Testimony: Pennsylvania Senate Finance Committee Hearing on the Privatization of the Pennsylvania Lottery

Authors: 
Stephen Herzenberg
Publication Date: 
January 14, 2013

The following is written testimony provided by Stephen Herzenberg to the Pennsylvania Senate Finance Committee.

Download a PDF Version of this Testimony

My name is Stephen Herzenberg. I hold a Ph.D. in economics from the Massachusetts Institute of Technology and am the Executive Director of the Keystone Research Center (www.keystoneresearch.org). I appreciate the opportunity to submit written testimony to the Senate Finance Committee on the issue of the privatization of the Pennsylvania lottery. I also wish to recognize Senator Brubaker for his leadership in seeking to ensure a more transparent and rigorous process for deciding whether to privatize the lottery.

Attached as part of my written testimony is a briefing paper my organization released in December 2012, which raised a series of questions about lottery privatization. One indication of the nature of the deliberative process regarding lottery privatization is that all of the questions we raised a month ago remain questions today.

Why the Commonwealth Could Lose $1 to $2 Billion Over 20 Years in Revenue for Seniors’ Programs. One central issue in the lottery privatization debate has been the potential impact on revenues for seniors’ programs. I want to unpack Keystone Research Center’s analysis that the deal negotiated with Camelot could cost the Commonwealth over a billion dollars in revenue for seniors’ programs over a 20-year period. Like any estimate, this estimate depends on the assumptions made. Therefore, I want to lay out the assumptions necessary for the state to lose $1 billion in revenue so that readers can judge for themselves whether our assumptions are reasonable.

The first step in the analysis is evaluating the revenue guarantees, or Annual Profit Commitments (APCs), which Camelot has provided the state. As our brief explains, these guarantees grow at a compound rate of about 3% per year over the full 20-year period (more than 3% at the beginning, less than 3% later in the period)—about the rate of inflation in the United States since the early 1980s.[1] We believe it is reasonable to assume that the Commonwealth could earn this growth of lottery profit without privatization with an expansion in lottery games to include keno and online gaming.

The next step in our analysis is to examine the profit received by Camelot if lottery system profits exceed the APCs. Our briefing paper estimates Camelot profit for three scenarios, with the results of these estimates presented in tables in Appendix 2 of our policy brief.

  • “Scenario 1” table presents Camelot profits if system profits exceed the APCs by 5%.
  • “Scenario 2” table presents estimates if Camelot achieves system profits exceed the APCs by 10%.
  • “Scenario 3” table presents estimates if Camelot achieves system profits that exceed the APCs by 15%. 

The second-to-last column in these three tables provides the “Contractor Profit” in each of the 20 years, including incentive payments plus administrative management expense. That column shows that Camelot would receive:

  • $1.041 billion (in undiscounted nominal-dollar profit) in Scenario 1;
  • $1.911 billion in Scenario 2; and
  • $2.009 billion in Scenario 3.[2]

The differences in the results for the three scenarios are driven primarily by the following features of the proposed contract with Camelot: after a small range just above the APC commitment, Camelot receives an incentive payment equal to half any additional revenue up to an incentive payment cap set at 5% of total system profit. Thus, in Scenario 2, which still leaves Camelot below (but close to) the incentive cap in each year, Camelot receives roughly twice as much money as in Scenario 1. In Scenario 3, since the incentive cap kicks in at a little over 10% above the APCs, Camelot receives only a little more than in Scenario 2; because of the cap, Camelot doesn’t gain a lot from achieving 15% versus 10% above the APC. 

Our three scenarios establish that Camelot can receive payments of $1 billion to $2 billion over 20 years for achieving system profits 5% to 10% above the APCs.

The last step in our analysis is the most speculative: what would the lottery achieve without privatization? If the lottery could achieve the same revenues as Camelot, 5% to 10% above the APCs, then the revenue Camelot receives in these scenarios is lost revenue for seniors programs: i.e., the Commonwealth loses $1 to $1.9 billion (or $0.8 billion to $1.65 billion not counting administrative expense payments). In arguably the most plausible revenue range (i.e., a little above a relatively easily attained target), up to about 11% above the APCs, Camelot would receive about half of the increase in revenue that exceeds inflation.

The Conflict of Interest of the Commonwealth’s Privatization Advisor. Our policy brief pointed to the financial self-interest of the Commonwealth’s privatization advisor in the deal with Camelot going through. Based on a December 6, 2012 press report, we noted that Greenhill & Co. stood to earn at least $3 million if privatization is implemented. (We also noted, as have many others, the pre-existing relationship between Camelot and Greenhill, established when Greenhill worked on the $576 million sale of Camelot to its current owner, the Ontario teachers’ pension fund.) Since our brief was released, other press reports have raised the potential payout for Greenhill & Company if privatization goes through to a whopping $30 million to $50 million.[3] At $3 million or $50 million, our concern is that the financial self-interest of the privatization advisor—reinforced by a pre-existing social relationship with the one bidder—would cloud Greenhill’s ability to give the Commonwealth sound advice regarding whether privatization is a good idea.

Reforming Consideration of Privatization Decisions. The lack of transparency and rushed nature of the Commonwealth’s consideration of lottery privatization make us—and many other Pennsylvanians—nervous. That’s why we continue to believe that the contract with Camelot should not proceed. We also believe that the commonwealth needs to reform its basic approach to decisions about how to most efficiently and effectively deliver state services. First, the orientation of state discussions should not be towards—or against—privatization. The state’s goal should be efficiently and effectively delivering state services based on the pros and cons in any specific situation. Second, the consultants to the commonwealth need to have a balanced perspective and not to have a financial stake in privatization. Third, the Governor’s Advisory Council on Privatization and Innovation needs to be more balanced. Fourth, the General Assembly needs to be afforded ample opportunity for hearings and to provide input on decisions about how the state delivers different services. 

Read KRC's Policy Brief:

Unanswered Questions: In the Rush to Privatize the Pennsylvania Lottery, There Is Still a Lot We Don’t Know


Footnotes

[1] From 2001-02 to 2010-11 lottery system profits in Pennsylvania grew by 21% more than the rate of inflation. Keystone Research Center calculation based on Pennsylvania Lottery’s Comparative Statement of Income and Expenditures as of June 30 of each fiscal year.

[2] These amounts are about $240 billion to $260 billion lower in each scenario if you exclude the administrative expense: about $800 million for Scenario 1, $1.65 billion in Scenario 2; and $1.75 million in Scenario 3.

[3] See, for example, http://www.pennlive.com/midstate/index.ssf/2012/12/pennsylvania_lottery_should_no.html and http://articles.mcall.com/2012-12-25/news/mc-pa-rendell-lottery-privatization-20121225_1_corbett-administration-corbett-signs-tom-corbett