thousand per month. With option 2, you have an equal chance of ither (sic) the same income, Rp 800 thousand per month, or, if you are lucky, Rp 1.6 million. per month, which is more. Which option will you choose? Answers 1. Rp 800 thousand per month 2. Rp 1.6 million or Rp 800 thousand per month 8. DON’T KNOW

Note: The wording above is directly from the IFLS4 surveys. The translation isn’t really one I would have chosen… If you want to see the full list of questions, check them out here.

So, yes, it looks like, in fact, the question is pretty much as Ry4ns4n represented it. And it looks like the RAND Corporation really intended it this way because the follow-up question if you select answer 1 is as follows:

Indonesian	English
Pertanyaan Apakah Ibu/Bapak/Sdr yakin? Pada pilihan pertama Ibu/Bapak/Sdr akan selalu mendapatkan Rp 800 ribu. Pada pilihan kedua Ibu/Bapak/Sdr akan mendapatkan setidaknya Rp 800 ribu per bulan dan mungkin akan mendapat Rp 1,6 juta per bulan. Jawaban 1. Tetap memilih pilihan 1 SI11 2. Berubah ke pilihan 2 8. TIDAK TAHU	Question Are you sure? In option 2 you will get at least Rp 800 thousand per month and you may get Rp 1.6 million per month. In option 1 you will always get Rp 800 thousand per month. Answers 1. Still picks option 1 2. Switches to option 2 8. DON’T KNOW

I was still very confused at this point. The question seemed pointless to me, so I went in and looked at the results.

Sure enough, as Ry4ns4n already told me, the results were startling. When offered a choice between IDR 800,000 and an equal chance of IDR 800,000 and IDR 1.6 million, the results broke down like this:

Source: Nusantara Economics analysis of IFLS-4 data

So, from 29,054 respondents, 45%, or 13,079 respondents chose the guaranteed IDR 800,000 over the option with a chance of more and no chance of less.

Then, once they are asked “are you sure” and have it further explained to them, the results break down like this:

Source: Nusantara Economics analysis of IFLS-4 data

So, when they have the question further explained to them, only 91% of people that chose the worse option chose to stick with it.

So, out of the whole sample, even after being challenged, 12,043 people, or 41% of the sampled population would choose IDR 800,000 over equal chances at IDR 800,000 and IDR 1.6 million.

This is astounding

I really find this result astounding... I mean, pretty much all economists believe that agents act to maximise their utility or, at least, their perceived utility. Money is definitely not the only contributor to utility, but for small amounts of money, it's not very controversial to say that, all things being equal, almost anyone would prefer more to less.

I like to think that I have a broader-than-average understanding of what maximising utility means, and I like to think I'm pretty good at identifying where different groups might react dramatically differently to the same stimuli. But, if you had asked me to guess what proportion of people would choose option 1, I would probably have been willing to bet quite a lot of money that it would be below 10%. Under almost no circumstances would I think it would exceed 20%.

41%? Well, that's so far past my reasonable expectations that I start to question the the rationality assumption, which rests right at the centre of pretty much all mainstream economics.

So, what’s going on?

The short answer is: I don’t know. I’ll hazard a few guesses, but these are very preliminary. More notes to myself on further avenues to look down, and hypotheses to test when I get some time to dig through the data a bit more. In the meantime, if anyone wants to challenge/debunk my theories, or has some alternative theories on what’s going on and wants to run some numbers and/or do their own write up, I’d be happy to link/cross-post/host a guest-post.

My first theory is that there will have been a certain proportion of people that just won’t have understood the question due to low mathematical literacy. As I noted in a previous post, uncertainty confuses people, and a lot of people won’t have had practice at breaking down a problem like this into a mathematical framework*.

My guess is that this proportion probably isn’t that large, because later there’s a similar question with the pay-offs reversed, where the respondents are asked to choose between IDR 4 million and a IDR 4 million with a chance of IDR 2 million, and 90% of people answer the “right” way there. Ry4ns4n’s infographic provides some information on propensity to be what he calls “risk averse” with level of education, but the results seem a bit up and down… There are some maths and logic questions early in the survey, you could perhaps use those to try see whether the proportion of people that chose IDR 800,000 were over-represented in the population with the lowest mathematical literacy.

I would also guess that there would be a proportion of people were probably mentally exhausted by the length of the questionnaire, and were bamboozled by the gear shift from a series of questions about their personal plans for retirement, to a question that sounds like an IQ test. There’s a series of questions at the end of the section about how engaged and attentive the respondent was, but I haven’t gotten around to exporting the data on those ones, plus that’s going to be a very subjective call, and it applies to the whole book of questions, not just the section I’m looking at here. I suspect this is going to be tough to try and test.

Next, I think there will be a certain proportion of people that will think this sounds too much like gambling, which is moderately taboo in a reasonable proportion of Indonesia, and will reject it on that basis. This could explain some of the difference in people that are happy to remove uncertainty on the downside, but don’t want to take it on the upside. I haven’t looked enough through the survey to know if there are any questions on attitudes to gambling, but in their absence, maybe you could overlay the responses with self-reported levels of religiosity.

Finally, and I think, most importantly, I think we come down to the issue of trust. I wrote about this in the same blog post I linked above and also here. Most of the people that take this survey are relatively poor, and poor people have very low levels of trust with fancy-sounding schemes. You might think you’re just asking a simple question about risk tolerance, but a poor person might look at the offer and assume that you’re trying to cheat them somewhere. After all, they have been trained in the real world where, when someone offers you something for nothing, you’re best off walking away as soon as possible, because they're probably trying to cheat you. My guess would be that this is the biggest factor.

I’m very interested in why the RAND Corporation saw fit to include this question. This section of the survey is called “RISK AND TIME PREFERENCES.” I’m not sure that it’s accurate to say that answers to this question reveals anything about a respondent’s risk tolerance or time preference. I think it reveals more about mathematical literacy, tolerance for situations that sound like gambling, or trust in institutions than in someone’s tolerance for risk. After all, nothing is actually at risk in this question.

But then, I wonder if, maybe, that’s the point.

In this section, you want to get people to reveal their risk tolerances. It’s easier to get them to do that if they are answering the questions in the frame of mind where they understand the questions, are happy to weigh up options that sound like gambling, etc. etc. If you ask this question first, maybe it can act as a nice filter to get rid of the people that aren’t going to answer your questions in a way that is useful to you. That way, when you get into the questions about how they actually do want to bear risk, you’ve removed a whole lot of people that will introduce a lot of crazy noise into your dataset. Maybe...

As I noted above, I very much welcome any challenges or thoughts on my theories and questions above.

So what?

After I finally accepted that, yes, indeed, the question was correctly phrased, and that the answers appeared to be legitimate, I still boggled over this for quite some time. It took quite a while, but now I am at peace with it.

Whatever drove 41% of respondents to answer these questions the way they did, I think these results serve as a great reminder that you should never assume you know how any group of people thinks**. Always, always question your preconceptions and assumptions, and test them where possible, because people will surprise you.

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* This reminds me of a story a teacher friend of mine told me once. She was teaching a maths class to a bunch of year 7s in a high school in Australia, and was describing how the uniform distribution of rolling one die gets turned into a peaked distribution by rolling two. She was unable to convince a good chunk of her class that a single dice had a uniform distribution until she sat with them, rolling a single die, building a histogram for 20 minutes. “But, it’s harder to roll a 6 than it is a 1, right?” This stuff is just not that intuitive unless you really think about it a lot…

** This will be the third and last time I will link to this post, but I did want to drop in this graph that I saw on Chris Blattman’s blog post from the World Bank’s 2015 World Development report.

Source: World Development Report 2015, via Chris Blattman

Indonesia (quietly) launches 2015 PPP book

I was looking at the BAPPENAS PPP Directorate website just now to try and find the exact wording for a regulation and I noticed that they had, very quietly, launched their 2015 PPP book two weeks ago.

The list of projects is the same as the one I reported in June. If you would like a copy, you can download it here.

Recommended reading: Data Genetics blog

My previous post on roulette was essentially my impersonation of Nick Berry from Data Genetics, which houses one of my favourite blogs.

I love the way he makes mathematics really practical. For example, I learnt about the Secretary Problem from his blog, and my wife and I used it to help us make decisions about potentially buying houses.

While I certainly can't claim to to understand every step he takes in his mathematical analysis, he always takes care to lay out his arguments and his methodology in a really accessible way. When I do have to use some fancy analysis in my work (or blogging), this is what I'm also aiming for.

So, if you liked my post, and want to see what someone with a lot more power under the hood does, I highly recommend the Data Genetics blog.

Don't tell me you don't want to find out what a Chicken Nugget number is...

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NB: I actually started the previous blog post months ago, but got distracted with other things halfway through the write-up. While my post was lying, half-finished, I was quite alarmed to see that Data Genetics had a post about roulette, and thought that he might have sniped me! Luckily for me, Nick concerns himself more with the mechanics of the wheel than debunking tired old betting strategies.

Can you beat the casinos at roulette using statistics?

The proposition

Have you heard this one before? Some guy called Steve comes up to you and says that he can beat roulette. All he does is keep betting on black, then double every time he loses. As long as he follows this strategy, Steve can’t lose!

He even puts together a quick Monte Carlo simulation to prove it to you. Check out the results below:

See, there are some bumps, but in the long run, you’re guaranteed to make money! Genius! Those stupid casinos don’t stand a chance against a genius like Steve!

Starting from a $0 balance, and a $1 bet, after 10,000 rounds, Steve finishes with $4,828 in the bank.

The reality check

If beating roulette is so easy, why do casinos have it? Why aren’t statistical geniuses like Steve robbing casinos blind all the time?

Is it really this simple? You have probably guessed that it is not. But why?

Part of the answer has to do with liquidity constraints, and the other part has to do with what most people would consider to be an appropriate return for a given level of risk. Both of these things have some pretty profound implications and describe some important things about how people, firms and governments act in the real world. So, let’s get to it.

Liquidity constraints

You might have noticed one funny thing about the example above. Steve started with a zero bank balance. In the real world, casinos don’t just let you walk in with no cash in hand and start gambling. You have to have money to bet money.

Steve was also a little tricky in the way he developed his graph above. He showed you 10,000 scenarios, which sounds like it would be enough to show you a trend, but he picked one of the better rounds of 10,000 scenarios. Let me show you another few rounds of 10,000 scenarios that I just generated using Monte Carlo simulation:

In the first example above, the biggest bet Steve has to make to keep himself in business is $8,192. In the second, the biggest bet is $16,384. Has he got that sort of cash lying around? If not, is someone going to lend him that money? If not, he hasn’t got a viable business model here.

The other major constraint on Steve is the fact that tables typically have upper and lower limits on how much you can bet. I don’t hang out in casinos much, but a bit of googling makes it sound like common lower and upper limits for tables are $5 and $500, or $10 and $1000. On these sorts of tables, Steve would have maxed out and lost his shirt.

Let’s say for the sake of argument that Steve has $1,000 in his pocket that he scrimped and saved up with big dreams of hitting it rich. He has told all of his friends about his genius system, and 99 of them want to join him, all of them with $1,000 in their pockets. They quit their jobs, and take the bus down to the casino to start their new full-time jobs playing roulette. For the sake of our example, let’s say they find a casino that has a $1 minimum and some arbitrarily large upper limit on the bet at the tables. What would happen to them?

So, they all turn up at their new job, playing roulette, on Monday morning and start playing, 8 hours a day for the first week at 30 seconds per spin. Starting at $1 per bet, doubling if they don’t win, and going home if they run out of money. By Monday mid-morning the following week, Steve is still at it, and has clocked 5,000 spins. He looks around to see how everyone’s doing and is surprised to see that the 100 of them that started have been whittled down to 13, including himself.

LD 50 means something like this.

In fact, half of their mates were gone by the 1,520th spin, just after lunch on the second day of their new career, and 75% were done by the 3,900th, just before close of business on the fourth day. The first of their mates to fall was done by the 31st spin.

On the first day, the 100 of them started with $100,000. After the 5,000th spin, the aggregate bank balance was $34,385, meaning they had lost $65,615 to the casino over that time.

The graph below shows the distribution of their ending bank balances.

You can see that 87 of them lost everything. A few are in the 3000s, and a few more are in the middle*.

So, what’s going on?

If you’re starting with $1000 in the bank and kicking off your betting with $1, you’ll stay solvent as long as you don’t get 10 losses in a row, or 11, 12 and so on if you’ve had some time to build up your bank with some winnings. “But”, Steve insists, “the chances of that happening are tiny. Look at my table below!”

This is true, the chances of getting 10 or 11 losses in a row are very small (1 in 692, and 1 in 1330, respectively. But, small chances have a way of adding up when you play thousands of games. Have a look at the following table that shows you your chance of a streak of X losses occurring when you play Y games. As an example, in the top left corner, you’ve got a 2.07% chance of a streak of 5 losses not occurring when you play 100 games, or a 67.64% chance of a streak of 12 losses not occurring when you play 1,000 games.

In this table, cells that are red mean that you’re highly likely to see streaks this long, yellow means you’re about 50-50, and green means you’re pretty safe.

If you’re playing with a bank of a million dollars and you play 20,000 games (about a month, full-time, by my count), you’ve got a bit over a 4% chance of losing your full million dollars… Does that sound like a safe bet to you?

So, if that’s the risk, what are the returns? For Steve and his mates, the average return they got is negative $656. So, let’s look at the guy that did the best. He came out with $3,439 in the bank, or a net gain of $2,439. Not bad for a week’s work, but he also suffered through around an 87% chance of losing that money.

That doesn’t sound like a very good deal to me.

In fact, you’d get better odds just betting the whole $1,000 on black, then, if you win, betting your $2,000 on black again. In that case, you’ll get $3,000 profit if you win, and “only” a 77% chance of losing your money. You also get to spend your week doing something more fun than staring at a roulette wheel in a soulless casino.

In summary, yes, Steve’s system can make you a small amount of money, but it carries with it an unacceptably high risk for the potential reward.

So what?

So what? Well, most of my readers probably aren’t the type to think that they can beat casinos, so why am I spending all this time debunking stupid roulette strategies that have been debunked hundreds of times**.

I generally blog about infrastructure and public sector issues, and this sort of thing has pretty profound implications for the sort of long-term ventures that governments are required to enter into as a part of their regular course of business. If a government and a private party agree to build a power plant and operate it over a 30 year period, the risk of a major earthquake occurring on any given day is very low, but the chance of one occurring over a 30 year period might be extremely high; especially in a place like Indonesia, where I live. Other low probability, high-impact events include things like currency shocks, demand shocks, civil disorder, and so on.

Arrangements like our friend Steve’s roulette strategy are what people like Nassim Nicholas Taleb calls a “fragile system.” That is, it’s a system that works, and looks great at first, because it works the vast majority of the time; but when it is tested by extreme events, it fails catastrophically.

This is also an example of something I wrote about in an early blog post, where I urge readers to balance quantitative analysis with an understanding of the real world, and I said “there’s nothing more dangerous than a genius with a model.” Not that Steve is a genius, but to someone with little understanding of statistics, he might sound like one***.

Lessons for the real world

So, what can we learn from the experience of Steve and his mates that we can apply to decision-making in business and government?

1. When you build a system, don’t ignore the low probability events; especially when your system is expected to be long-lived.
2. Just because something seems to be working for someone in the short-term doesn’t mean it’s a good system.
3. If someone is using fancy mathematics to make an extraordinary claim, be extremely sceptical, and make sure you do your own homework and understand it before putting it into practice.

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* It’s kind of interesting to look at why the ones that are in the middle are there. They aren’t there because they’re on big losing streaks, they’re there because they ran up against their minimum bank balance so couldn’t double their previous bet. The following graph shows the bank balances of two players, one that managed to avoid hitting the minimum balance, and one that hit it three times and managed to survive, although weakened.

** Most comprehensively here and here.

*** Despite being comprehensively debunked, there are plenty of clowns trying to pass themselves off as geniuses to sell their garbage systems, or encourage you to try them in their casinos. In their cases, they may well be geniuses, but their genius is in creating enticing systems to scam people rather than in advanced statistics.

Gender segregated buses for Jakarta's Busway?

In one of my first posts, I talked about the reasons that societies sometimes choose to segregate vehicles, or sections of vehicles by gender, and the costs associated with doing so.

Coconuts Jakarta is reporting that Transjakarta, the operator of Jakarta's busway service, is considering introducing female-only buses to combat sexual harassment. The comment was made by the President Director of Transjakarta in response to a recent incident of sexual harassment that occurred on a public footbridge after both patrons had been riding a Transjakarta bus.

In my abovelinked post, I wrote about how gender segregation on public transport decreases the efficiency of the fleet, and imposes some other more difficult-to-value costs on society. In the case of completely gender segregated buses, as opposed to gender segregated sections of buses, the impacts on efficiency will be extreme.

When you have impacts on efficiency, one of two things happen: passenger wait times increase, or your fleet size needs to increase. At present, the fleet in Jakarta is well below what is needed,  and they're currently scaling up as fast as they can but it will take a few years until the fleet size is sufficient, no matter what the gender segregation policy. So, in Jakarta, an efficiency impact will flow pretty much entirely  through to wait times for at least the next few years.

If this is being seriously proposed, the biggest questions for me would be:

• What proportion of buses would be women-only?
• Would the gender-segregated sections in existing buses be preserved?

Currently, around one third of bus space is segregated for women. This means that, if you don't maintain the gender segregated sections in existing buses, to maintain the total women dedicated capacity would mean every third bus would need to be women-only. This would mean that, on average*, if you're a women that wants to ride in a dedicated section, you'd need to wait 3 times as long to get that dedicated section. You're also increasing wait times for men by 1.5 times**, because now they'll only get two buses that they can ride on in the time they used to get three. 

If you do maintain the gender-segregated sections, and offer a smaller fleet of women-dedicated buses, those buses will be even less frequent, so wait times for women wanting a completely segregated bus will be more than 3 times the current wait times.

If forced to wait for 3 (or more) times longer than they currently do, would women still choose to ride the Busway, or would they switch to other forms of transport, or elect not to travel? 

This particular case of sexual harassment would have been prevented had the victim in question been travelling on a gender segregated bus, as the harasser followed her off the bus. However, had that particular woman been on a gender segregated bus, the harasser may have selected another woman on the mixed bus, or just some other woman on his walk home that wasn't riding the bus at all.

The costs this policy would impose would be significant, and the largest burden would be borne by women. If it is seriously being considered, Transjakarta and the city government of Jakarta should first publish data on sexual harassment rates on the Busway, their estimates of how many incidents would be avoided by this policy intervention, and the expected impacts on travel times. Following publication of this analysis, they should undertake a survey of the Busway's passengers (disaggregated by gender) to see if the change would be welcome. 

When an incident occurs, the natural instinct for a lot of people is to demand change to make sure it never happens again. But, in situations like this, the rush to show concrete action can result in policy outcomes that can be counterproductive. Sometimes the cure is worse than the disease. 

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*Ignoring peaking effects for simplicity.

**Ditto

Regulated business be like...

This is pretty much how most disputes go in competition and regulatory economics.

Indonesia Air Asia still in business

Whatever the problem Indonesia's transport ministry saw with Indonesia Air Asia's balance sheet, the Jakarta Globe reported yesterday that the government had given them an extension on their capital requirement and that now they need to comply by September 30.

This is good news. Although, perhaps "good news" is a bit of a strong term to use when the government avoids scoring an obvious own goal like this, we'll take what we can get.

Will your microfinance or financial inclusion initiative work?

I wrote in a recent post about how poor people are fundamentally different to non-poor people in the way they use money, and in their approach to risk. In that post, I took a dim view of a government proposal to provide financial products to the community. This reminded me of my long-running, but somewhat dormant fascination with microfinance and financial inclusion generally.

I never actually worked in the field, but there was a pretty long period in my 20s when I hung out a lot with a whole lot of really poor people on a regular basis, the end of which coincided with a lot of time spent reading David Roodman’s Open Book blog*. Over this period, I thought about poverty, cashflows and the way poor people use their money a lot, and I came up with three necessary, but not sufficient conditions for the success of a microfinance, or financial inclusion project, startup or other initiative.

For your microfinance or financial inclusion initiative to succeed, it must:

• Create value
• Be understood, and
• Be trusted.

In the rest of the post, I’ll explain what I mean by each.

Create value

For a product to create value for a poor person it must meet a need. It might let them smooth out their earnings, let them borrow more cheaply than from the local loan shark, help them retain their savings, help them transfer money to family members cheaply and transparently, give them payouts when they experience income shocks/illnesses/accidents, or anything like that.

So, if your initiative doesn’t solve a problem they actually have (rather than one you think they have**) better than some existing solution they have (or better than doing nothing), then you’d better go back to the drawing board.

Be understood

If you want poor people to sign up to your initiative, they will have to understand it, and that’s not easy when you’re talking about money and uncertainty. People are really bad at understanding risk and acting on it, and there's recent evidence that poverty makes people even worse at particular kinds of tasks.

If you’re talking about a financial inclusion project, then almost by definition, the people will have little experience with and understanding of the financial system. Just because you ran the numbers and found that poor rice farmers could benefit by purchasing micro-rice-price-hedges doesn’t mean you can explain it to them in terms they can understand.

Be trusted

Poor people are very risk averse in financial decisions. They need to be, otherwise they’ll run the risk of running out of money and having to sell off some asset, get kicked out of their home, or something like that.

Poor people are also disproportionately located in poor countries, and poor countries usually have poor public institutions, and few, if any, consumer protections for people screwed by unscrupulous actors. And, what minimal protections exist, are usually not available to poor people who haven’t got the time or money it takes to pursue remedies that might be available to them. As a result, they have a low level of trust in government and private companies.

As an example of this, a new paper by Bold, Kaizzi, Svensson, and Yanagizawa-Drott (which I saw on Chris Blattman’s blog) describes an experiment where seed and fertiliser sold to farmers in Uganda was tested to see if it was as advertised. They found that 30-50% of the inputs sold to farmers were either counterfeit or adulterated. In a place like Uganda, farmers typically don’t have access to testing facilities, and even if they did, there aren’t the consumer protections for them to seek remedies. In this context, they just shrug their shoulders, and don’t use the inputs, leading to lower productivity.

When you turn up with your bleeding-heart idea to help the poor people help themselves, it’s not immediately clear to them whether or not you actually plan on helping them, or if you’re just one more in a long line of scammers trying to bilk them out of their hard-earned savings.

Summing up

So, if you can meet these three criteria, you’ll be on your way to a successful microfinance or financial inclusion project. Good luck.

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*Which resulted in his book, Due Diligence: An Impertinent Inquiry into Microfinance, which everyone interested in this field should read.

**This is relevant too.

Fairly valuing music and musicians' work

I really enjoyed this article by Liam Boluk from REDEF It's full of fascinating insights, data and analysis about the state of the music industry and how the revenue models have been changing over the past few decades.

This might seem to be of peripheral relevance to the general sort of infrastructure economics that I post on, but a lot of the hard problems in economics are in pricing. You come across similar issues thinking about how you split costs and revenues fairly between producers, users and distributors whether you're talking about music, mangoes, medicines or megawatt.hours.

I think my music spend would roughly follow the trend seen in the graph above, but that might change, since I just signed up to Apple Music and think I'll stick around. As that will probably crowd out most other spending on recorded music I'll do, I doubt we'll see my trend line return to the lofty heights of the early 2000s, when CDs were probably my biggest single expense after rent and food, but it will be more than I have spent in the past few years on recorded music.

One thing I really like about the streaming model is that payments are more proportional to use than the more traditional album sale. Notionally, the value that I get from music is probably pretty much proportional to how much I listen to it, but with the old album model, I pay pretty much the same whether I listen to something once, or thousands of times. So, someone like Merzbow, whose album I listened to maybe 5 minutes of one time will have gotten about the same amount as, say, Ben Folds Five, whose album Whatever and Ever Amen was the first CD I ever bought with my own money and listened to on repeat for years. If you look at it per play, Merzbow probably got thousands of times more money out of me than Ben Folds Five did. Streaming reverses the proportionality, meaning, going forward, artists I listen to on repeat over the next decade will get money over that whole period, rather than just the one hit.

The big (and legitimate) complaint, of course, is that the payments per stream are minuscule. Boluk's article sets out the depressing math: "The average Spotify user, for example, listens to more than 1,300 tracks per month. When consumption is that great, the value of any one stream becomes slight. The economics bear this out: if we focus exclusively on Spotify paid subscribers ($9.99/month), the implied value of any one stream was $0.0076 in Q1 of 2015."

As Boluk points out in the article, a lot of that might have to do with Spotify's free model. Spotify's free (ad-supported) model is good enough for the majority of their users, so the only people that get pushed into the $9.99 per month group are the heavy users. My guess would be that my use would be quite a bit less than 1,300 tracks per month, but I still consider the access a pretty good deal.

If streaming services and willingness to pay for them becomes more mainstream--meaning the average user will consume less on average--then musicians will both get more listens, and more valuable listens.

How much does streaming diversify the recipients of music revenues?

Boluk spoke a bit about how the new revenue streaming model is diversifying the recipients of music revenues; meaning that the pie is shared more equally than it was in the past. As an example, in touring, he says that "in 2000, the Top 100 tours (which included ‘NSYNC, Metallica and Snoop Dogg & Dr. Dre) collected nearly 90% of annual concert revenues. Today, that share has fallen to only 44%."

It seems plausible that the same happens with streams. When I bought CDs in the 90s and 2000s, my consumption was very lumpy. If I really liked two artists, but only had enough money for one album, one would get the whole lot, and the other would get nothing. Bigger artists had bigger pull factors, so more often, their must-have albums would sop up people's album budgets, leaving the little guys out in the cold. These days, you can just listen to both and revenues will flow to them. 

Boluk posted a diagram that helpfully illustrates Spotify's royalty model, which I reproduce below:

Source here, from Liam Boluk

Boluk identifies a few problems with it, but concludes that it's largely sensible; or at least, a it represents a least-worst option.

On the subject to diversifying the recipients of revenues, I noticed that, in fact, the way the payment mechanism is set up penalises niche artists in favour of big artists.

How Spotify's royalty mechanism makes small artists subsidise big artists

Last month, I'd guess that about 5% of my streams went to Gian Slater, while another 5% went to Beyonce, and the rest went to other music. If I was signed up to the Acme Music Streaming Company, and I was one of 10 customers, all of whom were charged $10, and AMSC followed Spotify's royalty model, the revenue splits out to the artists (ignoring label fees) could look a bit like the below:

So, you've got someone like me that listens disproportionately heavily to Gian, a pretty niche artist, and Beyonce, a mainstream artist. My listens are aggregated up with everyone else's then each artist's share is multiplied by the total revenues received to get their revenue shares.

But, there's another way this could shake out. Imagine what would happen if, instead of aggregating all of our plays together, everyone's revenue split out depending on who they listened to. See what the revenue shares based on the same number of streams could look like below:

In this case, Gian gets a whole lot more money. Why is this?

It's because when everything gets aggregated, even though I'm a heavy Gian Slater listener, my listens are only a drop in the ocean of everyone else's total streams.

So, if you're the kind of person that likes to listen to niche artists and wants to think that you're benefiting them by streaming them, well, you are, very slightly, but with the way that music tastes aggregate most likely more of your money is going to Insane Clown Posse than is going to all of your niche artists combined. If your music spend would otherwise have been on buying albums of your favourite niche bands, then stopping doing that and listening to them on a music streaming service like Spotify is probably losing them money.

It's interesting that smaller artists get screwed to the benefit of big artists, because, if anything, you could perhaps even argue that a large catalogue of niche artists is a driver of which service users sign up to. In the "which music streaming services should you sign up to" articles I read a few years ago the last time I considered signing up to one, a standard test was to see what proportion of obscure indie bands obscurest tracks were available. Until big artists start signing exclusive deals, niche artists will drive sign-ups for a small but significant proportion of people, even if they never end up listening to them!

I'd welcome critiques from people that know more about the industry, but I don't really see any way in which aggregation more fairly represents the value that users individually get from the service. 

Why don't streaming services split out revenue by person?

The short answer is: I don't know. I don't know remotely enough about the way the music industry works to say. My expertise ends at critiquing payment mechanisms and the incentives created by them. I'll hazard a few guesses, but you're better off reading people like Liam Boluk for the real industry knowledge.

My number one theory for why they don't do it is that it would be a pain in the arse. Aggregating is simpler computationally, but it's also simpler for artists to understand and for auditors to check. If you're sending an artist a royalty cheque, it's much simpler to just aggregate revenue flows and stream shares, then multiply one by the other. The top-line revenue figure can just be checked against the revenue numbers that come out in their quarterly financial statements. A royalty cheque based on person-by-person streams would be much more complicated.

It's possible that the industry bigwigs that negotiated the deals negotiated them on behalf of their big fish clients, and were happy to grab money off the small fry artists, but who knows?

This stuff is complicated

Designing payment mechanisms is not easy. People always think that there's some "best practice" formula that economists should just go an look up in a textbook, or that we can derive by just looking at some data.

The best option, or usually least-worst, is always going to be a subjective call about how you trade off the desires of one group of stakeholders against another. At the end of the day, you've got to make a call and you're always going to end up screwing someone.

Still, how you design these payment mechanisms really does literally shape the industry. In addition to looking at the aggregate, it's always important to understand the impacts on particular sub-groups of stakeholders. 

Governments pay when they choose to renegotiate terms

I wrote yesterday about how the Indonesian government were handling a renegotiation of the terms of toll road concession contracts. 

As an example of how this works in countries with more mature regulatory regimes, this article talks about the Victorian government's decision to make trams free in the Melbourne CBD.

The government reported that they did it to help lower the cost of living, and to make it easier for commuters and tourists to use trams in the city. As the operator of the trams would be losing money as a result of this change, the Victorian government had the compensate them for the loss. The cost of the initiative was estimated at around AUD 100 million for the first year of operations.

Reasonable people can differ over whether making trams free is worth the money, or whether AUD 100 million is reasonable compensation for the loss, but the way the Victorian government handled the renegotiation was professional, transparent, and consistent with investor expectations, and good regulatory practice. 

A government like Victoria's knows that it's cheaper to pay AUD 100 million in cash than it is to run the risk of tarnishing their reputation with investors by trying to force the private operator to take the burden of their policy decision. Either way, they'll pay, at least this way they know exactly what it costs them.

All of this contributes to Victoria's perception as a low-risk investment destination, which flows through into cheaper goods and services for Victorian consumers.