Victorian Auditor-General’s report
29 June 2011
 
Allocation of Electronic Gaming Machine Entitlements
 
Audit summary
Background
Gambling in its various forms is a significant source of state revenue, generating $1.63 billion through taxes in 2009–10. In clubs and hotels electronic gaming machines (EGM), or ‘poker machines’, contributed 60 per cent of this revenue.
In April 2008 the government announced that the two gaming operators’ licences to acquire, distribute, operate and monitor EGMs in clubs and hotels would not be renewed when they expire in 2012. Instead, as part of the new venue operator industry structure, clubs and hotels would be able to buy an entitlement for each EGM they want to operate in their venues. Restrictions on the number and location of EGMs prescribed by social policy would continue through distribution limits and ownership caps.
The catalyst for this change was the policy objective to ‘establish a venue operator industry that meets the government’s gambling guiding principles’. The guiding principles at the time of the April 2008 announcement were to:
·	provide consumer choice and service in a competitive and innovative marketplace
·	ensure the legitimate financial benefits of gambling are transparent, recognisable and fairly distributed to the community
·	reduce the harm caused by problem gambling
·	maintain high standards of transparency, probity, integrity, accountability and community engagement.
Besides the primary policy objective, the allocation was expected to achieve other secondary financial, social and stakeholder engagement outcomes. These were largely aligned with the guiding principles for gambling policy.
One of the intended financial outcomes was to capture ‘supernormal profits’. Supernormal profits are the increased profits that arise when there are restrictions on competition and limits on the quantity of a good or service. Venue operators have the potential to earn supernormal profits from gaming due to the regulatory restrictions on industry participants, and the number and location of EGMs. 
Consequently, the entitlements to operate these EGMs are significant assets in their own right—both to the state, as the creator and ‘seller’ of the entitlement; and to the entitlement holder, who acquires exclusivity in terms of a ten-year income stream from its EGMs. 
The process of allocating these entitlements to venue operators was managed by the Gambling Licences Review (GLR) project team in the Department of Justice (DOJ). A steering committee, chaired by DOJ and with representation from both the Department of Premier and Cabinet (DPC) and Department of Treasury and Finance (DTF), provided advice to government and directed the project team in its implementation of government policy and the project objectives.
The GLR project team managed the sale of the entitlements in two phases:
·	in October and November 2009—a fixed price, pre‑auction club offer (PACO) available only to existing clubs
·	in April and May 2010—a two‑stage auction for all hotel entitlements and the remaining unsold club entitlements.
Combined, PACO and the auction raised $980 million from the 27 300 entitlements that were allocated. Hotel operators paid $546 million for their 13 750 entitlements, all of which were purchased at auction. Club operators paid a total of $434 million for the remaining 13 550: $366 million at PACO and $68 million at auction.
The allocation was particularly complex to manage and involved significant risks. The project had numerous external stakeholders, tight time lines and constraints imposed by government announcements, such as the decision to sell the entitlements by auction. The auction design and implementation were technically complex and probity requirements were stringent.
A probity auditor was engaged to advise the project team and an Independent Review Panel (IRP) was established in 2007 under an amendment to the Gambling Regulation Act 2003. The purpose of both roles was to provide third-party assurance on the probity of the project. The IRP’s reports are tabled in Parliament.
Conclusion
The allocation of the EGM entitlements was achieved within very tight time lines. However, the project failed to achieve a satisfactory financial outcome and there were serious shortcomings in the project management.
The revenue obtained from the sale of the entitlements was around $3 billion less than the assessed fair market value of these assets. As a result of this very significant difference, the allocation largely failed to meet its intended financial outcome of capturing a greater share of the industry’s supernormal profits. This was due to the lack of demand at auction, combined with a low reserve, inadequate information and training for venue operators, and poor decisions made during the auction. Large venue operators, rather than the community, are the beneficiaries of this windfall gain.
Successfully allocating entitlements while maximising revenue within the social policy framework was undoubtedly a challenging proposition. These two objectives were not, however, mutually exclusive. A lower financial outcome may have been acceptable, or even desirable, if it meant that the project achieved better results in its intended social and stakeholder engagement outcomes. This was not the case. From a social policy perspective, the financial benefits of gaming have not been widely redistributed among the community as a result of the initial allocation. Stakeholder engagement outcomes also were only partly met, as the industry repeatedly raised concerns about the information provided by DOJ.
A series of project management weaknesses contributed to these unsatisfactory outcomes.
Foremost, there has been a blurring of the lines of authority and accountability by DOJ. This is especially evidenced by its misconstrued assertion that VAGO is ‘actively criticising the policy decisions of a previous government’. The ‘policy decisions’ to which DOJ refers are, however, operational and implementation matters. Responsibility for these rests with DOJ.
With respect to the implementation of PACO and the auction, DOJ’s advice to government was not robust. It was not subject to adequate quality assurance and did not take into account material changes in context.
DOJ failed to carry out adequate due diligence before acting on the advice provided by specialists that formed the basis for the design and operation of the auction. DOJ described the move to the venue operator structure as the most significant change for the gaming industry since the licences were awarded to the original gaming operators. Given the high stakes and the complex and technical nature of the undertaking, it was incumbent upon the department to demonstrate it had appropriately understood and appreciated the implications of specialist advice before accepting and acting on it. This was not the case. Much of the advice DOJ sought from specialists was conflicted, unduly restricted in scope or based on limited expertise.
There was a lack of decision review points, particularly when significant unplanned changes occurred. PACO was one such unexpected change that further complicated this already large and complex project by reducing demand for entitlements at auction. Proposals to remove barriers to entry were not accepted for social policy reasons, which also reduced demand for the auctioned entitlements. In these circumstances, there is a need for decision-makers and advisers to challenge or reaffirm the wisdom of continuing with agreed courses of action. DPC and DTF appropriately raised concerns on the merits of proceeding with the auction with their respective ministers. However, no formal review was undertaken. 
Although DPC and DTF advised their ministers, it is not evident from the minutes of the project’s interdepartmental steering committee that they discussed their concerns about the auction with DOJ. DOJ did not make a similar recommendation to its minister regarding the auction. This lack of transparency resulted in decision-makers being provided with different advice. 
DOJ provided contradictory advice on the purpose of the allocation. Prior to the auction DOJ advised the Minister for Gaming that the intention of the auction was to ‘achieve the allocation that maximises financial value subject to policy determinations aimed at social value’. However, the department asserted during the course of the audit that ‘maximising revenue was not the primary, or even secondary objective of the allocation’. This lack of clarity regarding the purpose of the allocation of EGM entitlements points to serious administrative failure. 
There were major concerns with other aspects of the management of the project. These concerns particularly related to DOJ’s procurement practices, where contracts worth $4.2 million were awarded to the two principal consultants without a competitive process. Cost control of the project was poor and significant cost overruns were incurred. Data integrity issues were created by weak knowledge management practices. The overzealous application of probity adversely affected stakeholder engagement.
Findings
Financial outcomes
The sale proceeds from the allocation fell significantly short of the fair market value of the entitlements. The industry paid $980 million for the right to operate EGMs over a ten‑year period. This is equivalent to around a third of the total revenue generated by EGMs in a single year, and a quarter of the estimated fair market values of the entitlements.
We valued the EGM entitlements in the range of $3.7 billion to $4.5 billion, with a mid‑point of $4.1 billion. This fair market value reflects the upper limit that existing venue operators would have been prepared to pay to acquire entitlements, taking into consideration the financial effect of the venue operator model and the existing social policy framework. This framework is intended to minimise the harm caused by problem gambling through measures such as regional caps and ownership restrictions. The fair market value also takes into account the industry environment at the time of the auction, including the uncertainty over future measures to combat problem gambling.
The Department of Treasury and Finance’s economic modelling
DTF carried out economic modelling between December 2007 and May 2009 to estimate the value of the entitlements. This modelling produced a range from $504 million at the low end to $4.2 billion at the high end. However, no further valuation was performed during the year leading up to the auction in 2010 that took into account the potential financial impact of PACO. This meant that government was not provided with the most appropriate and current advice. 
DTF’s most detailed estimate produced a figure of $964 million in 2008. The proximity of this estimate to the amount of revenue raised at auction is entirely coincidental for several reasons. The main reason is the purpose of this estimate was to calculate the level of supernormal profits in the industry, not to forecast the amount of revenue the allocation was likely to raise. Such a forecast would not have been possible at that time, as the details of the auction had not been decided and PACO was not announced until the following year. 
Furthermore, DTF’s 2008 calculation of supernormal profits was not comprehensive, as it failed to include supernormal profits at the venue operator level. This was because DTF decided at that time it could not establish with any degree of confidence the level of local competition between venues, or their costs. These factors affect the amount of supernormal profits venues earn. This information could have been reasonably estimated, however, had industry consultation taken place. 
DTF subsequently decided in 2009 that it would attempt to produce an estimate that did include supernormal profits at the venue operator level. This estimate of $4.2 billion is similar to our fair market valuation. However, the robustness of DTF’s calculation cannot be confirmed because of the lack of documentation on the method and assumptions it used.
DTF would have benefited from a third-party review to test the robustness of the assumptions it used. This did not occur and was a significant oversight.
Factors affecting the auction result 
It is reasonable to expect some difference between the fair market value and sale revenue. Market constraints, the level of competition, expectations of future earnings and individual attitudes towards risk are all key determinants of sale price. 
However, the very substantial difference between the estimated fair market value of the entitlements and the total PACO and auction proceeds is a strong prima facie indication that there were significant issues in the design and implementation of the allocation process.
The major reasons for the difference between the price paid for entitlements and their estimated fair market value were:
·	the prior allocation of entitlements to clubs through PACO and the regulatory restrictions on the industry reduced demand for the entitlements at auction
·	the reserve was set at a low price in a situation where the number of bidders was small and competition was lower than expected 
·	the auction design was not adequately reviewed by appropriately qualified specialists and led to unrealistic expectations of the duration of the auction
·	the conduct of the auction did not serve to maximise financial value subject to policy determinations
·	there were shortcomings in the information and training provided to the industry. 
Reduced demand at auction
There was a substantial difference in the actual number of bidders at auction compared to the number of potential bidders. The low number of bidders resulted in reduced demand and competition for the auctioned entitlements. From DTF’s perspective, this constituted an ‘adverse outcome’ for the state.
While 236 club operators purchased entitlements at PACO, only 149 club operators took part in the auction. Of the 4 838 entitlements sold at auction to clubs, 72 per cent were sold at the reserve price of $5 500. The average price clubs paid for entitlements at auction was a third of the average price paid at PACO.
The gaming industry’s regulatory approval processes also affected demand at auction. 
The regulatory processes and the associated costs involved in obtaining Victorian Commission for Gambling Regulation (VCGR) approval for new venues limit the number of new industry entrants. Of the 345 venue operators who took part in the auction, only 47 were new entrants. 
Approval is also required for existing venue operators to change the number of EGMs on their licence. This deterred venue operators from bidding for more entitlements. Of the existing venue operators who had EGMs at the time of the auction, 61 per cent bought the same number of entitlements as the number of EGMs in their premises immediately prior to the auction.
DOJ, DPC and DTF recognised that the regulatory and financial burden had the potential to limit the amount of revenue the allocation would raise, and these departments briefed the government accordingly. However, for social policy reasons, the existing approvals process was largely unchanged. The lower number of participants reduced demand at the auction, which meant DTF’s advice to reconsider the decision to auction the entitlements was prudent. 
To deal effectively with these types of scenarios, which were to be expected in such a lengthy and complex project, it would have been prudent to build decision review points into the process. Significant unplanned events have the potential to adversely affect project outcomes or require the rationale for continuing with a previously agreed course of action to be questioned. When these events occur, all relevant parties need to satisfactorily consider and resolve such issues if the project is to be successfully delivered.
Low reserve
The decision to largely retain the approvals process was made before the reserve was set. Therefore, it was known that the number of potential bidders in certain markets was likely to be low because these barriers to entry remained. As a consequence, prices at auction could not be expected to—and indeed did not—rise significantly above the reserve. The setting of an appropriate reserve price was, therefore, particularly critical in determining the price paid for entitlements.
The reserve was low: $5 500 for clubs and $11 000 for hotels. The hotel reserve was set at double the club reserve because hotels earn twice as much from EGMs as clubs. These prices equated to $550 per year for clubs and $1 100 per year for hotels over the ten‑year period of the entitlements. This is less than 1 per cent of the average revenue generated per club EGM and per hotel EGM in 2008–09. 
The rationale for the auction reserve was not robust. The reserve was based on the lowest price paid by a club at PACO. This particular club was the least profitable gaming venue in the state and closed shortly after the auction. 
When compared to the range of PACO prices, the price that formed the basis for the reserve was clearly an ‘outlier’. There is no evidence that this was communicated in the advice provided on the reserve prices. The lowest price paid at PACO was $5 743 per entitlement. The second lowest PACO price was $9 165, which is 60 per cent higher than the lowest price. The average PACO price was $42 014, or more than seven times the lowest price. 
The club sector largely accepted the PACO prices, as 96 per cent of eligible club opertors bought entitlements before the auction. This indicates they were prepared to pay more for their entitlements than the auction reserve of $5 500.
Auction design
There was inadequate analysis of the most appropriate mechanism to allocate entitlements. DOJ did not consider a wide enough range of possible sale mechanisms, nor did it subject the chosen auction format to sufficient third-party review before accepting and acting on the advice provided by the auction specialist.
There are more widely recognised types of auctions than the format chosen for the EGM entitlements. The ‘uniform pricing rule’ meant that the price participants paid was not necessarily the amount they bid. The price paid for the entitlements was based on the computed ‘market’ price, or the lowest accepted bid in a particular market. There were 176 markets, which were based on venue type and geography. Bidders in the same market paid the same price for the entitlements allocated to them in that market. 
Consequently, although the total value of the successful bids was $855 million, the amount actually raised by the auction was $614 million. The difference between the value of the bids and the price paid indicates bidders were willing to pay more for their entitlements. Although participants would have acted differently if another type of sale mechanism had been used, it is possible that a different sale mechanism would have raised more than $614 million. 
DOJ did not, however, adequately explore whether any other sale mechanism could have achieved better overall outcomes—namely higher revenue and/or lower cost—than the chosen auction format. DOJ selected this particular sale mechanism following specialist advice that an auction using a uniform pricing rule would ‘arrive at the bidder’s maximum willingness to pay sooner and so the auction will conclude quicker…there are no expected revenue differences between the uniform price auction and the ‘pay your bid’ auction’. 
DOJ did not exercise due diligence before accepting this advice. The auction specialist’s advice led to unrealistic expectations of the duration of the auction, which affected how it was conducted.
Auction conduct
More revenue could have been raised at auction had it been allowed to continue for longer. 
The $855 million value of bids placed is likely to be a conservative figure. One of the reasons for this is the auction was ended prematurely. The auctioneers took steps after 46 rounds to bring the auction to a close. The auction continued for another 17 rounds and generated a further $108 million. Although it is not possible to authoritatively quantify how much more revenue would have been raised if the auction had been allowed to continue, analysis of the auction data revealed that the average increase in revenue for each of the last five rounds was $11 million. The amount of revenue raised in round 59 of 63 was the highest of any round: $21.4 million. Bidding in the final round was $4.5 million greater than in the penultimate round. The auction was closed while bids were still being placed.
That bidders were willing to pay more is further confirmed by comparing the prices paid at PACO with the prices achieved at auction. For example, metropolitan clubs paid an average of $41 796 per entitlement at PACO, but only $9 544 at auction. 
Our survey of bidders also indicated that 61 per cent of respondents expected to pay more at auction.
Information and training
There were shortcomings in the information and training provided to the industry to prepare them for the allocation process. As a consequence, the intended outcome of an ‘informed and confident community and industry’ was not achieved.
The information provided to the public was limited, following probity advice that providing more extensive information would favour larger and better‑resourced commercial operators. Meetings with peak bodies were discontinued and individual questions were not answered if information was not already publicly available. Generalised responses were provided on the project’s website, which may or may not have addressed individual bidder concerns. DOJ did not attempt to establish whether bidders found these responses adequate.
The probity advice was overzealous and applied too rigidly by the GLR project team. With appropriate safeguards, such as publicly releasing transcripts of peak body meetings, additional information could have been provided to the industry without compromising probity. Since this did not occur, industry participants were unclear about a number of aspects of the allocation process.
The explanation of how prices would be calculated during the auction was ambiguous, with bidders particularly confused about how the price in other markets would affect the price in their own market. On auction day, 34 per cent of participants’ queries on the conduct of the auction related to the movement in prices. 
The auction rules did not explain how the system would determine partial allocations, which occurred when participants’ bids were equal to the market price. Participants whose bids were equal in price and quantity were not allocated the same number of entitlements. In one scenario, a bidder received its full complement of entitlements, but the other only received a partial allocation.
There was no confirmation that the training had given participants an adequate understanding of auction rules and processes. This was particularly critical given the complexity of the auction software and the associated rules. 
Project management and oversight
The management of the allocation of EGMs was successful in that both PACO and the auction were conducted within very short time lines. This was, however, at the expense of due process.
Procurement practices
Procurement was poorly planned, which resulted in a lack of competition in the engagement of consultants and non-compliance with procurement policy. 
The auction specialist/software provider was engaged by DOJ on an initial contract of $35 000 without a competitive process. Although the appropriate exemption was provided for this initial contract, the approvals required under procurement policy were not obtained when a further five contracts were created with the same party. The total value of these six contracts was $3.5 million. DOJ did not follow better practice in this procurement, as none of these contracts was awarded under a competitive process. While auction theory and the associated software is a very specialised area of expertise, there are other providers in this field. 
Similarly, the information technology (IT) adviser engaged to advise on hardware and software was awarded an initial contract for $36 000. This was increased twice, first to a cumulative value of $200 000 and then to $420 000.
Although the appropriate approvals were sought in this instance, the increases were a sign of poor planning. There was no testing of the market at any stage to demonstrate taxpayers were receiving value for money from these arrangements. In October 2010 the same IT adviser was awarded a further contract for $150 000 to provide advice on the wagering and betting component of the GLR, once again without a competitive process. 
In summary, there were eight contracts, two financial variations and a deed of settlement totalling $4.2 million for the auction specialist/software provider and the IT adviser, and no competitive process.
Specialist advice
The engagement of specialists to advise the project team was problematic. The roles and responsibilities of specialists lacked independence because they were not appropriately delineated and defined, and oversight arrangements were not robust.
The specialist engaged to provide advice on the auction design also provided the software to run the auction. This resulted in the auction specialist making recommendations on the auction design and then implementing these recommendations. This arrangement was inherently conflicted.
This lack of independence could have been overcome if appropriate third-party assurance had been sought on the auction design and software. This was not the case, as DOJ did not appropriately define the roles and responsibilities of its other advisers.
The Technical Reference Group (TRG) was established by DOJ in November 2008 to advise on aspects of the auction design. The TRG was, however, restricted from advising on whether the proposed auction design and software were the most appropriate in the circumstances, which limited its effectiveness.
The IT adviser engaged to provide quality assurance lacked expertise in auction theory and was dependent on the advice of the auction specialist/software provider. Particular concerns with this arrangement were that:
·	the test plan was based on the auction specialist/software provider’s contract requirements and software design specifications rather than an independently derived end‑to‑end test plan developed by third-party specialists.
·	there was insufficient third-party assurance that the algorithm would work as expected, especially in regard to the ranking rules that prioritised bids. 
The IT adviser’s responsibility for providing quality assurance was compromised by an expansion of its role to include collaboration with the auction specialist/software provider on the development of the technical specification. The IT adviser subsequently tested the specification for functionality and compliance with the auction objectives. This was another inherently conflicted arrangement, as it meant that the IT adviser was quality assuring its own work.
Cost control
There was insufficient control over the project costs. In the 2007–08 and 2008–09 budget cycles, DOJ sought funding of $20 million. This was to cover the department’s costs of allocating all five gambling licences for the three years to 30 June 2010. By October 2010, shortly after the allocation of EGM entitlements had been finalised, the department’s total project expenditure was $41 million; double the original budget. 
Costs were managed at a whole‑of‑GLR level. There was no separate cost reporting for the different licences within the GLR, which covered EGMs, monitoring, Keno, wagering and lotteries. These licences were substantial projects in their own right with separate requirements and time lines. 
The GLR project team estimated the cost of the EGM component of the GLR between July 2007 and October 2010 was $19 million. Since there were no detailed records of the amount of staff time assigned to the various licences over this period, it was not possible to confirm the accuracy of this figure.
Knowledge management
Knowledge management is particularly important in a project environment, where contractors often make up a significant portion of the team. Since a large number of contractors or staff can leave both during or immediately after a project has finished, effective knowledge management is critical for retaining corporate memory.
Sound knowledge management principles were applied in producing end‑of‑stage reports after major project milestones and establishing a dedicated website to disseminate information to the public. This website was regularly updated in the lead‑up to the auction. 
However, data quality and reliability were impaired by inconsistencies in the information recorded on venue operators. These inconsistencies indicated data management rules were not well defined or applied, which increases the likelihood of gaps and duplication in data. Discrepancies in naming conventions were found not only between the different records kept by VCGR and the GLR project team, but also often within the same document. 
It is crucial that accurate master data on venue operators is maintained to allow VCGR to monitor compliance with the regulatory framework. Complete and accurate details of ownership arrangements are necessary for VCGR to carry out probity assessments on industry participants. 
Probity
There is insufficient documentary evidence and third-party assurance for VAGO to definitively conclude that there were no major breaches of probity in the allocation process. 
DOJ did not keep sufficient documentation to allow an independent verification to be performed on the auction results. As such, we are unable to confirm that each venue operator received their correct entitlements for the correct price. 
There has still been no public assurance that the probity requirements were met. To date, the IRP has not tabled its report on the probity of the allocation of EGM entitlements. Given the elapsed time and proximity to August 2012, when the venue operator structure takes effect, it may be difficult for DOJ to respond to any adverse findings of the IRP.
This delay occurred because the GLR project team requested that the IRP and probity auditor give priority to other, more time‑critical GLR licensing processes. As a result, the probity auditor’s report was only produced in May 2011, a year after the auction took place. This report is an internal DOJ document and has not been released publicly.
Although the probity auditor’s report noted 36 issues, none was considered material. The probity auditor concluded that the GLR had complied in material aspects with the probity requirements. However, this report needs to be treated with caution, primarily because there are several important omissions in terms of the evidence considered to support its findings. For example, the report did not assess whether venue operators were disadvantaged by an inadvertent breach of the regulatory framework, or by a lack of clarity on the auction rules. Furthermore, the IRP has previously questioned the adequacy of the oversight provided by this particular probity auditor.
Recommendations
Number	Recommendation	Page	
1.	For issues that are significant and material, the Department of Treasury and Finance should apply a more rigorous approach and obtain specialist third-party assurance so that the advice provided to government to inform key decisions is robust.	24	
2.	The Department of Justice should obtain appropriately tailored third-party assurance over the robustness of specialist advice where this advice is critical to the success of a strategy or project.	48	
3.	The Department of Justice should develop processes to provide assurance that training participants have gained sufficient knowledge to fulfil the intentions of the training program.	48	
4.	The Department of Justice should build effective decision review points into projects to allow re-evaluation or re‑confirmation of particular courses of action.	69	
5.	The Department of Justice, together with other members of the interdepartmental steering committee, should develop communication protocols regarding the sharing of information.	69	
6.	The Department of Justice should establish improvements in contract management so that consultants’ roles and responsibilities are independent, appropriately scoped and performed by consultants with relevant expertise.	69	
7.	The Department of Justice should improve procurement practices by:
·	promoting more stringent oversight by the Accredited Purchasing Unit of compliance with procurement policy
·	providing more effective procurement planning at the project management level.	69	
8.	The Department of Justice should manage probity in a manner that balances information provision with safeguards over fair, equitable and impartial treatment.	69	
9.	The Department of Justice should provide cost reporting for the Gambling Licences Review project on an individual licence basis.	69	
10.	The Department of Justice should establish knowledge management processes to address not only knowledge retention but also concerns with inaccurate or inconsistent information.	69	

Submissions and comments received
In addition to progressive engagement during the course of the audit, in accordance with section 16(3) of the Audit Act 1994 a copy of this report was provided to the Department of Justice, the Department of Treasury and Finance, the Department of Premier and Cabinet, the Victorian Commission for Gambling Regulation and the Independent Review Panel with a request for submissions or comments.
Agency views have been considered in reaching our audit conclusions and are represented to the extent relevant and warranted in preparing this report. Their full section 16(3) submissions and comments, however, are included in Appendix B.