And Legislative Issues Relating to the Reform of Public Health Care Providers

FINAL REPORT FOR

Department of the Prime Minister and Cabinet National Interim Provider Board

i h STRUCTURAL, ORGANISATIONAL

I AND LEGISLATIVE ISSUES RELATING TO THE REFORM OF PUBLIC HEALTH CARE PROVIDERS

I May 1992 1-!

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CS FIRSTBOSTON

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IMPORTANT NOTE

This report has been prepared at the request of the National Interim Provider Board by CS First Boston NZ Limited.

Whereas all reasonable steps have been taken to ensure that the information in the report is true and correct in every respect, CS First Boston NZ Limited neither warrants the accuracy of the said information nor is any responsibility accepted whatsoever for any loss which may be suffered by any party as a result of any error or omission in the said information or any conclusion that may be drawn from it.

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TABLE OF CONTEN rs

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1.0 EXECUTIVE SUMMARY 1

1.1 Introduction 2 1.2 Acknowledgements 2 1.3 Alternative Forms of Health Care Organisation 2 1.3.1 International Experience 3 1.3.2 Organisational Model for CHEs 4 1.3.3 Community Trusts 5 1.4 I Criteria and Principles for Reconfiguration 5 1.4.1 Competition Issues 1.4.2 Organisational Issues 6 1.4.3 Suggested Commerce Act Changes 7 1.5 Potential Impediments to the Development of

Efficient, Market-Driven Health Care Providers 8 1.5.1 1 Competitive Neutrality 8 1.5.2 Policy Uncertainty 8 1.5.3 Competitive Funding 9

1.5.4 Contracting Issues 9 1.5.5 Surplus Property 9 1.6 Reconfiguration and Management Process 10 1.6.1 Critical Issues 10 1.6.2 Suggested Approach 11 1.6.3 Supervisory Board 11 1.6.4 Crown HealthEnterprise Transition Boards 12 1.6.5 Crown Health Enterprises I.)0 1.6.6 Ministerial Monitoring Unit 14 1.6.7 Relationship to the Role of the NIPB 1.7 14 Timetable and Legislation 15

2.0 BACKGROUND TO THE STUDY

2.1 Introduction 17 2.2 The Governments Proposed Reforms 17 2.3 Terms of Reference for the Current Study 19 2.4 Approach 20 2.5 Outline of Sections 3.0 to 6.0 21

3.0 ALTERNATIVE FORMS FOR HEALTH CARE PROVIDERS 23

3.1 Introduction 23 3.2 Theoretical Analysis of For-Profits and Not-For-Profits 24

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3.2.1 Ownership and Incentives in For-Profits and Not-For-Profits 24 3.2.1.1 Characteristics of Not-For-Profit Corporations 25 3.2.1.2 The Profit Motive 26 3.2.1.3 Who Gets Control? 27 3.2.1.4 Implications for Managerial Performance 28 3.2.2 Theoretical Arguments for the Not-For-Profit Form 30 3.2.2.1 Information Problems 31 3.2.2.2 The Provision of Local Collective Goods 33 3.2.3 Experience with For-Profits and Not-For-Profits in the US 34 3.2.4 Reasons for the Dominant Position of Not-For-Profits 37 3.2.5 Application to the Health Sector in New Zealand 40 3.3 The SOE Framework and Experience 43 3.3.1 The SOE Framework 44 3.3.2 Review of SOE Experience 46 3.3.2.1 SOEs 46 3.3.2.2 Ports 47 3.3.2.3 Airports 50 3.3.2.4 Local Authority Trading Enterprises 51 3.3.2.5 Crown Research Institutes 52 3:3.2.6 Electricity Supply Authorities 54 3.3.3 Flexibility of the SOE Approach 55 3.3.4 Relevance of the SOE Model to Health Reform 60 3.3.4.1 Health Care Institutions as Businesses 60 3.3.4.2 The Robustness of the SOE Model 62 3.4 Implications for Crown Health Enterprises 63 3.4.1 The "Default" Option 63 I 3.4.2 Community Trusts 65 3.4.2.1 Key Elements of the Community Trust Model 65 3.4.2.2 Principles for Establishment of Community Trusts 66 3.4.2.3 Community Trusts vs. Direct Subsidisation 68

4.0 CRITERIA AND PRINCIPLES FOR RECONFIGURATION 71

4.1 Introduction 71 4.2 Criterion 72 4.3 Competition Issues 75 4.3.1 International Experience with Health Care

Competition and Antitrust 79 -- 4.3.1.1 Empirical Evidence on Competition in

in the US Health Sector 80 4.3.1.2 Retrospective Repayment Systems 80 4.3.1.3 Prospective Payment Systems (PPS) 81 4.3.1.4 Selective Discounting 81 4.3.2 US Antitrust Experience 81 4.3.2.1 Antitrust and Innovation in US Health Care Markets 82 4.3.2.2 Market Definition in US Antitrust Cases 84 4.3.3 Competition Law in New Zealand 85 4.4 Competition Considerations in the New Zealand

Health Care Market 88 4.4.1 Identification of Relevant Markets 89 4.4.1.1 Acute Services 89 4.4.1.2 Non-Acute Hospital Services 93 4.4.1.3 Primary Health Services 95

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4.4.2 Market Constraints 96 4.4.2.1 Acute Services 96 44.2.2 Non-Acute Hospital Services 98 4.4.2.3 Primary Health Services 101 4.4.3 Countervailing Power of RI-lAs 101 4.4.4 Political and Regulatory Constraints 104 4.4.5 Summary of Market and Political Constraints 4.5 105 Integration Economies and Restructuring Costs 106 4.5.1 Behavioural Versus Structural Regulations 107 4.5.2 Insights from the US 107 4.5.3 Economies of Scale and Scope 109 4.5.4 Financial Viability 112 4.5.5 Community of Interest Considerations 114 4.5.6 Managerial Resource Constraints 115 4.5.7 Process Considerations 118 4.5.8 Summary of Integration Economies and Restructuring Costs 120 4.6 Conclusions 121 U 5.0 POTENTIAL IMPEDIMENTS TO THE DEVELOPMENT OF EFFICIENT, MARKET-DRIVEN HEALTH CARE PROVIDERS 125

5.1 Introduction 125 5.2 Barriers to Competition and Restructuring 125 5.2.1 Regulatory and Political Barriers to Entry 125 5.2.2 Competitive Neutrality 126 5.2.2.1 Treatment of Competing Providers by RHAs 126 5.2.2.2 Valuation and Cost of Capital for CI-lEs 126 5.2.2.3 Ability of CHEs to Fail 128 5.2.2.4 Political Involvement in CHEs 129 5.2.2.5 Tax Exempt Status of Not-For-Profits 130 5.2.2.6 Planning Controls 130 5.2.2.7 Compensation of Specialists 130 5.2.3 Risks for New Entrants 132 5.2.4 Importance of Competing Insurers 133 5.2.5 Power of Medical Practitioners 135 5.2.5.1 Regulatory Barriers 135 5.2.5.2 Medical Ethics and Etiquette 138 5.2.5.3 Antitrust Issues Involving Medical Practitioners 139 5.2.6 Industrial Relations 5.3 Contracting Issues 140 141 5.3.1 Coordination of Funder and Provider Reform 141 5.3.1.1 Development of Contracting Arrangements 141 5.3.1.2 Impact of Reforming Providers Ahead of Funders 142 5.3.1.3 Cost and Quality Control 142 5.3.2 Transitional Arrangements for Contract Development 5.4 Structure of CHEs 144 146 5.4.1 Current Configuration of Public Assets 146 5.4.2 Incentives for Divestment of Assets, Mergers and Takeovers and Contracting Out of Management 147 5.4.3 Availability of Skilled Directors and Management 150 5.4.4 Duplication of Expensive Services 5.5 150 Conclusions 150

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6.0 RECONFIGURATION AND MANAGEMENT PROCESS 153

6.1 Introduction 153

6.2 Critical Issues 153 153 6.2.1 The Need for a Decentralised Process 6.2.2 The Need to Provide for Diversity 154 155 6.23 The Need for a Commercial Framework 6.2.4 Non-Commercial Issues 156 6.2.5 Monitoring Issues 157 159 6.2.6 Competition Considerations Coordination with Health Care Funding Reform 159 6.2.7 6.2.8 Business Valuations 162 162 6.3 Recommended Approach 6.3.1 Crown Health Enterprise Supervisory Board 162 Crown Health Enterprise Transition Boards 168 6.3.2 6.3.3 Crown Health Enterprises 170 6.3.4 Ministerial Monitoring Unit 171 6.3.5 Relationship to Role of NIPB 172 Auditing 174 6.3.6 6.3.7 Legislative Constraints 174 6.4 Timetable and Sequencing Issues 175 6.5 Strengths and Weaknesses of Proposed Approach 178 6.5.1 Strengths 178 6.5.2 Weaknesses 179 6.5.3 Overall Assessment 179 _1

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TABLE OF CONTENTS - APPENDICES

- - I APPENDIX A: Overview of New Zealand Health Care Services

APPENDIX B: Profile of a Competitive Provider Market

APPENDIX C: Market Definition, Market Concentration and Entry Barriers

APPENDIX D: Examination of the Effect of Competition on Hospital Efficiency

APPENDIX E: Bell Gully Buddle Weir Report on Competition Law and Health Care

in New Zealand

APPENDIX F: Economies of Scale, Scope and "Chain .3 APPENDIX C: UK Reform Experience

APPENDIX 1-I: Chapman Tripp Sheffield Young Letter Reporting on Legislative Issues

APPENDIX I: Legislation Administered by the Department of Health

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SECTION 1.0: EXECUTIVE SUMMARY /

1.1 Introduction

CS First Boston NZ Limited ("CS First Boston") has pleasure in presenting this report on structural, organisational and legislative issues relating to the reform of public health care providers, to the National Interim Provider Board ("NIPB"). The report is one of several commissioned by the NIPB to assist in its advice to the Government regarding the establishment and management of new government-owned health provider units as outlined in the 1991 Budget and the Statement of Government Health Policy.

The terms of reference for this report required CS First Boston to:

assess the role for alternative organisational forms, including for-profits, not-for- profits, and community trusts, in a competitive health care industry;

provide recommendations on the least-costly process for enabling the public health sector to move to an efficient structure and form of organisation while minimising the disruption to existing services;

develop a series of detailed principles and a recommended process to be used nationally for establishing the initial industry configuration and organisational arrangements for government-owned health care providers;

identify potential major impediments to the development of efficient, market- driven government-owned health care providers and advise on how to minimise these;

advise on the preferred management arrangements for establishing the new structure of public providers and for ensuring efficient performance and adequate organisational flexibility thereafter;

make recommendations on the ongoing relationship between public sector health providers and their owners, including reporting and monitoring arrangements; and

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advise on the preferred legislative and administrative arrangements for giving effect to the recommendations arising from the tasks outlined above.

1.2 Acknowledgements

In preparing the report, we visited four area health boards and met with key personnel. Without exception, the individuals concerned were very helpful, making available considerable time for interviews and follow-up discussions. Every attempt was made to meet our requests for information. We also benefited from comments provided on a summary or draft of the report at a series of "validation meetings" organised by the NIPB. The meetings were attended by area health board personnel, independent consultants, members of the NIPB, and officials from various government departments. We also held useful discussions with a number of health care professionals, managers, and advisors working for private and government organisations in New Zealand, Australia, the UK, and the US.

Advice on particular health care issues and comments on a draft of the report were provided by the following consultants: Professor Derek North, Dean of Medicine at the School of Medicine, The University of Auckland; Dr David Green, Director of the Instiftite of Economic Affairs, London; Professor Tony Culyer, Head of Department of Economics and Related Studies, University of York; and Professor Patricia Danzon, Professor of Health Care Systems, Insurance and Risk Management, The Wharton School, University of Pennsylvania. The involvement of these individuals has been of considerable assistance to CS First Boston. Geoff Swier, who managed the project on behalf of the NIPB, and Chris Clarke, a member of the executive of the NIPB, also provided valuable assistance.

Notwithstanding the assistance of the individuals referred to above, full responsibility for the report lies with CS First Boston.

1.3 Alternative Forms of Health Care Organisation

In establishing an initial structure for health provision, it will be crucial to ensure that managers have sufficient autonomy to take important decisions about resource reallocation, investment and divestment. It will be equally important to ensure that they have incentives to exercise this autonomy in a way which results in the best possible outcomes for users of the health system. The organisational arrangements adopted for government-owned health care

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organisations will affect how much autonomy managers have, and what their incentives are to exercise their discretion in an economically sensible way.

In Section 3.0 we review the international experience with for-profit and not-for-profit organisational structures and consider their relative merits. We then discuss the options for I New Zealand and propose an organisational model for crown health enterprises ("CHEs").

1.3.1 International Experience

The most widely-studied competitive health care industry is that in the US. Around 85 percent of health care institutions in the US are not-for-profit, either state owned or privately owned. However, not-for-profit health care organisations in the US benefit substantially from a range of tax and regulatory advantages that do not apply to their for- profit counterparts. It is not possible, therefore, to infer from the US experience that the prominent position of not-for-profits is a natural outcome of competitive forces.

In fact, our review of the US experience tends to highlight the similarities between the for- profit and not-for-profit models (as observed in the US). Not-for-profit and for-profit organisations frequently adopt similar corporate and managerial structures and both are essentially commercial" organisations. Moreover, both organisational forms require providers to generate an economic surplus to survive; the essential difference between the two forms being the manner in which the surplus is used. In for-profit organisations the surplus is returned to shareholders; in not-for-profits the surplus is more likely to be appropriated in some form by managers or other suppliers of specialist services or dissipated through inefficient management practices.

While there are a range of theoretical arguments that might explain or justify the use of the not-for-profit form, our general conclusion is that these are not strongly applicable to health care institutions. In the New Zealand context, we believe that any benefits from a not-for- profit charter would be offset by the incentive problems arising from a lack of clear ownership and resulting difficulties in making providers accountable to government for efficient performance.

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1.3.2 Organisational Model for CHEs

In our view the key ingredient for ensuring efficient government-owned health care organisations in New Zealand is a commercial framework involving high levels of management accountability. A requirement that CHEs earn a normal return on their assets, in the face of competition, enforced by managerial monitoring and accountability mechanisms, will be the most effective means of achieving this. For this model to yield sustainable benefits:

clear and non-conflicting commercial objectives must be set for CHEs;

high-quality directors must be appointed to CHE boards and non-performing directors and boards must be expeditiously replaced;

an arms-length relationship between managers and the shareholder Ministers must be established and rigorously maintained;

other government agencies must be precluded from impinging on CHEs managerial autonomy;

mechanisms must be established for holding managers accountable for the achievement of the objectives set for them, and for monitoring their performance;

C non-commercial objectives must be separated out, and funded separately by the government; and

C all regulatory advantages and disadvantages enjoyed and/or suffered by the CHE vis-a-vis actual or potential competitors must be removed.

The components of this model together comprise a mutually-reinforcing package. The successful application of the model to health care institutions would depend both on the rigorous application of its complementary parts and on a high degree of commitment to maintaining the model.

This approach should not, however, be interpreted or applied as a rigid model that precludes organisational flexibility. Instead, the provider units initially established by the NIPB should be encouraged to adopt non-corporate and hybrid organisational arrangements where

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these would improve efficiency. Such arrangements might include, for example, the creation of non-profit subsidiaries, community trusts or joint ventures; or leasing facilities on a long- term basis to other providers.

1.3.3 Community Trusts

Li Community trusts are part of a diverse menu of organisational arrangements for achieving creative solutions to specific health care needs. Commercial provider units should be given flexibility to tailor their organisational and structural arrangements to the specific circumstances they face. This should include scope to transfer assets to community trusts if this provides efficiency gains. This might occur if a community trust has lower operating costs or provides a form of service delivery that is preferred by a regional health authority ("RHA") and the community trust wishes to lease or purchase public health care assets. Such assets should not, however, be leased or sold to community trusts at prices below those which would be paid by third parties or commensurate with the returns the public provider would achieve if it retained the assets for its own use. The transitional arrangements we propose make explicit provision for the identification of community trusts.

1.4 Criteria and Principles for Reconfiguration

In Section 4.0 we discuss the criteria and principles that should guide the restructuring of -. government-owned health care providers and the establishment of an initial configuration of assets and organisations.

1.4.1 Competition Issues

1 The establishment of a competitive health care market in New Zealand will result in a transition to a far less centralised and more diverse industry structure. However, there is considerable uncertainty regarding the manner and speed in which this process will unfold. It is, therefore, difficult to accurately anticipate either the nature of the competitive responses that will emerge in the health care market or the competitive constraints that will apply to publicly-owned providers.

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potential is realised, however, will depend on the quality of the accountability mechanisms and regulatory arrangements applying to RHAs and health care providers.

Competition concerns regarding the health care market will be best met by establishing purchaser and provider arrangements and designing a regulatory environment that encourage neutral treatment of all actual and potential providers, that avoid unwarranted impediments to new entrants, and that provide robust incentives for high levels of commercial performance by provider units and RHAs. In general, we believe these factors will have a far greater impact on the success of the reforms than will the initial configuration of government-owned provider assets.

Competitive health care markets are characterised by decentralisation, specialisation and diversity. This, together with the pervasive economic costs of behavioural regulation, lead us to believe that such regulation should not be relied upon extensively, if at all, to address perceived market power problems in the New Zealand health care industry. Any interventions to address market power difficulties should, instead, rely principally on. structural break up in the near term.

The major potential area of competition concern relates to 24 hour acute care services. No private hospital in New Zealand provides 24 hour acute services and, depending on the contractual arrangements agreed with RHAs and the perceived polity uncertainty surrounding provision by the private sector, expansion into these services might involve serious financial and organisational risks. There is considerable scope for competition from the private sector in non-acute hospital services and primary health care

Although many government-owned hospitals are likely to face limited competition in acute care services in the immediate future, they will be constrained by the market power of RHAs as regional monopoly purchasers and the threat of behavioural regulation or structural break up in .the event of politically objectionable behaviour on their part. Notwithstanding these constraints, however, we believe there is a case for breaking up those area health boards with two or more medium or large acute care hospitals where this would involve relatively low restructuring costs and limited organisational diseconomies.

1.4.2 Organisational Issues

Breaking up those area health boards with two or more medium or large acute care hospitals would, in our view, be unlikely to involve serious losses in terms of foregone economies of scale I

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and scope. While there is an increasing trend towards the operation of chains or groups of hospitals in the US, this form of organisation is unlikely to provide overwhelming cost advantages relative to single-site hospital organisations or to reduce restructuring costs. We believe that the NIPB should allow chains to be formed over time if they can be shown to provide efficiency advantages, rather than require that chains be established at the outset.

The internal reorganisation already undertaken by some area health boards is broadly consistent with the principles underlying the Governments reform proposals. We believe that the internal structures in place in these areas should form the basis of any break-up directives provided by the NIPB to the provider units responsible for the establishment of CHEs and community trusts Where it is less clear that the logic which has driven internal restructuring is consistent with the broad thrust of the Governments reform proposals, we suggest that the provider units responsible for the establishment of CHEs and community trusts be given greater flexibility to determine the initial configuration of assets. However, if, in such cases, the area health boards have two or more medium or large acute care hospitals, the units responsible for establishing CHEs and community trusts should be required to separate the hospitals into competing provider units.

The major concerns regarding the supply of suitably qualified managers and directors relate to the quality of the commercial framework governing the establishment and ongoing management of CHEs, rather than to the number of CHEs per Se. We believe that it is essential that these concerns be met head on by developing robust accountability and monitoring arrangements for CHE directors and managers and by institutionalising an arms- length relationship between Ministers and CHEs rather than by altering the number of CHEs.

1.4.3 Suggested Commerce Act Changes

International experience suggests that competition law has a valuable role to play in facilitating the use of new and innovative forms of health care funding and provision and in regulating the ongoing restructuring of the health industry. To avoid unnecessary restructuring costs and to limit the scope for arrangements that damage the competitive process in the health care industry, we recommend that the NIPB seek several changes relating to the Commerce Act to bring CHEs within the jurisdiction of the Act. In addition, we suggest that the NIPB undertake further work on the benefits to the health industry of exposing labour market arrangements to the Commerce Act and of the best means of achieving this.

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1.5 Potential Impediments to the Development of Efficient, Market- Driven Health Care Providers

In Section 5.0 we consider the potential impediments to the development of efficient, market- driven health care providers. In our view, the two most serious impediments to successfully restructuring the health care industry are the prospect that CHEs will not be established on a competitively neutral basis and the policy uncertainty surrounding the Governments health reform proposals.

1.5.1 Competitive Neutrality

Competitive neutrality is essential to ensuring that business success on the part of providers reflects their relative efficiency rather than underlying policy distortions. Competitive neutrality requires that:

RHAs are neutral in their choice of provider, selecting the organisation producing the desired service at the lowest quality-adjusted cost irrespective of ownership;

• public providers are established with commercial balance sheets and, following any initial restructuring, are required to earn a commercial rate of return-on their assets;

• .CHEs are restructured and, where appropriate, broken up in the event of business failure;

• non-commercial political involvement in CHEs takes the form of transparent funding or accounting for the non-commercial activities sought;

the tax-exempt status of not-for-profit health care providers is removed; and

planning controls do not unduly inhibit competition.

1.5.2 Policy Uncertainty

The reversal of a number of major policy initiatives announced by the Government in the 1991 Budget and the lack of a concerted effort by the Government to "sell" the proposed health reforms, has increased the uncertainty and perceived risk for private providers contemplating entry to the health care market. Private sector providers will be cautious

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about competing for the provision of core health services while the current level of uncertainty remains.

- 1.5.3 Competitive Funding

In our view, major sustained gains from the reform of the health system are unlikely unless competition between health plans as proposed by the Government is allowed to develop. With monopoly public purchasers, consumers are constrained from using their insurance purchase decisions to express preferences regarding the type of coverage offered and the ability of health plans to control costs. Monopoly health plans are therefore unlikely to have consistently strong incentives to act as prudent purchasers in contracting for services on behalf of consumers. These problems will be exacerbated by the difficulties in defining the objectives of RI-lAs, measuring consumer satisfaction with their performance, and ensuring RHA accountability. The lack of competition at the funder/purchaser level has also been identified as a problem with the UK health reform.

1.5.4 Contracting Issues

The development of formal and robust contracting arrangements between arms-length providers and purchasers is likely to be one of the most difficult elements of the reform and will require several iterations of experimentation and learning. Ensuring coordination between funders and providers throughout this process will be critical to maxirnising the benefits of reform and minimising transition costs. Inadequate coordination between funding and provision and under-resourced funders have been two of the major problems experienced with the UK health reform. To give providers meaningful information on the future demand for health care services and to facilitate the development of contract design and enforcement skills, it is essential that RHAs be established as soon as practicable and that they are adequately resourced from the outset.

1.5.5 Surplus Property

Our discussions with area health boards and analysis undertaken by the Audit Office indicate that many boards are burdened with excess capacity and poorly located facilities and buildings. Unless CHEs are free to sell or lease surplus assets, they will bear extra costs and valuable assets will be underutilised or idle. S

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1.6 Reconfiguration and Management Process

In Section 6.0 we consider the management, accountability and associated organisational arrangements for governing the reorganisation of government-owned health care providers into market-driven health care units.

1.6.1 Critical Issues

The complexity and scale of the changes needed to implement the Governments health reform proposals rule out the possibility of organising the changes by way of detailed planning from the centre. A centralised approach would be unable to gather, process, or efficiently respond to the vast amount of widely-dispersed information relevant to the best way of meeting the demands of purchasers. A highly-decentralised process, which empowers managers and the people they work with, will be necessary to achieve an efficient transition.

The arrangements for managing the provider reforms must also provide:

scope for diverse organisational arrangements including community trusts, unbundled provider units, mergers, joint ventures, contracting out, and the leasing or sale of surplus assets;

a commercial framework that ensures high levels of accountability and management efficiency while providing adequate flexibility for innovation and experimentation;

mechanisms that enable politicians to influence a range of non-commercial considerations relating to the provision of health care services in a least-cost and c transparent manner;

monitoring mechanisms that allow for the intrinsic weaknesses in commercial performance monitoring under government ownership;

considerable scope for major organisational restructurings (e.g. CHE mergers and divestments) and suitable arrangements for monitoring such transactions;

a process for ensuring that certain area health boards are broken up into competing health providers at an early stage in the reform process; and

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a process for coordinating the development of the contracting skills of purchasers and funders and ensuring that the establishment of a commercial focus for CHEs takes place within a robust purchasing environment.

1.6.2 Suggested Approach

The approach we suggest for the restructuring and ongoing management of government-owned health care providers is based around the establishment of a Crown Health Enterprise Transition Board ("CHETB) for each of the existing area health boards and a Supervisory Board which would set the objectives of all CHETBs and monitor their performance. Each transition board would determine a commercialconfiguration of business units for the assets within its control (subject to objectives, directives and guidelines provided by the Supervisory Board) and establish individual CHEs and community trusts. Once established, CHEs would report to and be monitored by the Supervisory Board.

1.6.3 Supervisory Board

The Supervisory Board would be a commercial organisation and would own all government health care businesses on behalf of the Minister of Crown Health Enterprises ("Minister of CHEs"). The Supervisory Board would be governed by a board of directors appointed by government and would be accountable to the Minister of CHEs. The Supervisory Boards responsibilities would include:

reaching agreement with the Minister of CHEs regarding the statement of corporate intent and performance targets of the Supervisory Board. This would include details of any structural break up of assets government requires the Supervisory Board to undertake (following the advice of the NIPB) on competition grounds;

• providing the Minister of CHEs with six-monthly and annual reports of the Supervisory Board, such reports also being publicly released;

• appointing directors to CHETBs and reviewing CHETBs recommendations for CHE board directors on the basis of guidelines specified by government;

negotiating an annual statement of corporate intent with each CHETB;

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monitoring the commercial performance of CHETBs and ensuring that CHETBs satisfactorily break up assets as required by the Supervisory Board;

• acting as an internal capital market in ratifying and, where desirable, facilitating restructuring transactions involving multiple CHETBs or CHEs or the creation of new CHEs;

acting as a restructuring agent in the event of major business failures by CHETBs or CHEs;

• applying CHE valuation principles developed by the NIPB and negotiating commercial CHE valuations and balance sheet structures with CHETBs;

• coordinating the implementation of commercial balance sheet structures for CHEs on the basis of broad procedures developed by the NflB; -

• negotiating a statement of corporate intent with individual CHEs that have been separated from their CHETB and monitoring the performance of such CHEs; and

• receiving CHE dividend payments and providing new equity to CHEs requiring additional equity capital.

We suggest that a review of the benefits of retaining the Supervisory Board be undertaken after three years and that the Supervisory Boards enabling legislation include a four-year sunset clause.

The most critical determinant of the success of the Supervisory Board would be the quality of the people appointed to it. Given the complexity of the issues that would face the Supervisory Board and the magnitude of the assets under its control, the Government should endeavour to appoint individuals of the highest calibre as its directors.

1.6.4 Crown Health Enterprise Transition Boards

Each CHETB would be responsible for:

the day-to-day operations of the health care provider units within its control, including contract management, managerial appointments and remuneration;

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reaching agreement with the Supervisory Board regarding the CHETBs statement of corporate intent and performance targets (these would focus on the CHETBs restructuring and organisational functions);

preparing half-yearly and annual reports which would be provided to the Supervisory Board and made available publicly;

breaking up existing area health board assets into competing business units in accordance with directives or guidelines provided by the Supervisory Board;

reorganising and restructuring the assets and activities of the relevant area health board into the most efficient form for the new purchasing and regulatory environment;

developing efficiency-enhancing merger and acquisition proposals involving the assets of other CHETBs and presenting such proposals to the Supervisory Board for ratification;

0 establishing individual CHEs and nominating CHE directors for approval by the Supervisory Board;

U working with relevant community groups to establish community trusts;

C rationalising, leasing or disposing of surplus assets; and

negotiating with the Supervisory Board to establish asset valuations and commercial balance sheet structures for individual CHEs.

The role of each CHETB would be a transitional one. Once a CHETB had established the CHEs in its area and met the structural guidelines provided by the Supervisory Board, it would be wound up.

1.6.5 Crown Health Enterprises

CHEs would be required to operate as successful businesses and would be monitored along conventional SOE lines. However, CHEs might vary considerably in terms of the range of

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services they provide and the form of service delivery they adopt. CHEs would be required to:

a agree a statement of corporate intent and performance targets with the Supervisory Board;

a prepare half-yearly and annual reports to be provided to the Supervisory Board and made available publicly;

a compete with other CHEs and with private sector providers;

a as appropriate, pay dividends to the Supervisory Board;

a establish community trusts in accordance with the guidelines laid down by the Supervisory Board and work with community groups to establish community trusts;

U rationalise, lease or dispose of surplus assets; and

identify and develop restructuring proposals involving other CHEs or the creation of new CHEs and present such proposals to the Supervisory Board.

1.6.6 Ministerial Monitoring Unit

Because the Supervisory Board would be a commercial entity, we suggest that it be monitored by a specialist monitoring unit which would report to the Minister of CHEs. The monitoring unit would- not have any management responsibilities. The monitoring unit would become directly responsible for monitoring all CHEs in the event that the Supervisory Board was eventually wound up. --

1.6.7 Relationship to the Role of the NIPB

The Supervisory Board would be responsible for implementing most of the commercial tasks included in the t\JIPBs terms of reference. Several other responsibilities of the NIPB would not, however, be resolved through the establishment of the Supervisory Board. The resolution of these matters would need to be undertaken by an agency with policy advisory, rather than commercial, responsibilities. We suggest that the NIPB be merged with the Policy and Regulatory Directorate, with the merged entity being responsible for all

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outstanding policy issues on both the funding and provider sides of the reform process. This would be a major step towards achieving the coordination required between these two areas and would enable the policy analysis of funding and provision issues to draw on a common pool of analytical resources.

1.7 Timetable and Legislation

A suggested timetable for the establishment of the Supervisory Board, RHAs, CHETBs, Cl-IFs and community trusts is provided in Section 6.4. The key features of this include:

• selection of the Supervisory Board and establishment boards for RHAs in March/April 1992;

• selection by the Supervisory Board of CHETB directors in May/June 1992;

• appointment of Supervisory Board and CHETB directors in July 1992;

• appointment of all CHE directors by May 1993; and

• the wind up of all CHETBs by June 1993.

The legislative constraints and requirements for meeting this timetable have been reviewed by Chapman Tripp Sheffield Young. They note that some legislation would be required by 1 July 1992 to establish the structure and organisations outlined above though this need not be extensive. A wide range of other legislation concerning the health sector should also be reviewed as part of the reform process. Review of this could be deferred to a later date.

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SECTION 2.0: BACKGROUND TO THE STUDY

2.1 Introduction

This section begins by outlining, by way of background, the Governments proposed reform of the health care sector and the role of the National Interim Provider Board ("NIPB"). It then spells out the terms of reference for this study and the approach adopted by CS First Boston NZ Limited ("CS First Boston").

2.2 The Governments Proposed Reforms

The Government announced its proposed reform of the health care sector in the "green and white paper", the Statement of Government Health Policy, issued at the time of the 1991 Budget. The Government noted in the paper that the primary aims of the reform were to:

improve access for all New Zealanders to a health care system that is effective, fair and affordable;

encourage efficiency, flexibility and innovation in the delivery of health care to the community;

U reduce waiting times for hospital operations;

U widen the choice of hospitals and health care services for consumers;

• enhance the working environment for health professionals;

• recognise the importance of the public health effort in preventing illness and injury and in promoting health;

• increase the sensitivity of the health care system to the changing needs of people in our society."

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The reforms involve (among other proposed changes) the following:

• separation of the purchasing and providing functions currently performed by the area health boards;

• establishment of four regional health authorities ("RHAs") to manage the purchasing of and contracting for, health services throughout New Zealand. The RHAs are to take over responsibility for funding both primary care provided by general practitioners ("GPs"), funding for pharmaceutical prescriptions and hospital-based care. The RHAs will not own provider units but will purchase services from the public, private or voluntary sectors. From July 1993, people will have the choice of obtaining their health care plans through RHAs or other non- government health care plans; and

most public hospitals will be established on more business-like lines as crown health enterprises ("CHEs") with appointed boards of directors with commercial as well as health sector expertise. Smaller communities will be given the opportunity of taking over local hospitals and running them as community trusts.

To assist in implementing the reforms, the Government established the NIPB to oversee the reform of provider units and the Policy, Regulation and Implementation Directorate to evaluate and implement reform of funding and purchasing of health care.

The task of the NIPB is to assist the Government to plan and to manage the transition to new health provider forms as outlined in the 1991 Budget and the Statement of Government Health Policy. The NIPBs terms of reference involve a mix of re2l.jlatory, legal. financial. commercial, economic and tax responsibilities. The timetable contained in the Governments "green and white" paper on health reform envisages that the tasks of the NIPB will be completed in time for it to be wound down in the year ended June 1993. The NIPB has appointed several consultants to assist in achieving its task.

The Policy, Regulation and Implementation Directorate is responsible for reform of the funding/purchasing part of the health sector reforms. The Directorate is responsible for further policy development and for the design and drafting of legislation and regulations to give effect to the announced reforms. The Directorate is responsible for identifying resources currently devoted to purchasing services within area health boards and the Department of Health, developing a framework for Contracts with secondary care providers during the 11

( )t1Ii(iCflt 1,11 ______(;S Ft Rs1 130 TON

1991/92 financial year, and establishing the RHAs (and if the RHAs are not fully functioning, contracting with CHEs and community trusts for secondary services from July 1992). The Government expects the Directorate to complete its tasks between July 1992 and July 1993.

2.3 Terms of Reference for the Current Study

The terms of reference for this report are presented below.

(i) "Assess the role for alternative organisational forms, including for-profit, not-for- profit, and community trusts, in a competitive health care industry. This analysis will assist in developing a reform process that enables the most efficient organisational form(s) to evolve over time rather than to prescribe or prejudge the most efficient arrangements.

(ii) Provide recommendations on the least-costly process to enable the public health provider sector to move to an efficient structure and forms of organisation with the appropriate degree of flexibility while involving the least disruption to existing services. This should include an assessment of the extent to which the initial configuration of provider assets established by the Board should be regarded as a first cut rather than a definitive structure and the flexibility and incentives that should be given to establishment boards and crown health enterprises (CHEs) to encourage efficient restructuring and reorganisation. The analysis should include an assessment of the principles, criteria and process that should guide the establishment of community trusts.

(iii) On the basis of (i) and (ii) and having regard to potential competition (i.e. allocative efficiency) concerns, develop a series of detailed principles and a recommended process to be used nationally for establishing the initial industry configuration and organisational arrangements for the public health provider sector.

(iv) Identify potential major impediments to the development of efficient, market- driven public health providers and provide advice on how to minimise these. This should include consideration of regulatory barriers to entry, the incentives for CHEs to divest surplus property assets, and the incentives for CHEs to contract out 1

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activities where this would be efficient. Attention should also be given to the quality of the incentives provided to CHEs by regional health authorities ("RHAs") including the degree of competition established by RHAs between private and public providers and the portability of individuals funding entitlements.

(v) Advise on the preferred management arrangements for establishing the new structure of public providers and for ensuring efficient performance and adequate organisational flexibility thereafter. This should include an assessment of the role and accountability arrangements for establishment boards and their relationship with the Board.

(vi) Make recommendations on the ongoing relationship between public sector health providers and their owners, including reporting and monitoring arrangements.

(vii) Advise on the preferred legislative and administrative arrangements for giving effect to the recommendations arising from the tasks outlined above."

2.4 Approach

On 24 October, 1991 CS First Boston was engaged by the NIPB to undertake a study of the issues outlined in the above terms of reference to be completed by January 3, 1992. The consultancy agreement between CS First Boston and the NTPB included a detailed work plan which specified the various components of the study and the individuals who would work on the project. This provided for approximately 85 percent of the consultant days to be provided by staff of CS First Boston. The remaining days were allocated to a number of independent consultants that were part of the CS First Boston team.

Advice on particular health care issues and comments on a draft of the report were provided by the following consultants: Professor Derek North, Dean of the School of Medicine, the University of Auckland; Dr . David Green, Director of the Institute of Economic Affairs, London; Professor Tony Culyer, Head of Department of Economics and Related Studies, University of York; and Professor Patricia Danzon, Professor of Health Care Systems, Insurance and Risk Management, the Wharton School, University of Pennsylvania. The involvement of these individuals has been of considerable assistance to CS First Boston.

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In the course of our study, we drew on personnel from CS First Bostons London, New York and Singapore offices for advice on insights that might be provided from those countries. We - held discussions with a number of individuals in the private and public sectors in New Zealand and with academics and other individuals involved in the health care industry in -, Australia, the UK and the US. As part of the study, we spent a total of four days visiting four of the area health boards, and talking to key personnel. Without exception, individuals were very helpful, making available considerable time for interviews and follow-up discussions. Every attempt has been made to meet our requests for information.

Comments were also provided on the draft report or a summary of the report at a series of "validation meetings" organised by the NIPB. Those attending the validation meetings included individuals from area health boards, independent consultants, members of the NIPB and officials from the Department of Health, Prime Ministers Department and Treasury. The input of individuals attending these meetings proved to be very useful to us.

Staff of the NTPB also reviewed and provided helpful comments on the draft. Geoff Swier, who managed the project on behalf of the NIPB, made a significant contribution to the analysis through his comments on the draft paper and by assisting with the development of the preferred process for reconfiguration of the provider assets. Chris Clarke, a member of the executive of the NIPB, also assisted, particularly in the review of New Zealand experience and in facilitating our access to individuals and information. Nevertheless, full responsibility for the report lies with CS First Boston.

2.5 Outline of Sections 3.0 to 6.0

Section 3.0 of this report reviews the alternative organisational forms for health care providers. The section considers the relative merits of for-profit and not-for-profit ownership structures. It discusses principles and structures adopted in previous reforms of government organisations. We propose a "default" model for CHEs and discuss the community trust model.

The criteria and principles for reconfiguration of provider assets are reviewed in Section 4.0. The concept of efficiency, which is the principle criterion for the provider reform, is discussed. We then consider the competition issues of relevance to determining both the initial configuration of publicly owned provider assets and the subsequent process for governing the ongoing restructuring of those assets. The management issues (such as economies

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of scale and scope) that affect the preferred initial configuration of government-owned health care assets are also reviewed.

Section 5.0 considers the potential impediments to the development of efficient, market- driven health care providers. This section reviews the potential barriers to competition and restructuring and considers the prerequisites for establishing robust contracts between providers and funders. We then examine the constraints that the proposed commercial framework for public providers might impose on the development of an efficient structure of public health care providers.

Finally, in Section 6.0 we consider the management, accountability and associated organisational arrangements for governing the reorganisation of government-owned health care assets into market-driven provider units following establishment of the initial configuration of assets and organisations.

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SECTION 3.0: ALTERNATIVE FORMS FOR HEALTH CARE PROVIDERS

3.1 Introduction

The quality of managerial decision-making in any organisation depends both on the capacity of managers to take decisions that make the best use of scarce resources, and on their incentives to take these decisions. In establishing an initial structure for health provision, it will be crucial t 6 ensure that managers have sufficient autonomy to take what may be quite dramatic decisions about resource reallocation, investment and divestment. It will be equally important to ensure that they have incentives to exercise this autonomy in a way which ensures the best possible outcomes for users of the health system.

Organisational and ownership arrangements are critical in defining how much autonomy managers have, and what their incentives are to exercise it in an economically sensible fashion. Two factors are important in defining ownership and organisational form: first, who the owners are, and, secondly, what structures are in place to enable owners to exercise control over managers (including through the transfer of ownership shares). The first defines who (explicitly or implicitly) enjoys the benefits and bears the risks associated with owning the residual income stream from the organisations activities - who receives the profits, and who bears the losses. The second defines the avenues (and the efficacy of the avenues) by which owners can ensure that managers act in their interests.

In this section, we consider alternative organisational and ownership structures for health care providers. Our objective is to assess the most appropriate initial structure for health care institutions, in the light of a more general concern to ensure that these institutions will be able to evolve, over time, in a way which is consistent with efficient provision of health services. The two criteria must be satisfied here are:

the initial structure must be consistent with sound operational and investment decision-making in the interim or transitional period; and

the initial structure should not preclude (and should as far as possible minimise the costs of) the adoption of other organisational and ownership forms in the future, where these prove more appropriate for the delivery of particular services.

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The section is set out as follows: In Section 3.2, we consider the relative merits of the for- profit and not-for-profit structures, and comment on their relative performance in the US. In Section 3.3, we discuss the principles and structures of the state-owned enterprise model which has been applied to government businesses in New Zealand, and assess its relevance to the health sector. In Section 3.4, we propose a "default" option for crown health enterprises, and discuss the community trust model.

3.2 Theoretical Analysis of For-Profits and Not-For-Profits

In this section, our concern is to assess the relative merits of for-profit and not-for-profit organisations from a theoretical perspective, and, consequently, the ownership form which would serve as the most appropriate default option for health care providers in New Zealand

We begin, in Section 3.2.1, by considering the implications of these two ownership forms for the capacity and incentives of managers to make sound business decisions. The broad implication of this analysis is that the for-profit form will yield stronger incentives for efficient resource use than the not-for-profit form. In Section 3.2.2, we consider theoretical arguments for the use of the not-for-profit form in the health care sector, notwithstanding managerial incentive problems. In Section 3.2.3, we describe empirical evidence on the performance of not-for-profit and for-profit health care institutions in the US. In Section 3.2.4 we consider reasons for the dominance of the US health system by not-for-profit organisations. In Section 3.2.5, we draw some conclusions on the appropriate "default" option for health care providers, and comment briefly on the scope for other options, such as the community trust option, to be adopted over time.

3.2,1 Ownership and Incentives in For-Profits and Not-For-Profits

The essential difference between the for-profit and the not-for-profit form is that, in the former owners have a right to the residual income of the organisation, whereas in the latter there is no such right; profits are not distributed and any residual profit must be reinvested in the organisation or dissipated . through inefficiency or above-market payments to suppliers of inputs. Therefore, "a nonprofit corporation is distinguished from a for-profit (or business) corporation primarily by the absence of stock or other indicia of ownership that give their owners a simultaneous share in both profits and control". 1 In addition, almost all not-for-

1 Hansmann, H. B. (1980), "The Role of Nonprofit Enterprise", Yale Law Journal, 89, p 838.

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profit corporation statutes require that qualifying organisations serve a limited number of purposes (scientific, educational, benevolent, religious, and so forth).

However, both for-profit and not-for-profit providers must generate an economic surplus (or obtain funding for any shortfalls) to survive. They are both essentially "commercial" organisations. The key difference is the manner in which the surplus is used. In for-profit organisations the surplus is returned to shareholders; in not-for-profits the surplus is more likely to be appropriated in some form by managers or other suppliers of specialist services or dissipated through inefficient management practices.

The differences between for-profit and not-for-profit organisations can be expected to have implications for the incentives of managers tomake operational and investment decisions that maximise efficiency. To explain why, we begin by describing the incentives associated with a profit motive, and the means available to owners in for-profit organisations for aligning managers incentives with their own. We then consider the incentive and control structures likely to evolve when the profit motive is absent.

3.2.1.1 Characteristics of Not-For-Profit Corporations

There are two basic kinds of not-for-profit corporation: non-membership and membership. Non-membership not-for-profits are essentially entrepreneurial run by a self-perpetuating management which, beyond the requirements of company and any specific not-for-profit corporation statutes, is answerable only to itself. At least superficially, membership corporations, sometimes referred to as "mutuals", resemble (for-profit) investor-owned corporations quite closely. A body of individuals (the "members") has authority to elect a board of directors or "trustees", which is then responsible for the conduct of the corporation, and employs managers to run its day-to-day affairs. In the case of a hospital, the members may include representatives of the local community, representatives of a religious group affiliated with the hospital, and members of the medical staff.

In the US, where not-for-profits dominate the hospital sector, state non-profit corporation laws generally offer some protection to members with respect to actions taken by the board or management - for example, requiring that the books of the corporation be open for inspection by the members. However, it is generally permissible for the members and the board of trustees to be the same. people so that "nonprofit corporations can be governed by self-

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perpetuating boards answerable only to themselves (and to state law) with respect to the internal affairs of the corporation".2

3.2.1.2 The Profit Motive

The driving force for efficiency in a market economy is the prospect of reaping a surplus or profit. Where firms must compete for customers, the ability to make a return over and above costs depends on an ability to use resources better than ones competitors - -to develop a more cost-effective production process, to make use of information about customers different preferences about quality, to implement stream-lined managerial systems, to develop new and desirable products, and so forth. Organisations that develop cost-minimising production processes and managerial systems, and respond perceptively to customer demands, prosper at the expense of those less successful in these areas. Profit provides a focus for the maximisation of the difference between costs and income which, given the presence, or even a threat, of competition, drives efficiency of resource use.

Profits accrue to owners. The relationship between the owners and managers, and hence the mechanism by which the profit incentive is maintained, differs between organisational forms. An important component of competition between companies is competition for the most effective managerial and ownership structure - which will differ according to the type and scale of a companys activities. In owner-managed companies, for example, the owner- manager bears the residual risk associated with the companys activities, and exercises control directly. In partnerships, risk-bearing and managerial responsibility are shared among the partners.

Where, as in the case of most modern corporations, for-profit organisations are not owner- managed, the potency of the profit incentive will depend on the success of owners in controlling" managers - in ensuring that managers incentives are, as far as possible, aligned with their own. In closely-held (non-listed) corporations, managers may have an ownership share, but the majority of shares may be held by non-managers. Non-executive owners will often, however, have sufficiently large shareholdings to have an incentive to monitor managers actively, and to exercise a significant threat to managers both through the board structure and through the threat to sell their shareholdings. In listed companies; owners monitor managers .and exercise control primarily through a range of. sharemarket mechanisms, including corporate takeovers, direct replacement of under-performing

2 Horty, J. F. and Mulholland, D. M. (1983), "Legal Aspects of Nonprofit Status, in B. H. Cray (ed), The New Health Care For Profit: Doctors and Hospitals in a Competitive Environment, Washington DC, National Academy Press, p 21.

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managers, and representation through the board of directors. The state-owned enterprise model (see Section 3.3 below) attempts to provide proxies for these monitoring and control mechanisms (including the use of boards of directors, annual reporting requirements and requirements for the provision of annual statements of corporate intent). Managers have considerable latitude, but in exercising this latitude they are answerable to owners. Owners incentives to enforce this answerability follow directly from their expectations of profit.

In the absence of an expectation of profit (as where profit-making is disallowed), we may expect (a) that the incentives for efficient resource use will be weakened, and (b) that the incentives to monitor and control the activities of managers will be weakened.

3.2.13 Who Gets Control?

In for-profit corporations that are not closely held, ownership is separated from control, the latter resting, at least on a day-to-day basis, with management. However, owners have a number of means by which to ensure that managers do not diverge too far from representation of owner interests. These include:

the operation of the sharemarket and the monitoring activities of market analysts;

the disciplines exerted by boards of directors;

the threat or reality of corporate takeovers (in which the management team is vulnerable to replacement); and

the operation of the market for managerial labour, which utilises, among other things, information gathered and processed by the capital market.

Where control lies in a not-for-profit corporation depends in part on how it is constituted. For example, non-membership boards typically have a freer hand in directing the corporation than membership boards. Particularly in areas where there is a strong tradition of community involvement through membership, for example, hospitals "will often haveboards and management that are reluctant to embark on aggressive new or nontraditional hospital ventures for fear of upsetting some elements of the community, particularly the physi6ans.3 In some cases, corporate memberships will be composed entirely or partially of staff

3 ibid,p21.

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physicians, which "places the board in the rather peculiar position of having to answer to the same group whose medical quality it is responsible for overseeing".4

Because, in many instances, membership can be acquired for the payment of token dues, it is at least theoretically possible for a faction within a hospital to "buy" a sufficient share of membership to wrest control from an existing board or management. However, the risk of such "takeovers" can be blunted by providing stringent membership requirements in the corporation bylaws, or enabling the board to screen new members. Further, at least in the US, the courts have typically protected the rights of incumbent boards and managers in such cases. This suggests that non-equity market alternatives to the constraint imposed by the threat of takeover that constrains managers in for-profit firms are likely to be weaker for not-for- profit managers.

The absence of equity market constraints (and the threat of takeover in particular) would seem to imply a higher degree of latitude for not-for-profit managers than for .their for-profit counterparts. However, not-for-profit managers will remain constrained by exposure to competition in their product markets (in particular, as in the US health sector, where they are in competition with for-profit firms) and will face sanctions in the managerial labur market in the event of obvious poor performance. They are also likely to face internal rules and constraints - either imposed by law (as in the case of restrictions on diversification and other requirements related to the awarding of special tax status), or imposed by members (for example, in the form of reporting requirements) which are more tightly binding than those observed in for-profit organisations. For example, in not-for-profit hospitals there may be more recourse to written rather than oral communications, more specific by-laws, more frequent scheduling of staff meetings, or more formal budgeting and accounting processes.5

3.2.1.4 Implications for Managerial Performance

The weakness of some market disciplines on not-for-profit managers vis-a-vis their for-profit counterparts may be expected to lead to differences in managerial behaviour, and therefore in organisational performance. Although some argument may be made that not-for-profit organisations attract a certain kind of manager (public-minded and upright) who will pursue the objectives of. the organisation with an unexpected honesty, differences in incentives can still be expected to matter. Given, further, that the non-distribution of profits rule does not, in general, preclude appropriation of at least some of the surplus generated by not-for-profit

4 ibid,p21. 5 See, for example, Clarkson, K. W. (1972), "Some Implications of Property Rights in Hospital Management, Journal of Law and Economics, 15, pp 363-384.

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organisations (by managers, key employees or contractors), the incentives for behaviour incompatible with efficient performance may be strong.

This expectation is to some extent borne out by empirical studies of not-for-profit hospitals in the US. One such study has found, for example, that:

"non-profit hospital chains acted for the self-interest of the professionals within them, not just for the welfare of society. They increased professional staffs comfort level through tax exemptions and the deferral of capital replacement without providing better, cheaper, or more accessible health care in return."6

Another found that individuals in not-for-profit nursing homes had a variety of legal means available to them by which to appropriate surplus revenues:

• linking their income to entrepreneurial activity conducted within the not-for-profit institution;

self-dealing through overlapping interests (operating on both the sale and the purchase side of the not-for-profit institutions transactions);

real estate transactions involving self-dealing; and

above-market fees, salaries and fringe benefits.7

Similar experience is cited in the case of HMOs in California in the early 1970s, where government officials had decided to preclude for-profits from participating in the states Medi-Cal programme because of a fear that for-profits might under-serve enrollees in order to increase their financial return:

"After several years, however, it was discovered that a number of the HMOs established as nonprofit corporations were run by the same individuals who owned the companies that were supplying them with

6 Herzlinger, R. E. and Krasker, W. S. (1987), Who Profits from Nonprofits ? ", Harvard Business Review, January/ February, p 104. Questions have been raised, however, about the quality of the econometrics in this study. 7 Etzioni, A. and Doty, P. (1976), Profit in Not-For-Profit Corporations: The Example of Health Care", Political Science Quarterly, 91, pp 433-453.

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goods and services (e.g., pharmacies, laundries, information processing services). By paying these suppliers inflated prices, profits, could be smuggled out of the HMO and indirectly captured through these other organisations.8

Competition for patients with for-profit companies (as in the health sector in the US) maybe expected to place limits on the extent to which not-for-profit managers are free to under- perform and divert resources towards personal benefits. Exposure to competition means that survival requires the adoption of reasonably efficient practices. As a practical example, it may be noted that as cost pressures on US hospitals increased through the 1980s, not-for- profits as well as for-profits moved to adopt improved management structures and tighter control over resources. (A discussion of empirical evidence on the relative performance of not- for-profit and for-profit health care institutions in the US is provided in Section 3.2.3 below).

3.2.2 Theoretical Arguments for the Not-For-Profit Form

The incentive problems associated with the not-for-profit model vis-a-vis the for-profit model suggest that there will be costs to the adoption of the not-for-profit model as a default option for health care institutions. However, it may be argued that there are some areas of activity in which not-for-profits will systematically out-perform for-profits. Where the benefits associated with the not-for-profit form in such circumstances outweigh the costs associated with weaker (or distorted) managerial incentives, we might expect to find not-for- profits dominating for-profits.

Arguments for the existence (and, in some cases, active regulatory support) of not-for-profits typically focus on areas of economic activity where the costs of doing business are, for some reason, high. In particular, they have been argued to perform better in handling certain kinds of information problems - such as the problem faced by patients in seeking health care - and in providing some kinds of local collective good. In this section, we consider the merits of these two arguments.

3.2.2.1 Information Problems

Perhaps the strongest argument for the not-for-profit model in the health care sector revolves around the problems that health care consumers face in judging their need for services, and

8 Schlesinger, M. et al. (1987), "Nonprofit and For-Profit Medical Care: Shifting Roles and Implications for Health Policy", Journal of Health Politics, Policy and Law, 12, p 451.

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the quality of services they are being offered. Consumers typically resolve these problems by relying on the advice of their doctors and hospitals. In this situation, it is argued, health care institutions that are operating for a profit will have incentives to reduce the quality of care, while at the same time providing unnecessary, chargeable, tests and treatments at - exaggerated prices. By contrast, the argument continues, a not-for-profit hospital would have no such incentive to provide either low-quality or redundant care at excessive prices.

Further, the sanction of reputation may be attenuated in the health care market. Whereas in many instances where consumers lack information before a purchase they can often become rapidly informed afterwards as a result of experience. It can be argued, however, that purchasers of health care have no such certainty after the event of the quality of the service that they have purchased. (If they feel better, was this because of, or in spite of, the treatment received? If they have not recovered, was the treatment, nevertheless, the best available?) This means, it is argued, that the sanction of reputation effects will be weaker forhealth care institutions than it is for the providers of many other goods and services. In this context, a not-for-profit may sell a brand-name of trust, benevolence, technical competence and fiduciary duty more successfully than a for-profit organisation:

"[Tihe advantage of a nonprofit producer is that the discipline of the market is supplemented by the additional protection given the consumer by another, broader contract, the organisations legal commitment to devote its entire earnings to the production of services. As a result of this institutional constraint, it is less imperative for the consumer either to shop around first or to enforce rigorously the contract he makes."9

To test whether these arguments make for some a priori preference for a not-for-profit model, two questions need to be addressed:

• how significant are these information problems? (by comparison with the problems that consumers face, and deal with, in other markets); and

• is there any a priori reason that not-for-profit organisations will out-perform for- profit ones in overcoming information problems in a way that minimises social costs?

9 Hansmann, op. cit., p 844. See also: Easley, D. and OHara, M. (1983), "The Economic Role of the Non-Profit Firm, Bell Journal of Economics, 14, pp 531-538; and James, E. and Rose-Ackerman, S. (1986), The Non-Profit Enterprise in Market Economies, in Lesourne, J . and Sonnenschein, H. (eds), Fundamentals of Pure and Applied Economics, New York, Harwood Academic Publishers.

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The answers to these questions will differ between sectors. In the case of health care, -it is clear that both consumers and health care providers face more considerable information problems than in many of the other markets in which they purchase goods and services. Further, as noted above, these informational problems may remain even after purchase (whereas, for example, a faulty appliance or car will reveal its defects after purchase).

It is, however, easy to overstate the magnitude of these problems, and, in particular, the extent to which they place patients (other than perhaps trauma patients) at the mercy of health care providers. Patients with chronic illnesses, for example, will often have the opportunity to become relatively well-informed about the merits of alternative treatments - in some cases better informed than their (non-specialist) general practitioner ("GP"). Health care consumers can also resort to a range of third party sources on the quality of different treatments and providers. These include information provided by their own GP (who will be motivated at least in part by his or her desire to maintain a relationship with the patient and the patients family), consumer literature, voluntary accreditation, certification of doctors and facilities, and screening and monitoring by insurance companies. Further, it is rare for patients to deal directly with hospitals; instead, their interests, are generally represented by the doctor who admits them to the hospital, in which case "the physician acts essentially as a very sophisticated purchasing agent for the patient in the latters dealing with the hospital".10 In this sense, the consumer cannot readily be seen as at the mercy of the hospital in a way which might make the not-for-profit corporate form desirable; the issue of trust is rather between the patient and the admitting physician. (Accordingly, Hansmann attributes the high incidence of not-for-profits in the US hospital sector to historical factors, rather than to their superior ability to handle the informational problems associated with health care provision.)

It is sometimes argued that doctors have so much information they can exploit patients and that government must protect the patient. However, it would not help the consumer if government responded to the obvious imbalance in information between doctor and patient by creating a public sector monopoly. This would buttress professional power by suppressing competition, the very means by which information on comparative efficiency is made available to consumers thus arming them with the means to protect themselves from exploitation by doctors. Consumer information is not a pre-condition for competition but the result of it.

10 Hansmann, op. cit., p 866.

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3.2.2.2 The Provision of Local Collective Goods

A second argument for not-for-profit firms is that they may succeed in meeting a diverse demand for local collective goods in a manner which is not feasible (or inordinately costly) for government. Not-for-profits, it is argued, have relatively effective methods at their disposal (with a little help from government subsidies) both for defining the demand for these local collective goods, and for compelling payment for them (over-coming or at least reducing the free rider" problem associated with public good provision). In particular, not- for-profits may be able to draw on various societal pressures in eliciting donations for causes that have a collective good element, such as charitable assistance.11

In addition to voluntary monetary contributions, not-for-profit institutions may encourage a level and quality of voluntary effort that might be expected to be absent in more profit- oriented institutions. For example, it is often argued, as in the public hospital system in New Zealand, that the public good orientation of not-for-profit institutions encourages a particular, altruistic commitment from employees, as well as the supply of volunteer support labour. However, while we would not wish to underestimate the importance of such efforts in not-for-profit hospitals, it is not clear to us that they will be absent in well-managed for- profit institutions. Professional employees across a wide range of for-profit institutions (inside and outside the health care sector) regularly exhibit a degree of pride in and commitment to their work beyond that attributable to a profit motive; altruistic effort is not the sole prerogative of the voluntary sector. In addition, at least in the US, volunteer labour (e.g. patient visitors and nursing aides) is found in the for-profit sector as well as the not-for- profit sector; it appears to be the nature of the work, rather than the nature of the institution, which encourages such effort.

It has also been argued that not-for-profits may perform better than for-profits in providing collective goods where individual purchasers of those goods cannot determine the incremental amount of the good that they have purchased. The problem being dealt-with here is not the traditional free-rider problem, but rather the inability to control the use to which a contribution is put after it has been made. (This may apply, for example, in the case of donations to a commercial-free radio station.) In such cases, a not-for-profit charter protective of patrons may economise on the contracting and enforcement costs that would occur if a for-profit was used to produce the good or service involved.12

11 See, for example, Weisbrod, B.A. (1988), The Non-profit Economy, Cambridge (MA), Harvard University Press. 12 Hansmann, op. cit..

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There clearly are important collective good components to health care, particularly at the preventative level - vaccination, water quality control and sewerage disposal are familiar examples. On the other hand, the great majority of health services consumed in hospitals are primarily private; the benefits are internalised by the patient, and the consumption of the service bythat patient precludes simultaneous consumption of the service by another. In such cases, the sort of collective good argument set out above does not, strictly speaking, apply.

3.2.3 Experience with For-Profits and Not-For-Profits in the US

Empirical studies of the performance of alternative ownership forms in the US has concentrated on differences between for-profit and not-for-profit institutions, both in terms of their cost-effectiveness, and in terms of the quality of care delivered. Studies of this kind face considerable difficulties, both in comparing like with like (given the enormous diversity of institutions and geographical variance in the pattern of demands for health care and differences in the areas served and services provided by for-profits and not-for-profits) and in determining appropriate measures of the variables of interest. (For example, in defining the cost-effectiveness of care in different institutions, cost per person-day may fail to reflect efficiencies related to differing lengths of stay, but cost per patient discharged may fail to capture the costs of rehabilitation outside the hospital where discharge is early).

Studies of the relative efficiency of not-for-profit and for-profit general hospitals have tended to find only small sometimes inconsistent differences in costs and efficiency. On

average, cost per day appears to be higher in for-profit . hospitals, but, due to shorter lengths

of stay, at least some studies have found for-profits overall costs to be smaller. 13 However, to the extent that differences in costs reflect differences in case mix between hospitals, this

may not indicate an efficiency advantage. 14 There also appear to be some differences in

13 For a survey see Schlesinger et al., op. cit., p 441. See also, for example, Cowing, T.G., and Holtman, A. C. (1983), "Multi-product Short-Run Hospital Cost Functions: Empirical Evidence and Policy Implications from Cross-Section Data", Southern Economic Journal, 49, pp 637-653; Robinson, J . and Luft, H. (1985), "The Impact of Hospital Market Structure on Patient Volume, Average Length of Stay and the Cost of Care", Journal of Health Economics, 4, 333-356; and Vita, M. C. (1990), "Exploring Hospital Production Relationships with Flexible FunctionalForms", Journal of Health Economics, 9, pp 1-21. 14 See, for example, Freund, D. et al. (1985), "Analysis of Length-of-Stay Differences Between Investor-Owned and Voluntary Hospitals", Inquiry, 22, Pp 33-44. This study, drawing on data from 338 hospitals in the late 1970s, suggests that the shorter average length of stay in for-profit hospitals can be explained by the tendency of such hospitals to attract shorter-stay patients. Differences in case mix (in this case, lower admissions of relatively "unprofitable" patient groups by for-profit hospitals) is also suggested in Bays, C. W. (1977), "Case-Mix Differences Between Non-Profit and For-Profit Hospitals", Inquiry, 14, pp 17-21.

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charging practices between for-profit and not-for-profit hospitals, with for-profit hospitals tending to have higher charge-out rates, in particular for ancillary services.15

For nursing homes, by contrast, for-profits have average costs 5 to 15 percent lower than not- for-profits. On the basis of this research, it has been suggested that there may be ownership- related differences in costs only where physicians roles are relatively attenuated. 16 This argument is to some extent borne out by research on other kinds of health care facility; for- profit agencies have lower costs in the provision of laboratory services and health insurance where physicians roles are relatively limited, but equal or higher costs for renal dialysis centres and health maintenance organisations.17 One reason suggested for this is that, under some circumstances, conflicts between the interests of professionals and institutional goals can raise the costs of for-profit facilities:

"Many of the decisions affecting resource allocation in hospitals and health maintenance organisations are made on a decentralised basis by the individual physician. The physician can use the institutions resources (e.g., nursing staff, medical equipment) to support his-or her own practice, or can conserve those resources to create a later year-end surplus for the facility ... The more strongly physicians believe that the institutional surplus will be spent in a manner compatible with their own values - e.g., to pay for state-of-the-art technology - the more likely they will be to conserve institutional resources when treating patients. If physicians anticipate that for-profit facilities will divert a portionof, the surplus to pay shareholders or to finance unrelated business activities, the medical staff will be more likely to use institutional resources to support their own practices, thus increasing the costs of care in the facility."18

Empirical studies of the quality of care delivered by for-profi and not-for-profit acute care hospitals have not found measurable differences on such indicators as in-hospital mortality, post-discharge mortality, hospital readmissions, or the use of higher-risk discretionary

15 See, for example, Pattison, R. V. and Katz, H. M. (1983), "Investor-Owned and Not-For-Profit Hospitals"; New England Journal of Medicine, 309, pp 347-353. 16 The dominant shareholders in most non-chain; for-profit hospitals are doctors. Where for-profit hospitals are operated in chains, doctors are less willing to dominate as shareholders, and managers may be less willing to submit to professional demands. See, for example, Pauly, M. and Redisch, M. (1973), The Not-For-Profit As a Physicians Cooperative", American Economic Review, 63, pp 87-99; 17 Schlesinger et al., op. cit., p 441. 18 ibid, p 442.

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procedures.19 A 1986 review of research on the quality of care by the Institute of Medicine concluded that "differences between investor-owned and not-for-profit hospitals were small, and the directions of the differences were not consistent".20

There is some evidence, however, that, while on average the quality of care may be much the same between for-profits and not-for-profits, in sectors where physicians play a less active role, the lowest quality facilities may be disproportionately for-profit. In this case, professional norms might be seen as providing a buffer against truly wretched care. However, there may well be other indicators of quality in which for-profits perform better:

"Nome aspects of quality take the form of amenities such as a less sterile environment or more flexible scheduling of procedures. Health care professionals may place far less value on these dimensions of quality than do patients. Not only would professional norms not serve as a protective buffer for these aspects of quality, but they may also encourage facilities to sacrifice amenities to devote more resources to other aspects of quality. Under these circumstances, for-profit facilities could offer better quality in this sense than do their non-profit counterparts."21

Overall, the studies that have been published to date appear to show rather less difference between the performance of not-for-profit and for-profit institutions than might be expected from a purely theoretical consideration of managerial incentive structures within the two kinds of institution. A likely explanation is the degree of competition between not-for-profits and for-profits for admissions (so that a system composed more exclusively of not-for-profits might be-expected to perform more poorly than a mixed system). If convergence in the performance of for-profits and not-for-profits in the US primarily reflects competition between hospitals of each form (in the face of aggressive, competing, third-party payers), the presumption that ownership type is largely irrelevant may not carry over to the New Zealand context. In particular, given (at least initially) the presence of relatively few private for-profits in New Zealand, and monopoly power on the part of RHAs, commercial incentives are likely to be weak relative to the US.

19 See, for example, Gaumer, C. (1986), "Medicare Patient Outcomes and Hospital Organisational Mission", in Gray, B.H. (ed), For-Profit Enterprise in Health Care, Washington DC, National Academy Press. 20 cited in Schlesinger ci al., op. cit., p 443. 21 ibid, p 443.

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The studies also reveal the difficulties of comparing like with like in the health care sector (so that either similarities or wide differences in apparent performance may conceal important differences in the type and quality of care being delivered). While the studies summarised above make serious efforts to avoid this problem, it is important to treat (and in particular compare) their results with some caution.

3.2.4 Reasons for the Dominant Position of Not-For-Profits

In the US, around 85 percent of health care institutions are not-for-profit, either state-owned or privately held. The relatively minor role played by for-profit hospitals in the US needs to be placed in a historical and regulatory context. In the early years of this century, for- profits exceeded not-for-profits in number, but by the mid-1920s had gone into a relative decline that has persisted by and large to the present day.

This decline may in part be explained by resistance by an increasingly strong medical profession to for-profit provision of health care. For example, in a code of ethics adopted in 1934, the American Medical Association ("AMA") stated that it was "unprofessional" for a physician to permit "a direct profit" to be made from his work. The AMA asserted, moreover, that the making of a profit from medical work "is beneath the dignity of professional practice, is unfair competition with the profession at large, is harmful alike to the profession of medicine and the welfare of the people, and is against sound public policy". 22 This did not, mean that the AMA opposed profits made by doctors from their own work, or physician owners of medical groups making a profit from these groups; rather, it opposed anybody else (such as a private investor) making a profit from the work of doctors. As one commentator has put it:

"the exclusion of the corporation from medical care, like the exclusion of the state, helped maintain the collective autonomy of the profession and -- reflected its general success in asserting its collective interests over the interests of individual physicians."23

Legislative support for the professionalisation of medicine can in this way be seen as reinforcing the status of not-for-profit health care at the expense of for-profit health care. Up to the present day, for-profit institutions tend to be more important in areas of health care where the role of physicians is relatively small, such as nursing homes, health insurance,

22 Starr, P. (1982), The Social Transformation of American Medicine, New York, Basic Books, p 216. 23 ibid, p 220.

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blood banks, and residences for the intellectually handicapped; not-for-profits are more prominent in such areas as acute care and teaching institutions.24

The relative position of not-for-profits in the post-war period was influenced by the Hospital Survey and Construction Act of 1946 (the "Hill-Burton" Act). Privately financed hospital construction had virtually ceased during the depression, and nearly 800 hospitals closed between 1928 and 1938; the Hill Burton Act sought to remedy this situation by funding the construction of public and not-for-profit hospitals. For-profit institutions were ineligible for support either for the construction of new facilities, or for the extension of existing ones. Between 1947 and 1971, the Hill-Burton programme supported a total of 10,748 projects, creating 470,329 inpatient beds and assisting more than 3,000 outpatient and other health care facilities.2 The Hill-Burton Act also required states to licence hospitals as a condition of federal support, and it is suggested that some state agencies have used their regulatory powers to impede the development of for-profit institutions.26 -

Another factor favouring the not-for-profit sector for much of the present century was the protection of not-for-profit hospitals from tort liability for medical malpractice This differentiation extended through to 1965 for private not-for-profit hospitals, and (in some states) 1978 for government-owned hospitals.27

From the 1960s (in particular, the implementation of Medicare and Medicaid in 1965) until the mid-1970s, government subsidies to the health sector expanded to include health insurance and. direct payment for treatment. Through this period, most evidently in the health insurance business, but also in health care provision, for-profit institutions grew markedly more rapidly than their not-for-profit counterparts. The for-profit share of the acute care sector, for example, rose from 5 percent to 7 percent as a result of the implementation of Medicare, and the share of the nursing home sector from 60 percent to 70 percent.28 Overall, however, the for-profit sectors share in the health care industry remains relatively small.

Post-war initiatives such as the Hill-Burton Act could be seen as resulting in a marked numerical advantage for not-for-profit institutions. The survival of not-for-profit hospitals (and their continuing dominance of the health care sector) requires, however, some ongoing

24 Schlesinger et al., op. cit.. 25 Bennett and DiLorenzo, op. cit., p 74. 26 ibid, p 75; see also: Goodman, J.C. (1980), The Regulation of Medical Care: Is the Price Too High?, Washington DC, Cato Institute.

27 Stevens, op. cit., p 315 and P 344. 28 Schlesinger et al., op. cit., p 434.

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advantage. In the case of the US, however, it is clear that, notwithstanding any such "natural" advantages, the strength of the not-for-profit sector derives to a substantial extent from its favourable tax status.

The most significant factor here is the availability of an exemption from federal income tax under Section 501 (c) (3) of the Internal Revenue Code. This in theory allows not-for-profits to devote resources that would otherwise go to taxes to the development of internal operations, and also frees them from the need to base decisions on their tax implications (except where unrelated taxable business income may be involved). Even where the actual amount of tax involved was not great, an exemption under Section 501 (c) (3), was at least until 1983 important as a prerequisite for obtaining an exemption from federal social security taxes. In addition, an- exemption provides access to tax-deductible donations and tax-exempt bond- financing. Not-for-profit institutions are also typically exempt from state taxation, most significantly property taxation, but also state sales taxes and corporate income taxes.29

Not-for-profits are eligible for tax-deductible voluntary contributions, and for access to low- cost debt-financing by means of tax-exempt municipal bonds. While the importance of charitable contributions is now small, access to municipal bond financing appears to be an important source of continuing advantage for not-for-profit hospitals. Almost 80 percent of hospital debt through the 1970s and 1980s was raised by means of these bonds, at rates averaging between one and two percent below the Treasury bond rate. The largest issuers are state and municipal hospitals and not-for-profits. While for-profit hospitals have been allowed to issue municipal bonds, the amount that can be raised in this way is capped at a relatively low figure.30

29 Horty, J.F. and Mulholland, D.M. (1983), "Legal Differences Between Investor-Owned and Nonprofit Health Care Institutions", in Gray, B. H. (ed), The New Health Care For Profit: Doctors and Hospitals in a Competitive Environment, Washington DC, National Academy Press, pp 17-34. 30 $10 million in 1987. See: Lamb, L. and Rappaport, S. P. (1987), Municipal Bonds (2nd edition), New York, McGraw Hill.

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In some respects, not-for-profits are disadvantaged vis-a-vis for-profit institutions. For example, many state laws governing not-for-profit corporations disallow the transfer of funds dedicated to charitable purposes without judicial approval. This can create difficulties, for example, when hospitals wish to convert assets such as real estate into cash, but face restrictions placed on the use of the property involved when it was donated. The same state laws also often require greater public accountability for not-for-profit institutions than is the norm for for-profits, for example imposing open meeting requirements that have the potential to give competitors access to commercially sensitive information. In addition, not-for-profits are generally under a stronger (sometimes implicit) obligation to provide uncompensated care as a condition for retention of their tax-exempt status. In other areas, the regulatory treatment of for-profits and not-for-profits is more neutral. For example, both kinds of institution are subject to federal labour laws and federal antitrust laws.31 32

For these reasons, it is not possible to infer from the US experience that a high ratio of not- for-profit to for-profit health care institutions is a natural outcome of competitive forces in an industry characterised by special problems of information and trust. Rather, the dominance of the not-for-profit sector reflects in part the influence of successive legislative and regulatory interventions that have favoured them at the expense of for-profit enterprises.

3.2.5 Application to the Health Sector in New Zealand

In considering whether the corporate charters established for health care institutions in the course of the current reform process should be not-for-profit or for-profit in form, the first task is to weigh up the costs and benefits of the two forms, as described in Sections 3.2.1 and 3.2.2 above, in the light of empirical evidence. Here, our general conclusion is that the sorts of theoretical arguments that might explain or justify the use of the not-for-profit form are not strongly applicable to health care institutions, so that any benefits arising from a not-for- profit charter are likely to be weak, and more than offset by potential incentive problems and resulting inefficiencies. In so far as the relatively commercial performance of not-for-profits in the US is a result of aggressive competition from for-profits for funds from competing insurers, and these conditions cannot be replicated in the early stages of reform in New Zealand, we would suggest that the US empirical evidence on the relative performance of the two types should be discounted.

31 ibid, p 30. 32 Questions have continued regarding the applicability of antitrust provisions to not-for-profit institutions. For example, in United States v. Carillon Health Systems (708 F. Supp. 84 (WD Va 1989)), concerning a merger between two not-for-profit hospitals in Roanoke, Virginia; the district court held that Section 7 of the Clayton Act (concerning mergers) did not apply to not-for-profit hospitals, so that the merger could not be in violation of the Sherman Act.

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A second issue to consider is the implications of continuing government ownership of health • care institutions for the choice between a for-profit and a not-for-profit charter. In our view, the prospect of continuing state ownership if anything reinforces the case for a for-profit charter. Where trading enterprises are held in state ownership, even if they are exposed to competition in their output markets, the incentives on managers to perform will be weak relative to those found in private sector enterprises, because of their relatively limited exposure to capital market competition. (This issue will be considered in more detail in Section 3.3.1 below.)

The incentive problems associated with the not-for-profit form could be expected to be compounded in this context. Private sector not-for-profit firms, as noted in Section 3.2.1 above, are less exposed to capital market pressures than their for-profit counterparts, by reason of not participating in the market for equity. They remain, however, exposed to the pressures of monitoring by their creditors, and to the risk of bankruptcy. These latter pressures are likely to be weaker for state-owned firms (for example, because of a perceived government guarantee on debt, lowering the interest rate paid, and an expectation that the government will act to avert bankruptcy). In this context, a constraint to make a profit, in particular in the face of competition, enforced by managerial monitoring and accountability mechanisms, will be an important means of encouraging managerial performance.

A third issue, to take into account in deciding the appropriate default option for health care institutions is the extent to which efficient departures from the initial options can be implemented in the future. In part, this. is a matter of avoiding inappropriate regulatory barriers to the adoption of forms other than those initially used. For example, unnecessary barriers to the establishment of not-for-profit subsidiaries by for-profit health care institutions should be avoided; so too, should regulatory barriers to the independent establishment of either for-profit or not-for-profit institutions by new entrants to the health care market.

However, even in the absence of significant costs of switching between the two forms, a case can be made for starting out from a for-profit base, in so far as managers in for-profit organisations might be expected to have stronger incentives to adapt their structures and practices to the needs of the market than do not-for-profit managers. This will be particularly important given the likely diversity of organisational and ownership arrangements in an efficient, competitive health care system. The efficient provision of services is likely to require a variety of organisational innovations, including innovative

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company-subsidiary structures and contracting out. As noted in Appendix A, which provides an overview of the current New Zealand health care system, a number of area health boards have already developed contractual arrangements with not-for-profits in their region, for example, the Canterbury Area Health Board contracts out some long-term care and domiciliary nursing services to the Nurse Maude Hospital. As will be discussed in more detail in Section 3.4.21 it may be appropriate for some services to be handled through a community trust structure. The for-profit structure is likely to have strong advantages over the not-for-profit structure in providing CHE managers with the incentives required to make decisions in a focused and timely way.

A more general question to consider here is what for-profit and not-for-profit corporate structures might look like in organisations that remained in government ownership. In the case of the for-profit form, a model is provided by the SCE structure applied to various government trading enterprises. This model is described in more detail in Section 3.3. It is less immediately clear how a competition-oriented, not-for-profit, state-owned health care institution might look like. First, as not-for-profit organisations do not have owners in the conventional sense, the SOE model of shareholder ministers representing the general public would not be applicable. Instead, some form of trust structure would probably be needed. In the absence of a dividend requirement, more extensive rules on internal management practices would probably be required, implying a far more extensive and detailed monitoring process than under the SOE structure. There would be a proportionately greater reliance on competition as a source of incentives for commercial performance (in the absence of SOE-type proxies for capital market checks), an emphasis which could be argued to be inappropriate at least in the early stages of reform. If not-for-profit status brought with it the range of tax exemptions normally allowed not-for-profit institutions, this competitive pressure (vis-a-vis for-profits) would also be weakened. In the US, not-for-profit objectives have never had to be defined in the manner required in New Zealand. 33 We believe that any attempt to introduce a "not-for-Rrofit" model in New Zealand, would involve either a series of ineffective administrative rules or a "commercial approach" which would incorporate similar governance mechanisms and accountability arrangements to those that apply under the State-Owned Enterprises Act.

While we believe there is a strong case for adopting a for-profit model as the initial basis for New Zealands government-owned health care providers, there is considerable scope for confusion over the application of SOE principles in the health sector. Efficient health care provision requires a commercial framework that will ensure a high level of accountability

Patricia Danzon, pers. corn., 20 December, 1991.

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and management efficiency, rather than a rigid model that prescribes a particular organisational form. Thus, while we believe that the provider units established initially by the NIPB should be subject to the key elements of the SOE framework as outlined in Section 3.3, those units should be encouraged to adopt non-corporate and hybrid organisational arrangements where this is expected to improve efficiency.

Regardless of which default model is chosen for government-owned health care providers, it is essential that they are subject to the same regulatory regime as private sector providers. Neutral treatment will shift market share towards the most efficient providers and will force providers to adopt efficient organisational arrangements over time. These issues are discussed in more detail in Section 5.0.

3.3 The SOE Framework and Experience

In New Zealand, central and local government are involved as owners in a variety of organisations that produce goods and services for private and/or public consumption. The State-Owned Enterprise Act of 1986 provided a model for the governance of the subset of these organisations which, by virtue of producing primarily for private consumption, could be seen as most closely resembling private sector businesses.

In this section, we consider the appropriateness of the state-owned enterprise ("SOE) model, or variations on that model, to health care institutions. We begin, in Section 3.3.1, by describing the principles behind and basic features of the SOE model. In Section 3.3.2, we review the experience to date in the SOEs, and in the ports and airports, for which a similar model has been applied. We then consider variations on the model applied or mooted for local authority trading enterprises ("LATEs"), Crown Research Institutes (CRIs") and Electricity Supply Authorities ("ESAs"). In Section 3.3.3 we discuss the flexibility of the SOE model, and in Section 3.3.4 we consider its relevance to health care reform.

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3.3.1 The SOE Framework

The key elements of the SOE framework are as follows:

the managers of SOEs are set clear and unconflicting objectives. Generally, this is an objective of operating the enterprise concerned as a commercial business;

the objectives of SOEs are; required to be set out in a detailed fashion in annual statements of corporate intent, which are subject to the approval of the shareholder Ministers, and against which managers are held accountable;

where government requires the performance of a social service function by. an SOE (in conflict with the objective of commercial performance), the services required must be contracted for explicitly and separately;

managers are given a high degree of autonomy over day-to-day operational decisions, as in private sector corporations;

• managers are answerable to owners (represented by sharehoIder.Ministers) via a board of directors, appointed on the basis of commercial expertise. This board is also responsible for strategic decision-making;

• SOEs are required to furnish half-yearly reports and accounts; the latter are audited by the government Audit Office; and

• SOEs are subject to monitoring by the State-Owned Enterprises Steering Committee, the State-Owned Enterprises Advisory Unit attached to the office of the Minister of. State-Owned Enterprises and the Treasury (on behalf of the shareholder Ministers).

A critical aspect of the establishment of an SOE is the removal of regulatory advantages and disadvantages, so as to expose the SOE as fully and fairly as possible to competition in its output and input markets. Examples include the removal of the Post Offices statutory monopoly on telecommunications services as part of the establishment of Telecom Corporation of New Zealand ("Telecom), and the removal of an explicit government guarantee on SOE debt.

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The approach adopted under the SOE legislation involves applying to government trading enterprises governance and control mechanisms that are either the same as, or closely mimic, those applying for private sector businesses. SOEs are conceived as essentially commercial enterprises, exposed to and reacting to market forces in a manner comparable to any private sector enterprise.

Where, by virtue of government ownership, SOEs cannot be exposed directly to the market pressures faced by private sector enterprises (most notably, in the market for equity), they are constrained by rules designed to ensure that they behave as if they did, indeed, face such pressures. Examples of this include requirements for a corporate statement of intent, auditing arrangements, and the institution of boards of directors to represent shareholder Ministers.

Notwithstanding these attempts to implement disciplines for SOEs comparable to those applying to listed corporations, the incentives of SOE managers to use resources efficiently are generally weaker than if they were exposed to a full range of capital market pressures. In particular, SOE managers are not exposed to the same rigorous monitoring of their performance by sharemarket analysts and brokers that are routine for listed companies; nor are they exposed to the threat of being taken over. In addition, their creditors are likely to perceive a government guarantee on debt even if any formal guarantee is absent, and the threat of bankruptcy is weakened (if not removed entirely) by a belief that government would not allow one of its trading enterprises to fall over (as in the case of the Development Finance Corporation of New Zealand).

The relative weakness of capital market constraints on SCE managers is one key weakness in the SOE model. A second weakness is the greater susceptibility of SOEs to political intervention - the risk that they will be used to achieve politically favoured, rather than purely commercial ends. For these two reasons, the SOE model, while representing a significant advance over the departmental model as-a means of governing the activities of government-owned businesses, is unlikely to perform as well as, for example, the private sector listed corporation model in ensuring the efficient use of resources on a sustainable basis.

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3.3.2 Review of SOE Experience

3.3.2.1 .SOEs

The SOE reform process has lead to a major improvement in the performance of a wide range of SOEs. Many SOEs have turned a position of loss to profitability. In most SOEs, output per employee has increased substantially, and costs of production are significantly lower. The organisations have become more responsive to consumer needs. Treasury estimates that shareholder wealth in the original 14 SOEs increased by $1.7 billion in their, first three years. The success of the corporatisation programme is illustrated by a number of different businesses.

CoalCorp was formed from the operation of State Coal Mines which made losses in 20 of its last 22 years of operation. Some miners were employed in uneconomic mines at an annual cost of around $122,000 per job. In its first full year of operation CoalCorp turned a loss of $23 million into a small profit without increasing its prices. By the third year of its operation, CoalCorps profits stood at $22.7 million. Despite reducing its staff numbers by half, CoalCorps annual production is now higher than that achieved by the old State Coal Mines.

New Zealand Post Limited ("NZ Post") was formed from the postal business of the former New Zealand Post Office. Although the postal business incurred losses of; $38 million in 1986/87 and was expected to incur losses in the order of $50 million in 1987/88, NZ Post actually achieved a substantial profit in that year, its first year of operation. The profit was achieved .without price increases for basic mail and with price reductions of 30 to 50 percent for unaddressed mail. Service delivery improved by 5 to 10 percent despite an increase in the volume of mail delivered. In 1989/90 NZ Post achieved a profit of $53 million.

Telecom was formed in 1987 to take over and operate the telecommunications operations of the Post Office. Following a thorough strategic review, Telecom decentralised its operations and moved to establish six major subsidiary companies with clear lines of accountability and areas of responsibility. Nearly 100 senior executives, including a new Chief Executive, were recruited into all areas of the business at a number of levels. The company introduced up-to- date management systems including a decentralised integrated accounting system, computerised billing and a centralised network management system.

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Staff were reduced from around 25,600 in 1987 to approximately 17,000 in 1990. Telecom reduced costs in many areas by using sub-contractors for services previously provided within the company (Telecom even built its own furniture at one stage). In many cases, former Telecom staff are now sub-contracting to the company as well as to other clients.

Consumer services have improved. For example, the average time for new telephone connections has been reduced from six weeks to two working days. The introduction of the directory service computer in Auckland, resulted in calls being answered on average within 8 seconds down from the 60 second average of the old Post Office. More efficient pricing has been achieved by removing cross-subsidies between local and long distance calling.

Telecom was privatised in 1990.

Electricity Corporation of New Zealand ("Electricorp") has achieved a number of substantial improvements in performance. Reduced real costs and increased volumes have enabled Electricorp to hold electricity prices in real terms. Over the first three years of its operations, Electricorp reduced its unit costs in real terms by a total of 23 percent. The real average wholesale price of electricity was reduced by 8 percent over the three years.34 Overall, productivity (measured in terms of GWh per employee) has increased by 71 percent to March 1991.

While the SOE reform processes has lead to increased performance by many SOEs, it has not proved successful for others, for example problems have been experienced in ensuring that Government Property Services operates in a commercial and profitable manner. In other cases, it has been suggested that the SOE model is not appropriate; for example, it is possible that the PowerDesignBuild Group, a subsidiary of Electricorp which provides consulting services, would have been more appropriately established as a partnership rather than as a -- corporate structure.

3.3.2.2 Ports

Historically, New Zealands ports were administered by harbour boards, which operated as a branch of local government, with board members subject to election by registered voters in a manner comparable to the election of local councils.

4 Draws on Deane, R. (1989), Corporaf isaf ion and Privatisation: A Discussion of the Issues, paper presented to the Napier Chamber of Commerce; and Barber, D. (1991), "The SOE Surge", Management, December.

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In 1988, the government legislated for the formation of port companies to take over the commercial operations of each of New Zealands ports. Local harbour boards retained responsibility for providing non-port-related operational activities and non-commercial services, primarily related to safety or "good navigation". The commercial assets of each port were valued and, when approved by the Ministry of Transport, transferred to a port company. The government also abolished the New Zealand Ports Authority, a body which had been charged with developing a national ports plan aimed at guiding port investment and reducing duplication of activities, thus freeing port companies to operate their own equipment on port company wharfs (rather than being required to hire it from harbour boards).

The principal legislation guiding the port reform process was the Port Companies Act of 1988. This Act provided for the formation of port companies to carry out port-related commercial activities, and established accountability- arrangements for port companies and their managers.

The , principal objective of each port company is to operate as a successful business. Each port company is required to have no fewer than six directors, with no more than two being members of the harbour board, territorial authority or other such bodies. The Act restricts each harbour board to registering a single port company, although subsidiary companies are allowed.

Port companies are required to provide a statement of corporate intent which specifies, among other things, the objectives of the company, the nature and scope of the activities to be undertaken, and performance targets. A statement of corporate intent is not required if the company is listed on the stock exchange, or if some of the shares are held by persons other than the harbour board or its nominees, and if the Minister of Transport waives the requirement for a statement. The directors are required to provide half-yearly and annual reports and accounts, and the Audit Office has the responsibility for auditing the accounts of both port companies and their subsidiaries. - -

A harbour board may contract with a port company for the provision of non-commercial services by the latter, and the Act includes arbitration provisions for such cases.

The shareholdings were initially vested in the harbour boards and subsequently transferred to regional councils. The 1988 Act required that the majority shareholding in port companies (51 percent) be held by local authority bodies, but allowed the balance to be disposed of to

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other shareholders. The Port Companies Amendment Act of 1990 repealed this restriction, effectively providing for full privatisation of port companies.

The Act provides that no amendment be made to the memorandum of association or articles of association of a port company without the prior written approval of the Minister of Transport. The Port Companies Amendment Act 1990 provides that when at least 50 percent of the shares are held by a party or parties other than local authorities, then a number of the provisions of the Port Companies Act will not apply to the port company (including the requirement that the Minister of Transport approve changes to the articles of association, the requirement to provide a statement of corporate intent, the adoption of the objective of operating as a successful business, and the requirements relating to reports and accounts).

The previous Labour government moved to normalise employment arrangements for waterside workers in 1989, through the Waterfront Industry Reform Act 1989 and the Waterfront Industry Restructuring Act 1989. The Waterfront Industry Commission, which had previously administered the-labour pool for waterside employees, was wound up on 30 September 1989 and normal employer-employee arrangements came into effect. At that time there was a period of dislocation lasting several week. A set of principles was agreed at a national basis and local negotiations specified a number of terms and conditions on a port by port basis. As a result of these reforms, working hours have become more flexible and a number of ports are now working on a 24 hour a day, 7 day a week basis.

The first year savings from port reform have been estimated by the Ministry of Transport to stand at $58 million. The improved labour productivity and port management has, for example, enabled substantial reductions in stevedoring charges. Conventional stevedoring charges have been reduced by between 20 percent and 50 percent since October 1989.

A number of port companies have been able to hold charges constant over an extended period, thus implying significant reductions in real terms. For example, in the two and a half year period to the beginning of 1991, the Tauranga port company had not increased its charges. As at August 1990, the Auckland port company had achieved a real reduction in charges of around 14 percent. - -

However, despite these major advances, there has been some disquiet expressed by potential investors, and port users about how rigorous the regional councils have been in monitoring the port companies. An example is the large redevelopment at the Port of Tauranga (Sulphur

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Point). This represents a large capital investment (over $100 million) which, according to many in the industry, appears unlikely to generate an adequate rate of return.

3.3.2.3 Airports35

New Zealand has a total of 202 licensed aerodromes, 64 of which are public, that is available for general use by the public. Until 1 April, 1988, 24 of the public aerodromes were operated as joint ventures under joint venture agreements between central government and one or a number of territorial authorities. Generally, the day-to-day management of the airports fell to the local authority, and costs and revenues were shared equally between the joint venture partners. The airports were not regarded as strictly commercial operations. No dividends were paid to the airport partners during the operation of the joint ventures.

Difficulties occurred in the commercial operation of the joint ventures. Local body decision- making structures were cumbersome, exacerbated by the overlay of central governments bureaucratic and political controls on capital expenditure. The Governments concern with the inefficient operation of the airports resulted in its decision in 1985 to corporatise joint venture and, Ministry of Transport airports. In December 1986, legislation provided for airport companies to replace joint ventures.

The government experienced some difficulty in persuading local authorities of, the benefits of corporatisation. in the case of Auckland, special legislation establishing the airport company was introduced in December 1987. At the time of its establishment, the Crown took a 50 percent shareholding and the 29 Auckland local authorities (since reduced to seven by amalgamations) obtained proportions of the remaining 50 percent .based on their original capital contribution to the establishment of the airport. In 1990, the Crown purchased Papakuras 1.6 percent shareholding, giving the Crown had a majority position. The other two international airports (Wellington and Christchurch) have also been established as companies, in the case of Christchurch, the Crown has a 25 percent shareholdirig with the Christchurch City Council holding the balance; in Wellington the Crown holds a 66 percent shareholding with Wellington City Council holding the balance. I In the first two years of its operation, Auckland International Airport Limited increased its profits threefold with a further increase achieved in 1991. In the case of Christchurch International Airport, profitability has increased since corpora tisa tion. Net profit for the

This section draws on: Travers Morgan Pty Ltd and Jarden Morgan NZ Limited (1989), Airport Regulatory Review, Report to Officials in Ministry of Commerce, the Ministry of Transport and the Treasury.

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fifteen months to 30 June 1991 represented an annualised improvement of 14 percent over the comparable rate of profit achieved in the preceding twelve month period. The corporatisation of Wellington airport is too recent to allow assessment of any performance improvements.

3.3.2.4 Local Authority Trading Enterprises

The legislative framework for LATEs was provided for in a 1989 amendment to the Local Government Act of 1974. LATEs are defined as companies in which a local authority holds equity securities that carry 50 percent or more of the voting rights, a company in which any combination of local authorities holds such equity securities, or any organisation through which a local authority or local authorities operate a trading undertaking with the purpose of making a profit. Port companies formed under the Port Companies Act 1988, and airport companies. formed under the Airport Authorities Act 1966, are excluded from this definition.

The LATE legislation establishes for trading enterprises owned by local authorities a framework comparable to the SOE framework. As with SOEs, the principal objective of LATEs, specified in the legislation, is to operate as successful businesses. LATEs are debarred from undertaking any regulatory function. They are subject to requirements to prepare statements of corporate intent,36 and half-yearly and annual reports and accounts (subject to Audit Office auditing), comparable to those found in the SOE legislation.

The LATE legislation provides for the creation by local authorities of establishment units which have the functions of identifying the undertakings to be transferred to LATEs, valuing these undertakings, determining an appropriate price or price methodology, specifying the debt securities to be issued, preparing draft memoranda and articles of association and a statement of corporate intent, and determining the best manner and time for transferring assets to a LATE. Establishment units also have the power to recommend divestment of all or part of a prospective LATE, although local authorities may also decide independently to divest such assets, without first creating an establishment unit. Establishment of LATEs has been voluntary.

Few councils have moved to establish LATEs preferring instead to establish business units that are not at arms-length from the council in part to prevent councils losing relatively close control of them. In part, the reluctance to establish LATEs has resulted from a tax distortion - while the businesses are part of a local authority, they are exempt from tax but if

36 This requirement is waived if LATE shares are listed on the New Zealand Stock Exchange.

-51- CS 1"iisi 1OSlO\ established as LATEs they become liable to company tax. Because only a small number of enterprises have been established it is difficult to assess the success of the framework as applied to local authority enterprises.

3.3.2.5 Crown Research Institutes

Historically, the New Zealand Government has funded scientific research (outside of the universities) through a number of government departments, most importantly the Department of Scientific and Industrial Research and the Ministry of Agriculture and Fisheries. This funding has been generally recognised as comprising both a public good component (basic research which, while yielding no immediate commercial benefit, is necessary to the advancement of a discipline that will, in time, yield applications of commercial and. social benefit), and a more commercial component (research with clear commercial applications, in which more or less exclusive property rights could be defined). As in the case of the area health boards, a range of interests was therefore represented by individual research institutions; the government was present both as an owner of (often capital-intensive) facilities, and as a dominant purchaser of output (both for the purposes of other government agencies, and on behalf of taxpayer-consumers).

Over recent years, there have been a number of attempts to reform both the funding of scientific research by government, and the structure of government organisations involved in the production of science. On the production side, the most recent initiative is the decision to create Crown Research Institutes ("CRIs") in various areas of research, which would compete with other research organisations (in the private sector and in the universities) both for government funding, , channelled through the Foundation for Science Research and Technology, and for commercial contracts.

CR1s are being established as corporate bodies, separate from the Crown, under special legislation broadly based on the Companies Act, but tailored to the specific character and needs of scientific and technological research. The resulting CR! legislation is modelled on the State-Owned Enterprises Act. The accountability provisions for CRIs (the use of statements of corporate intent and reporting requirements) are drawn directly from the State- Owned Enterprises Act. Similarly, the legislation will mimic the SOE legislation closely in providing for two shareholding Ministers, and appointment by the Cabinet of boards of five to nine persons, chosen not for their ability to represent sectional interests, but rather for their skills in management and in the application of research and technology. Except as provided for by legislation, CRIs, like SOEs, will operate under the Companies Act.

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In contrast, the purpose and operating principles are significantly different from those used for SOEs. In particular, the legislation specifies the purpose of each CR1 as being "to establish research capabilities, carry out scientific and technological research and provide related services". Accordingly, the principles of operation focus not so much on commercial practice as on operating in a responsible manner. "in order to generate sufficient operating funds to maintain continuing financial viability", on pursuing excellence in all their activities, and on undertaking research and providing related services "to the benefit of New Zealand".37

CRIs are required to include profit targets in their statements of corporate intent, linked to the requirements of maintaining financial viability and providing sufficient capital to maintain scientific capacity. However, because CRIs are seen as functioning primarily for the production of "scientific and technological dividends", the. government has agreed that financial dividend payments to the Crown will ordinarily be nil or a very low figure.38

The CRIs will be funded principally by the Foundation for Research, Science and Technology, but may also sell inputs to government departments, and are expected to raise funds through sales to the private sector.

The CR1 model represents an attempt to tailor the SOE model to a sector producing an output with a significant public good element, which may be difficult to either measure or to price. It therefore seeks to combine some of the disciplines of the company model (in particular, the use of a board and commercial reporting requirements) with mechanisms aimed at the more nebulous goals of maintaining a research base and promoting excellence (and relevance) in research. Controls in the latter area will come primarily through competition for funds both from the private sector and from the Foundation. In so far as the latter dominates funding, the quality of incentives on CRIs will depend on the quality of the mechanisms used by the Foundation to decide funding priorities.

Because the CR! model represents a departure from the SOE model that attempts to deal with particular public good and information problems, its relevance to the health system will depend on the extent to which the latter presents comparable problems. In particular, its relevance depends on how we conceive governments future role as an owner and funder of hospitals and other health care institutions, the weight that we place on the public good

37 Ministerial Task Group (1991), Crown Research Institutes: Research Companies for New Zealand, Wellington, Ministerial Science Task Group, p 124. 38 ibid, p 127.

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component of health care, and the difficulty which we expect to attach to measuring and pricing health care outputs.

Historically, funding and provision have been linked in the health care sector. Much emphasis has been placed on the social aspects of health care services, and, in the absence of imperatives for efficient pricing of services, the task of pricing has appeared difficult. However, these outcomes may be regarded as the result of a particular and deliberate approach to health care funding and provision, rather than the necessary result of public good, measurement or pricing problems. Further, as Appendix A shows, a number of area health boards have in recent years made significant progress in developing information systems relevant to the measurement and costing of services. In this sense, while the CR1 model may, superficially, appear suitable for health care institutions as they have been in the past, it is not well-designed for governing these institutions as we might want them to be. In particular, it would be a relatively poor means of providing managers with incentives to develop measurement and pricing mechanisms, and pursue efficiency in service delivery.

The CR! model may, however, be of some relevance to medical research. Medical research involves important public good considerations and raises similar governance and funding issues to other forms of scientific research. A full assessment of the relevance of the CR!

model to medical research is outside the scope of this report. 1

3.3.2.6 Electricity Supply Authorities

Electricity Supply Authorities ("ESAs") take the form either of Municipal Electricity Departments ("MEDs"), which are owned by local government, or of Electric Power Boards ("EPBs"), which are, in a legal sense, owned by the boards themselves.

The Government has recently prepared draft legislation (the Energy Sector Reform Bill 1991) which provides for corporatising ESAs by vesting their assets and liabilities into limited liability companies with shares held beneficially for the "community" by Electric Power Trusts ("Trusts"). The Energy Sector Reform Bill provides for the polling of consumers to allow a democratic determination of the ultimate ownership structure of the new companies. The polls may be called for by the Trusts, or the Minister of Energy or if requested by 5 percent of consumers. The Act limits individual shareholdings to a maximum of 15 percent except with the approval of the Minister. For MEDs, shares will be vested in the local authority concerned.

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The initial trustees of EPBs will be those appointed by government. Elections for subsequent trustees will be held three yearly. The first directors of the companies are to be appointed by the Minister with subsequent ones to be appointed by the Trusts or local authorities (as shareholders).

Companies will be expected to operate commercially and it will be up to the trustees or local authorities to determine dividend policy in accordance with statements of corporate intent required annually.

The vesting of ownership in the Trusts, on behalf of consumers, involves monitoring problems because of their relative lack of accountability to consumers as ultimate owners. The principal accountability mechanisms are three-yearly elections and the ability of consumers to request a poll of preferred ownership options. The latter is likely to be the most effective constraint.. The lack of interest in Electric Power Board elections in the past indicates the relative ineffectiveness of the former. Normal capital market constraints, including the threat of takeover will not apply as long as Trust ownership continues. Individual consumers, lacking the ability to transfer their implicit shareholding, will have few incentives to monitor trustees.

3.3.3 Flexibility of the SUE Approach

Experience with the SOE model to date suggests that it can be applied beneficially in a variety of situations, at both the central and local government level. However, experience both in New Zealand and overseas (for example, in Australia) suggests that the success of the model depends on maintaining its overall integrity. In particular, for the model to yield sustainable benefits:

the objectives set for the organisation involved must be clear and unconflicting;

high-quality directors must be appointed to SUE boards and non-performing - directors and boards must be expeditiously replaced;

an arms-length relationship between managers and shareholder Ministers must be established and rigorously maintained;

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other government agencies must be precluded from impinging on the managerial autonomy so established;

mechanisms must be established for holding managers accountable for the achievement of the objectives set for them, and for monitoring their performance;

non-commercial objectives must be separated Out, and funded separately by the government; and

all regulatory advantages and disadvantages enjoyed and/or suffered by the organisation vis-a-vis actual or potential competitors must be removed.

Experience over the past year suggests that there is a degree of political unwillingness to accept some of the basic principles of the SOE model as Sacrosanct. In particular, there has been an apparent unwillingness to allow SOEs full discretion over prices in such politically sensitive markets as the electricity market (as reflected both in Ministerial comments on proposed price increases by Electricorp, and debate over the regulatory regime to be applied to ESAs under the Energy Reform Act). Whether or not expressions of concern by Ministers are followed by direct intervention in the affairs of SOEs, developments of this kind reflect a threat to managerial autonomy, to the unambiguous commercial objective of SOEs, and to the principle of separating out (and separately funding) any social goals related to an SOEs activities.

In addition, there has been some drift away from the principle of appointing boards and managers for their commercial competence rather than, say, their ability torepresent certain sectional interests. The experience with the SOB model to date, as described in Section 3.3.2, suggests that performance is closely linked to the quality of appointments; given the difficulty of developing monitoring mechanisms for SOEs as potent as those which operate for private sector listed companies, the quality, focus and commitment of key personnel in SOEs is if anything more important to sustainable commercial success than in the private sector.

In order to understand the implications of such developments for the viability of the SOE model, it must be recognised that the components of the model (commercial objectives; managerial autonomy, and so forth) are interdependent. For example, managers who are required to operate their enterprises as commercial businesses, making a commercial rate of return, but who are constrained in their ability to set prices according to what they regard as

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market dictates, may find themselves unable to comply with their statement of corporate intent. Softening the requirement for commercial performance, however, while managers retain a high degree of autonomy, may result in resource wastage and excessive consumption of manager and employee perquisites. Weakening one component of the model, while retaining the others intact, is, therefore, likely to have perverse effects (and effects that may appear wildly out of proportion to the initial change in the rules).

Despite this broad interdependence, it is possible to identify some components of the SOE model which are particularly important to its success, and departures from which are likely to lead to a marked deterioration in the performance of the model as a whole. The first of these, in our view, is an unadulterated commercial focus. The second is the quality of external monitoring of the performance of SOE managers (embracing both the screening of appointments and monitoring to enable a rapid replacement of poor performers). We would suggest that this has been an area of weakness in the application of the SOB model to date, and one that is critical given the relative weakness of SOB exposure to capital market constraints and monitoring through the sharemarket. The third key component is, as discussed above, the maintenance of an arms-length relationship between SOE managers and politicians (as well as other government agencies). This is important both for the maintenance of a commercial focus (and certainty about the ability to pursue commercial goals), and for the attraction and maintenance of quality personnel; beyond some point, managers and directors with experience and opportunities in the private sector will be unwilling to work in SOEs if their efforts there are continually frustrated.

The question then arises as to how significant (and how diverse) departures from the basic principles of the SOB model must be before the overall model ceases to be viable. Here it is not only the magnitude of particular interventions that matters (through dramatic individual interventions may have profoundly destabilising effects), but also the repetition - of (even very minor) interventions, and the broader threat created by the knowledge, say, that Ministers willingness to intervene has increased.

As indicated above, we see departures from the SOE model in terms of commercial focus, the quality of appointments and monitoring of performance, and the maintenance of an arms- - length relationship with Ministers and the absence of regulatory barriers to competition as particularly damaging: There are important independencies between these aspects of the SOE framework; an arms length relationship with Ministers is essential in order to attract and retain high quality board members; effective monitoring and a commercial focus are

-57- i• i liOS]ON difficult to achieve if the organisation receives regulatory protection from competition.39 Deviations from other aspects of the SOF model may be rather less critical. For example, while the maintenance of a differential or economically suboptimal regulatory regime for SOEs may lead to generally poorer performance than a "clean regulatory regime, small changes in regulation are unlikely to be as damaging as, for example, a weakening of monitoring mechanisms, or a change in appointments policies.

A related question is whether there is some mutually consistent set of departures from the basic model which could at once reduce the risk of political intervention in the affairs of SOEs while maintaining the overall viability of the model (and producing the desired benefits in terms of efficient use of resources by government-owned businesses).

The SOE model (and its prospects of success) are based on a general principle of exposing managers of government-owned businesses as far as possible to the pressures of the marketplace. Any modifications to the model aimed at reducing the risk of political interference should, as far as possible, be consistent with maintaining these pressures.

The markets in which SOEs are most unambiguously exposed to competition (or at least the threat of competition) are the markets in which they sell the goods or services that they produce and (now to an increasing extent) the market for labour. In the capital market, by contrast, they are not exposed to the variety and magnitude of disciplihes confronting comparable private sector companies. In particular, lacking tradeable equity, they are not exposed to the disciplines of the sharemarket. In addition, to the extent that creditors perceive a government guarantee on SOE debt (even in the presence of statements to the contrary), SOEs can enjoy lower-than-market interest rates and a greatly reduced threat of bankruptcy.

It is possible that modifications to the basic model that tightened the constraints faced by SOPs in their use of capital could be implemented without great cost to the overall integrity of the model. These might include, for example, tighter controls on business diversification, a more formal Ministerial approval process for major investments, and the institution of a

A recent major review of the corporatisation of Electricorp concluded that the "critical influence of key leaders on the direction and process of change is, in our view, the major lesson that emerges from the study" (Spicer, B. H., Bowman, R. C. and Emanuel, D. M. (1991), From Government Department to State-Owned Enterprise: A Case Study of the Electricity Corporation of New Zealand Limited, A Report to the Treasury of New Zealand, p x. The report noted, however, that "it was the institutional change made possible by the SOP Act that played the primary role in the sweeping changes in organisation and management described in detail in our study" (ibid, p xi).

-58- d ( S Ii lSI 1OSi()\ leverage ratio above that which would apply in comparable private sector businesses (so as to restrict free cashflows to the SOE). Such checks might be considered, in particular, where there are concerns about the potency of competitive checks in an SOEs output markets (in which case managers autonomy is enhanced by their degree of monopoly power).

However, it is not clear that checks of this kind would satisfy the concerns that seem to underlie recent Ministerial interventions or threats of intervention, most notably with regard to SOE pricing. Further, controls over diversification and new investment may be used in a way which undermines SOEs ability to compete when they are operating in competitive markets, with potentially high (if hidden) costs. In this context, firm rules that modify the basic model (such as leverage rules) are likely to be preferable to sanctioning increased Ministerial discretion over some part of an SOEs activities (such as investment or diversification). Any provision for increased Ministerial discretion would, accordingly, need to be precisely specified so as to avoid pervasive day-to-day involvement by Ministers in SOE affairs. One means of doing this would be to define the criteria for the use of discretion in statute, so that any deviation would require a statutory amendment.

We have commented above on the importance of effective monitoring (including replacement of under-performing directors and managers) to the success of the SOE model. Strengthening independent monitoring through the use of a specialist monitoring agency may also have the effect of reducing the scope for direct political intervention in an SOEs operations. One possible monitoring structure for the health sector, were CHEs to be set up as SOEs, would involve the creation of a specialist monitoring agency, operating rather like the board of a large holding company. Individual CHE boards and managers, as in the case of subsidiary companies in a holding company, would be answerable to this agency, which would in turn be answerable to the shareholder Ministers. Particularly in the period of transition, the agency would act as a monitor and check on new investment and divestiture decisions by CHEs, as well as a source of expertise and advice. 1t would also serve as a buffer between individual CHEs and Ministers (and perhaps also other government agencies), reducing the risk of direct political intervention in the day-to-day affairs of CHEs. This monitoring body would, however, be required to distance itself from the detailed strategic and operational decision- making of CHEs, making for a highly decentralised management style. In Section 6.0 we describe in more detail the functions of a specialist monitoring agency of this kind.

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3.3.4 Relevance of the SOE Model to Health Reform

The SOE model is designed to increase the efficiency with which resources are used to meet consumer demands in government-owned entities which produce goods and services for private consumption. In particular, it is designed to handle those activities which can be conducted at an arms-length from the Parliament and Cabinet, and which produce outputs which are, to an acceptable degree, measureable and priceable - timber, electricity, postal services, rail transport - and that can sensibly be run as commercial businesses.

Deciding the relevance of the SOE model to health care institutions depends on answering two questions:

can the health care institutions be run efficiently and sustainably as business enterprises?; and

can we expect the SOE model to be robust as a means of promoting efficient provision of health care (or businesslike" behaviour on the part of those with control over operational and strategic decision-making in the health care sector), and sufficiently flexible to encourage efficient organisational innovations in this sector?

3.3.4.1 Health Care Institutions as Businesses

Experience with private sector provision of health care both in New Zealand and overseas indicates that health care institutions can and do function successfully as businesses. In particular, they can and do define and price health care outputs (including discretionary variations in the quality of care). (In this sense, the present deficiencies in cost information in New Zealand health care institutions should be seen not as an inevitable result of the special characteristics of health care, but rather as a result of past funding structures). They can (and do, given an appropriate regulatory environment) provide a full range of primary, secondary and tertiary care. Further, they can and do compete with each other on the basis of both price and quality; the focus on efficiency promoted by competition in the health care sector, as in other parts of the production sector, is focus not on pure cost-minimisation, but on efficiency in delivering what consumers want.

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Broadly speaking then, there is nothing special about health care as a product that sets it apart from other complex and valued goods and services routinely produced by both government and privately-owned business enterprises. This does not, of course, imply that there will not be instances in which the government - or local communities - do not require services that would not be supplied by health care institutions as a matter of commercial choice. (An example may be the retention of secondary care facilities in relatively small, out-lying communities.) However, as in the case of, say, the maintenance of uneconomic electricity or telecommunications services to rural areas, such requirements may generally be met through specific subsidies, or alternative modes of provision, without threatening the appropriateness, or viability, of a commercial model.

As noted above, there are likely to be particular difficulties for health care institutions in developing the kinds of cost and demand information that will enable them to make internal management and contracting decisions on a commercial basis. (However, as noted in Appendix A, a number of area health boards have already made significant progress in this area.) In this sense, the SOP model may appear to fit rather badly as a starting point for reform - to be designed on assumptions inappropriate to the current state of the health care industry.

Decisions about the appropriate model for health care institutions should, however, be determined not by how things currently are in the sector. Instead, they should focus on what is feasible, and on the sorts of incentive structures that will make desired outcomes possible. An unambiguously commercial model, by sharpening managers incentives to develop and make use of improved cost and service information and contracting mechanisms, and giving them the autonomy to do so, can be expected to hasten and focus efforts to increase the efficiency of service provision.

A further set of issues concerns those health care institutions that a commercially-oriented CHE would seek to close down, typically because demand was insufficient to cover costs on a sustainable basis. This is most likely to apply in the case of small, rural hospitals, where the number of beds is small (so that per-bed costs are higher than in larger, city hospitals) and demand is thin. In such cases, however, community attachment to the retention of (even a decreased level of) services will often be high, and local people may be willing to subsidise the retention of these services directly. Alternatively, RHAs, taking account of the time costs of rural patients, may offer funding contracts that help maintain the viability of such services. While in these institutions, as much as in larger ones, decision-making will be

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critical, they may not fit readily into large, SOE-type structures. In Section 3.4.2, we will consider the usefulness of the "community trust" model in such instances.

3.3.4.2 The Robustness of the SOE Model

As discussed in Section 3.3.3, the success of the SOE model depends on the integrity with which its different components are implemented and maintained. Managerial autonomy without matching accountability, political constraints on pricing practices or service quality, the appointment or retention of managers or directors with inadequate commercial skills, or the maintenance of regulatory advantages or barriers to entry, may all lead to perverse results. The successful application of the SOE model to health care institutions would therefore depend both on the rigorous application of the complementary components of the model, and on a high degree of political commitment to maintaining the model, and avoiding des tablising interventions.

Further, while the SOE model might be relatively easy to set up in the health care. sector, it is likely to prove difficult to maintain, even with strong political commitment. In particular, experience with the model in other sectors of the economy suggests that effective monitoring becomes more difficult with the passage of time, as existing managers and boards become entrenched. This suggests that, while a clear definition of CHE mandates as SOEs, and the appointment of high-quality, commercially-focused managers and establishment boards, would provide a strong basis for CHE performance through the first two or so years of the reform process, the success of the model beyond that point would depend increasingly on the strength and quality of external monitoring. The holding company model described in Section 6.0, would, in our view, go some distance towards ensuring that high quality monitoring could be maintained throughout the transition process, as well as reducing the risk of political intervention.

Another factor to take into consideration is the role of government agencies (the RHAs) for the purchase of health care. While competition between health care institutions for.RHA (and to a, lesser extent private insurance company) funds can be expected, this competition is unlikely to be as fierce as in markets where consumers have more direct control over their purchases (or over the selection of intermediaries, such as health maintenance organisations, to make purchases on their behalf). The amount of competitive pressure.in the health-care market (and hence the strength of incentives of health institution managers to ascertain consumer preferences and meet them cost-effectively) will depend very much on the path taken by funding reforms.

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3.4 Implications for Crown Health Enterprises

In this section, we summarise our conclusions on the appropriate corporate form for health care institutions. In Section 3.4.1, we suggest the use of a commercial framework based on the SOE model, as a basic or "default" model for health care enterprises. 40 In Section 3.4.2, we consider the application of a community trust model in instances where particular health care institutions might be closed down by commercially-oriented CHEs, but where local communities have an interest in the retention of a basic level of service.

3.4.1 The Default" Option

The restructuring of health care provision, at least with regard to ownership structures, will be facilitated by the specification of a "default" option - i.e., an option for corporate form which can be applied across CHEs and, by implication, the institutions that they manage, except in any particular instances where it can be shown that another model will clearly perform better. Suggesting one model as a default involves a presumption that, as a general rule, it will provide a desirable set of incentives and capabilities for CHE managers, and that there will be benefits in consistency in the model applied to different CHEs, at least at the outset (for example, to facilitate monitoring). There is not a presumption that this model should be applied universally; rather, departures from the model (for example, the adoption of the community trust model, considered below) should be possible. Indeed, in our view the process of reform should be a process of discovering, rather than constraining, the most appropriate corporate form for different aspects of health care. Such a process, however, should be guided by a commercial focus, and the burden of proof for illustrating the advantages of any such departures should rest on those proposing such departures.

The default option which we propose for CHEs is an SOE-type model, in which the objectives set for CHEs are commercial ones. The CHEs would operate for-profit - shareholder Ministers would act as owners, not "members", and managers would be held accountable to shareholders through appointed boards. Both managers and board members would be appointed primarily for their commercial expertise. In contrast with, for example, the CRIs, a positive dividend would be required (with the level of this dividend, as specified in the annual statement of corporate intent, subject to agreement with the shareholder Ministers). As with SOEs, social service functions other than health care services purchased by RHAs would be specified and contracted for separately by Ministers. (This might include, for

40 The grouping of health care institutions into enterprises is discussed in Section 6.0.

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example participation in public health programmes, including vaccination and consumer education.)

In Section 6.0 we will discuss a range of issues relating to the appropriate configuration of CHEs, and the range of decisions that might ideally be left to CHE managers and transitional boards to decide. What is clear is that, in comparison withearlier corpora tisations in industries which already operated in the marketplace (in particular, with separation of funding from provision), CHE establishment boards will face a particularly wide and complex set of questions about how best to structure and organise their activities and contracts, and how to define and price their outputs. These will include questions about when to use corporate models that diverge from the traditional SOE model. This at once makes managerial (and transition board) autonomy more important (in that there must be scope for possible innovative responses to complex issues), and makes accountability (and measurement of performance) more important and difficult. It also means that the costs of political interventions in CHE decisions are likely to be more difficult to define.

It follows that rigorous application of the various commercial mechanisms used in the SOE model to promote managerial accountability will be particularly important in the case of CHEs. An initial issue here will be the quality of board appointments (and their incentives to appoint high quality managers) - both as relates to the skills of the individuals involved, and as relates to their commercial focus. A second issue will be the establishment of a robust system for monitoring managerial and board performance. As noted above, we recommend for this purpose the creation of a specialist monitoring agency, located between the shareholder Ministers and individual CHE boards, which would operate similarly to the main board of a holding company - both monitoring and providing a check on the restructuring process as a whole. (The quality of appointments to such a board - and their selection for expertise rather than to represent particular interests - would be critical to the success of this option.)

Further direct checks on CHE autonomy might also be considered. One possibility, noted in Section 3.3.3, is to require relatively high leverage for CHEs. (This kind of simple, observable rule will be preferable to Controls that give greater Ministerial discretion over, say, major investments or business diversification although the latter may be viable if tightly constrained by statute.)

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3.4.2 Community Trusts

While providing considerable scope for innovative organisational and contracting arrangements, the SOE model described above may not be sufficiently flexible to ensure efficient provision of some kinds of health care, or to meet some specific community needs. The community trust model has been proposed as a means of meeting these needs in a way that is more responsive to the interests of health care consumers (at least for a range of services) than is possible for large, commercial hospital companies.

At present, an important sector of care - predominantly primary and preventative - is provided to some sections of the population through community trusts (refer Appendix A.3.7). These trusts may provide, for example, cervical screening services or antenatal services to local communities or ethnic groups, outside the institutional setting of hospitals. In other cases, community trusts have been set up to run small, local hospitals providing basic services (often obstetric or geriatric) to relatively isolated communities, financed in part through the area health boards. For example, the Southland Area Health Board has established two trusts based in "uneconomic" hospitals in Winton and Tuatapere, and contracts with these trusts for the provision of services such as antenatal care, obstetric services and occupational therapy services, while charging a peppercorn rental for their physical assets. On the East Coast of the North Island, the Hikurangi Community Clinics Trust has been established, with the support of the Tairawhiti Area Health Board, to develop a good primary health care service for people living between Tokomaru Bay and Tikitiki.

In this section, we focus on the use of the community trust model in those instances where a commercially-oriented CHE would seek to close down a health care institution that is valued highly by the local community that it serves. This would be the case if. for examole. the payments that an RHA or insurance company were prepared to make for treatment in a local hospital (based on the expected costs of treatment in larger:--city hospitals) were systematically lower than the costs of this treatment. Local people might, however, be prepared to bear at least some of the cost of keeping the hospital open, and government, for political reasons, might wish to subsidise such efforts.

3.4.2.1 Key Elements of the Community Trust Model

Under the community trust model, hospitals (Or other health care institutions) would be operated on a not-for-profit basis, with hospital management accountable to a board of trustees representing the local community. Like CHEs, they would be eligible for RHA

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funding and payments for treatment by private sector insurance companies; alternatively, they might provide services under contract to CHEs. These direct payments for service could be supplemented by donations (as in the case of other not-for-profit organisations), the use of volunteer labour, nominal direct charges to users, and/or direct government subsidies.

Incentives for the efficient operation of community trust hospitals would be just as important as in larger, city hospitals. However, the sources of these incentives would be rather different. In particular, community trust hospitals (if genuinely in areas where commercial operation would be non-economic) would not be exposed to direct competition with other health care providers. (Local patients would have the option of travelling to city hospitals, but at some cost in terms of time, and with a loss of amenities associated with care close to home.)

In addition, as discussed in Section 3.2.1, the not-for-profit model generally leaves more room for managerial discretion (and consumption of surpluses) than the for-profit model. This may be overcome for small community hospitals by close monitoring by the local community; monitoring will also be assisted to the extent that the range of services offered is relatively small. Community trusts would also have the option of employing a hospital management company (or similar organisation) to manage a hospital on their behalf, so that the community "problem" becomes one of monitoring the management company with specialist knowledge of health care, rather than attempting to monitor the efficiency of-the delivery of health care directly.41

3.4.2.2 Principles for Establishment of Community Trusts

In Section 6.0 we stress the importance of allowing health care providers in New Zealand to develop creative and diverse solutions to health care problems. This will be facilitated by giving providers considerable flexibility to tailor their organisational and structural arrangements to the specific circumstances they face. In this context, community trusts-should be seen as part of a menu of organisational arrangements which include private sector provision, joint ventures and not-for-profit providers - rather than as having any special status.

The initial issue to be dealt with in establishing community trusts would be to define which facilities would be suited by this model, and where decisions of this kind should be made.

41 As noted in Appendix B, for example, some US hospital management companies, such as Community Health and Healthtrust, have specialised in the management of small hospitals in rural communities.

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providers. The SOE model makes this explicit; where the government requires an SOE to perform a social service function, it must contract for, and reimburse, this function separately, rather than incorporating it in the SOFs statement of corporate intent.

If government is concerned about the access to hospitals in isolated communities, one option would be to provide direct income support, or subsidise private health insurance, for members of these communities. If its concern is, more specifically, to keep local hospitals open, it could do so within a commercial framework by contracting explicitly with CHEs, community trusts, or other providers to maintain and manage specified local hospitals, at some agreed level of service.

The case for contracting with CHEs to maintain "uneconomic" hospitals rather than converting them to community trusts will depend in part on the costs of defining and enforcing contracts that yield the quality and level of service required. It will also depend on the flexibility of the CHE structure as a means of providing at least some categories of service to local communities. If the community trust model affords, for at least some forms of care and some kinds of institution, a degree of flexibility that enables community trusts to outperform CHEs in meeting the needs of particular communities, the benefits of this flexibility may exceed any costs of reduced managerial efficiencies. (Comparable arguments may be made for the provision of primary and preventative care to some social groups, even in major metropolitan areas.) Decisions about contracting with CHEs for these services as against the establishment of community trusts will be influenced by how RHAs choose to fund core health care services, including their preferences about the geographic location of services, and their willingness (and ability) to represent patients time and locational costs in their contracts with CHEs.

Therefore, given contestability in the process by which assets are divested to community trusts, and clear managerial accountability within trusts, there are likely to be areas - both geographical and in terms of categories of care - for which the community trust model should be considered.

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Given the incentive advantages of an explicitly commercial orientation, as provided for in the SOE model, there will be a concern to ensure that a commercial focus applies as widely as possible - that hospitals are not categorised as community trusts which could feasibly be operated under the SOE framework. This will be all the more important if the costs of shifting a hospital back from the community trust model to the SOE model exceed the costs of moving in the opposite direction - as is likely once not-for-profit status has been granted, and local interests in hospital supervision have become entrenched. Information about the commercial viability of at least some local hospitals will presumably not become clear until some way through the restructuring process, and will be influenced by the geographic dimension of core health services. In particular, some hospitals that appear uneconomic at the outset may prove, under revised management arrangements, to be commercially viable.

This would suggest that the decision about which hospitals would be better run as community trusts should be left to the transition boards of CHEs to decide. Here there would be a need to guard against incentives on the part of CHEs to declare uneconomic hospitals that, while commercially unexciting, remain viable, knowing that the gap will be filled by government or local community subsidy, rather then by entry by a commercial competitor.

One way of reducing this risk would be to require the proposed specialist CHE monitoring agency to screen all decisions involving divestments above a specified size to community trusts. Another would be to require all such asset transfers to be implemented by means of a competitive bidding process, for example allowing other CHEs or private sector health care companies to bid for the assets alongside local community groups.

In deciding whether a local hospital with poor commercial prospects should be converted into a community trust, local interests (at least in part reflected in an ability to pay) should also be taken into account. Faced with at least a share of the costs of keeping such a hospital open, loc1 community members may decide that they would rather see it close (or be replaced by more basic clinic facilities), and travel further for medical care. Establishing, and providing a degree of government subsidy to, community trust hospitals in such circumstances would clearly represent a waste of resources.

Another set of issues surrounds the constitution and transfer of assets to community trusts, including the valuation of these hospitals, their financial structure, and the mode of asset transfer.

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In general, commercially-orientated CHEs should only transfer assets to community trusts if this is expected to improve the CHEs commercial performance. This might occur if a community trust has lower operating costs or provides a form of service delivery that is preferred to CHE delivery by the RHA and the community trust wishes to lease or purchase CHE assets. CHE assets should not, however, be leased or sold to community trusts at prices below those which would be paid by third parties or commensurate with the-returns the CHE would achieve if it retained the assets for its own use.

Applying the community trust model would require resolution of the question of where ownership of the facilities involved should rest. In recommending the SOE framework for CHEs, we have taken as given the Governments indication that it wishes to retain the existing public hospitals in state ownership. The community trust model would involve a transfer of assets to the local level; accountability for the use of these assets would therefore also presumably reside at the local level (whereas CHE managers would remain accountable to the Crown). This may in itself create considerable incentive problems, if community trust hospitals operate in expectation of government bail-outs, or if trust members do not have a significant personal stake in the financial viability of the institutions they control.

3.4.2.3 Community Trusts vs. Direct Subsidisation •1

The argument for community trusts is based, in part, on concerns that, should health care provision be conducted on an unambiguously commercial basis, smaller communities would lose valued access to local hospitals. As indicated above, this begs important questions about the true valuation placed by local communities on these services (are they valued only at their present direct cost, or would they be chosen even if local community members had to meet their full costs?). It also assumes that, should local hospitals pass this test (or if the government should decide, as a matter of policy, that it wishes to keep certain hospitals open to some extent regardless of cost), the creation of a special ownership model would be the best way of assuring their continued existence. However, as noted above, there may be considerable incentive problems associated with this model. In this section, we canvass some alternatives.

Generally speaking, economic analysis suggests that concerns about access by certain groups in society to valued goods and services, such as health care, are most efficiently met by means of direct income support, rather than the subsidised provision of services. Thus, for example, the present set of health care reforms is based on an assumption that equity concerns are better met by means of funding mechanisms than through mixing the objectives of health care

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SECTION 4.0: -CRITERIA AND PRINCIPLES FOR RECONFIGURATION

4.1 Introduction

The overview of New Zealands current health care system provided in Appendix A highlights the central role of government and bureaucratic decision-making in shaping the configuration and composition of New Zealands publicly-owned provider assets and services. Central government has had a pervasive influence on the services provided, the organisational arrangements adopted, the way and extent to which services are bundled, the technologies and assets used to produce outputs, and on the culture and attitudes prevailing among service providers.

A principal thrust of the Governments reform proposals as they affect the provision of • health care is to move away from a centrally-driven system and for health services to be organised and structured in response to the preferences expressed by consumers and - intermediaries acting on their behalf. In the first report we prepared for the NJPB, we characterised the management of this reform as requiring a process that enables the least-cost transition from the current configuration to the configuration most appropriate for the future market demand for health care services.42

In this section of the report we discuss the criteria and principles that should guide the restructuring of New Zealands public provider assets and the establishment of an initial configuration of assets and organisations.

Section 4.2 discusses and explains the concept of economic efficiency, which has been adopted by the NIPB as the principal criterion for the provider reform. Section 4.3 discusses the competition issues of relevance to determining both the initial configuration of publicly- owned health provider assets and the subsequent process for governing the ongoing restructuring of those assets. This includes a review of the international literature on the impact of competition on health care provision, and the US experience with health care antitrust. In Section 4.4 we discuss the need for several changes to the Commerce Act in light of the Governments health reform proposals. The principal competition issues relating to

42 CS First Boston NZ Limited (1991), Identification of Tasks and Priorities for the National Interim Provider Board, paper prepared for the National Interim Provider Board. ¼

-71- (S 1IRsT BOSTON the New Zealand health care market, including the scope for competition in each of the broad service areas- in which CHEs will participate, are discussed in Section 4.5. Section 4.6 reviews the management and restructuring issues that affect the preferred initial configuration of government-owned health care assets. These issues include the nature and extent of any economies of scale and scope, the financial viability of alternative provider units, community of interest considerations, managerial resource constraints, and process issues. Our conclusions are presented in Section 4.7.

There are a number of interdependencies linking the preferred initial configuration of government-owned health care assets and the most efficient process for governing their subsequent reorganisation. A preliminary discussion of these linkages is provided in Section 4.6.5. The preferred process for managing the ongoing reform of government-owned health care units is considered in detail in Section 6.0.

4.2 Criterion

The NIPB has adopted economic efficiency as the principal criterion for guiding the restructuring of health care provision. This reflects the fact that the most effective means of achieving the Governments fairness objectives for health services will be through the funding of health care. The Government has stated that health care should be financed so as to ensure all New Zealanders have affordable access to core health services and to provide greatest assistance to those least able to provide for themselves. (The Governments funding proposals are also intended to strengthen incentives for controlling health care costs and to enhance the responsiveness of providers to consumer preferences.)

As a criterion for assessing alternative structural, organisational and regulatory arrangements efficiency addresses three general concerns:

that resources should be used in a way which is technically and managerially efficient, so that the goods and services produced are produced at least cost. This means that the total amount of goods and services that can be produced from available resources will be maximised. Economists refer to this as productive efficiency;

. I

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that the mix of goods and services that is produced takes proper account of what consumers want, so that they are made as well off as possible. This condition will be met if, within the society as a whole, productive resources are apportioned to the production of goods and services that yield the highest value to consumers. Under idealised (but seldom achievable) conditions of consumer choice, this will be satisfied if the price of each good or service is set at the incremental, or marginal cost of producing it. This is referred to by economists as allocative efficiency; and

that resources should be used in a way that makes sense over time - that resource use takes account of differences in preferences about consumption between the present and the future, for example; and that resource use responds in a cost-effective way to changes in demand and technology over time. This is referred to by economists as dynamic efficiency.

Allocative efficiency in the health sector requires an optimal allocation of resources between:

activities that contribute to health and other resource uses;

medical care resources and other factors that contribute to health, such as lifestyle and the environment; and

various medical inputs, such as surgical care, primary care and pharmaceuticals.

Allocative efficiency in the use of health care resources applies to the prevention as well as treatment of illness and recognises suffering and inconvenience of patients as real social costs, along with more conventional resource costs such as labour and capital. Reductions in health care spending do not necessarily imply an improvement in efficiency.

Allocative efficiency is concerned, therefore, with whether the allocation of resources reflects consumers preferences. In most markets, purchasing decisions reveal consumers underlying preferences to suppliers and, subject to the existence of appropriate regulatory and taxation arrangements, provide the mechanism for achieving allocatively efficient outcomes. In the health care model proposed by the Government, however, the definition of core health services and the purchasing of these services will initially be the responsibility of politicians and government agencies. Consumers preferences regarding a myriad of quantitative, qualitative, service and delivery issues will, therefore, be subject to a series of political and bureaucratic filters and distortions.

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The Government has said that once RHAs and CHEs are established, people will be able to use their annual entitlement to government funding to purchase a health-care plan from a private sector intermediary. This option will provide individuals with a more direct means of expressing their preferences and should provide scope for improving allocative efficiency.

In most sectors of the economy, policy changes that strengthen productive and dynamic efficiency tend to enhance allocative efficiency, and vice versa. For example, the dismantling of legislative barriers protecting companies from competition not only tends to force them to align their prices more closely with costs (thereby improving allocative efficiency), but also encourages managers to review cost structures (productive efficiency) and the quality of long-term investment decisions (dynamic efficiency). However, the impact of greater competitive pressures in health care markets depends on the quality of the incentives facing the government agencies and insurance entities that purchase (generally the majority) of health core services on behalf of individuals.

Unless RHAs and private issuers have incentives to control costs and purchase the mix of services and price/quality tradeoffs preferred by consumers, more intensive competition by providers can affect service patterns and costs inways which do not reflect consumer preferences. For example, as the discussion in Appendix B of the US experience illustrates, competition may manifest itself in over servicing and cost inflation rather than efficiency gains. Thus, in health care markets, careful attention must be given to me incentives or intermediaries and to their relationship with providers when assessing the impact of competition on efficiency.

Because the essence of the NIPBs mandate is to design a least cost transition path, the NIPB must give critical attention to dynamic efficiency issues. In particular, the total costs of tile restructuring process will be very dependent on the extent to which health care managers are provided with robust incentives to:

appropriately balance the need to write-off redundant assets and organisational arrangements and adopt new, innovative arrangements against the need to preserve assets, skills and teams that will be valuable in the future; and I

accurately evaluate the uncertainties surrounding the future pattern of demand and to adopt investment and organisational strategies that recognise these uncertainties.

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The concepts of allocative, productive and dynamic efficiency sketched here are developed and applied in the remainder of this section.

4.3 Competition Issues

Although the Governments health reforms are designed to establish competitive provision, competition is not valuable as an end in itself but as a means of promoting economic efficiency and consumer welfare. However, even in this context, the?e are different views regarding the meaning of competition and the standards and tests that should be applied to ensure efficient outcomes. -

While we have attempted to present the analysis in this report in an applied manner and avoid unnecessary references to economic jargon and technique, we believe that it is important that the NIPB has a general awareness of the different views economists hold regarding "competition". The differences between these views potentially have major implications for the NIPBs advice to the Government regarding the initial configuration of government- owned health care assets and, in particular, the preferred degree of fragmentation of those assets.

Broadly speaking, there are two strands of economic literature concerning competition. The first of these dates back to Adam Smith, who in 1776 observed that people separately pursuing their own interests can frequently achieve wider objectives in an orderly and efficient way at the same time. Smith, cautioning against the demands of monopoly producers, remarked that the "sole end and purpose of production is consumption". For him, service of the consumer was paramount. Smiths view of competition as a process by which individual action could promote efficient outcomes has been developed this century by, in particular, Hayek and Schumpeter, who focused on competition as a process of discovering consumer preferences and developing innovative means of organisation and products for meeting those preferences. According to Hayek, competition is a discovery procedure which, by enabling all who can support themselves to back their own judgement, has facilitated the spirit of innovation on which prosperity rests. In this view the existence of, or potential for, monopoly or super profits provides the inducement for entrepreneurs to reallocate resources and engage in innovative activity.

This approach has been summarised as follows:

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"In its most fundamental sense, competition is ubiquitous to all economic systems. All forms of striving to enhance ones situation are competition. Indeed, there is competition wherever there is self-interest and scarcity. In this broad sense, neither government nor business policies affect the presence of competition, for neither self-interest nor scarcity is eliminated. The forms that competition take are, however, innumerable. The laws and rules of business conduct cannot increase or decrease competition, but they can and do alter the forms in which competition occurs."43 -

From this perspective, it is not meaningful to talk of the notion of "introducing competition" or "a competitive market" because competition between individuals for scarce resources is inevitable and ever present. The way in which competition manifests itself will differ according to the constraints imposed. Some constraints and systems of property rights will result in inferior outcomes to others. The role of government in this view is to establish the set of constraints that will enable individuals to pursue their own goals to the advantage of all. The most fundamental pre-condition for this is the system of property rights, including economic regulations, which best direct the actions of individuals towards enhancing the wider community interest.

The second broad strand of economic literature is based on the model of perfect competition. This assumes that many suppliers of an homogenous product exist in a market, each of whom is unable to affect the price at which output is sold, i.e. they are "price-takers". A firm would find no buyers if it charged above the market price (where price is equal to marginal cost) and would gain all its competitors business if it priced below the market. In text book economic analysis, the perfect competition model provides the benchmark against which the costs of monopoly or market power are assessed. A firm with market power has the ability to raise prices above marginal cost. As a result, some consumers are unable to purchase the goods or services that the company produces despite being willing to pay the incremental price of production, and as a result are obliged to purchase substitute products that are more costly to produce, or less suited to their needs. The (theoretical) reduction in consumer welfare arising from this situation is said to involve a loss of allocative efficiency.

However, the perfect competition model abstracts from many important practical constraints. It ignores information, contracting and organisational costs and it assumes homogenous products are purchased. In reality, products are differentiated, taxes ensure that prices

43 Leffler, K. (1985), "Towards a Reasonable Rule of Reason; Comments", Journal of Law and Economics, 28, pp 38-386. -

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generally do not equal marginal cost, and the political and regulatory environment provide important constraints on economic activity. While the simple competition model provides a useful device for explaining how prices affect the use of resources, it cannot explain the variety of competitive strategies that are adopted in the real world. It provides no explanation for the existence of firms or of complex contracting arrangements.

In contrast, the view of competition as a discovery procedure (rather than a particular market structure) is ideally suited to analysing and understanding the way the complex and messy details of reality drive the strategies and arrangements adopted by economic agents.

Modern competition and antitrust theory attempts to meld the rigour and theoretical elegance of the perfect competition model with the complexity and realism of the view that competition is a discovery procedure. In terms of the efficiency concepts outlined in Section 4.2 above, this (attempted) synthesis is achieved by balancing the productive efficiency advantages of arrangements that violate the model of perfect competition (e.g. joint ventures, franchising, efficient firms with "high" market shares) against the potential allocative efficiency costs of market power (e.g. resulting from a successful brand name or from reducing the number of direct competitors in the market place).

The marriage of these two views of competition is, however, an uneasy one; the theoretical underpinnings of each approach are dramatically different, and arguably incompatible, 44 as are the policy concerns and indicators of policy difficulties thrown up by each approach. This tension is reflected in recent criticisms of traditional competition policy (antitrust) and its theoretical basis. One such criticism is provided by two writers who recently argued that:

"we believe (1) that stimulating rivalry ought to be an important policy goal, (2) that the form of competition the antitrust laws should embrace is Schumpeterian dynamic competition, (3) that current antitrust is not designed to achieve this, (4) that the best guarantor of dynamic competition is a system that is open to international trade and has policies which facilitate innovation, and (5) that internal organisation and intercorporate links, and not government intervention, is important for successful innovation and commercialisation. Accordingly, we are uncomfortable with an approach to antitrust which measures market power from a static perspective and is inhospitable to a great deal of cooperative behaviour among competitors. If economic welfare is the goal of antitrust, then the promotion

44 See Ellig. J . (1991), "Untwisting the Strands of Chicago, Antitrust, Working Paper, Centre for the Study of Market Processes, Department of Economics, George Mason University.

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of innovation may henceforth need to take precedence over standard antitrust concerns."

We share these misgivings regarding conventional competition policy. We believe, however, that the tools developed for conventional competition policy do provide a useful adjunct to the analysis which flows from the view of competition as a discovery procedure. The NIPB should also be aware that the conventional antitrust literature represents a large and relatively settled body of scholarship.

Our approach to assessing competition in this paper involves use of conventional economic tools for assessing market power but pays special attention to the dynamic aspects of New Zealands health care markets. This reflects both our general scepticism regarding conventional antitrust analysis and the extreme importance of dynamic considerations in New Zealands health care markets at the present time. There are (at least) two aspects of this dynamism. First, health care technology and organisation is experiencing a process of rapid change internationally. As discussed in Appendix B, the last decade in the US, for example, has seen significant changes in the use of inpatient and outpatient care, and in the incidence and structure of more or less formal chains and contractural networks. Second, as mentioned above, the structure and organisation of New Zealands publicly owned health care assets is the product of a centrally-driven health care system. The establishment of a competitive health care market in New Zealand will result in a transition to a far less institutionalised, more decentralised and much more diverse industry.

However there is considerable uncertainty regarding the manner and speed in which the process of decentralisation and greater diversification will unfold as New Zealand moves towards a competitive provider market. This uncertainty means that it is extremely difficult to accurately anticipate either the nature of the provider responses that will emerge in the health care market or the competitive constraints that will apply to publicly-owned health providers.

Experience with the deregulation and corporatisation of other industries in New Zealand illustrates how easy it is to underestimate the competitive response when hide-bound centrally-driven government businesses are exposed to open competition. Health care services involve low capital intensity and considerable scope for competitive entry in comparison with some industries, such as telecommunications, where New Zealand has witnessed dram.tic

45 Jorde, T. M. and Teece, D. J. (1991), "Antitrust Policy and Innovation: Taking Account of Performance Competition and Competitor Cooperation", Journal of Institutional and Theoretical Economics, 147, p 119.

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competitive responses. The scope for competition in health care services in New Zealand is further enhanced by the pace of technological change and the likely cost pressures for decentralisation and supplier fragmentation in the New Zealand market. - - - This general background leads us to believe that competition concerns regarding the health care market will be best met by establishing purchaser and provider arrangements and designing a regulatory environment that provides neutral treatment to all actual and potential purchasers, that avoids unwarranted impediments to new entrants and that provides robust incentives for high levels of commercial performance by provider units. In general, we believe these factors will have a far greater impact on the success of the reforms than will the initial configuration of government-owned provider assets.

As background to the applied analysis in this section, Appendix C outlines the concepts and tools that are conventionally used to assess market power and potential allocative efficiency losses. This includes a discussion of the analytical constructs of market definition, market concentration and entry barriers.

4.3.1 International Experience with Health Care Competition and Antitrust

Appendix B highlights a number of serious structural and regulatory difficulties in the US health care industry stemming both from past regulatory interventions and from ongoing differential treatment of for-profits and not-for-profits, direct regulation, intervention in insurance marketing and inconsistencies in direct Medicare and Medicaid funding. competitive health Notwithstanding these difficulties, however, the US experience with . provision is generally regarded as being more extensive than in any other country, arid, in any event, is certainly the most comprehensively studied. While health care services in numerous other countries involve significant competitive elements, there are very few empirical studies concerning these countries published in the academic literature.46For these reasons, the literature and case law summarised below focuses on the US experience.

46 One recent review of hospital competition studies noted that our literature trawl has found no satisfactory empirical work elsewhere [i.e. outside of the US1" (Culyer, A.J. and Iosnett, J (IYYO), "Hospital Behaviour and Competition", p 12 in: Culyer A.J., Maynard, A.K. and Posnett, J.W. (eds) (1990), Corn petit ion in Health Care Markets: Reforming the MIS, London, MacMillan).

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4.3.1.1 Empirical Evidence on Coin petilfilion in the US Health Sector

This section briefly reviews the empiial evidence regarding the impact of competition (measured on the basis of various structral indicators) on health care providers in the US. A more detailed summary of the relevant lElerature is provided in Appendix D.

The primary conclusion regarding competition within the US health sector is that the impact of alternative structural configurations at the provider level is heavily contingent on the regulatory environment and the nature of the contractural and organisational relationship between funders and providers. As: the provision and funding of health services in New Zealand is significantly different frcrni that in the US, US results need to be evaluated carefully before they can be used presaiptively within the New Zealand context.

The US experience nevertheless highligkts that the quality of the contracts between RHAs and CHEs in New Zealand will be a crucial determinant of the nature and extent of the efficiency gains from the Governments health reform proposals.

The US literature is concerned principally with productive efficiency, and, in particular,

hospital costs. One form of competition is more productively efficient than another if it can 1 provide output of equivalent quality at lower cost. While simple in concept, productive efficiency is difficult to measure as hospital output has significant qualitative elements. In order to isolate the effects of competition on the operation of health care providers it is necessary to control for all other factors that might be responsible for inter-hospital cost variation. These factors include the qualitative aspects of the clinical services and amenities provided, case mix and location (urban hospitals may face higher rentals and wages for example). Although increasingly sophisticated methodologies have been employed to control for these factors, these have been unable to control all (non-competition) systematic cost factors.

The principal results from the studies of competition in the US are summarised below.

4.3.1.2 Retrospective Repayment Systems

The majority of early studies relate to the pre-1983 period when providers that were subject to retrospective payment systems and low copayments for patients. With full retrospective cost adjustment, hospitals tended to compete for physicians /patients across non-price dimensions such as quality of care and amenities. Most studies found that the more

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competitive the hospital market (in structural terms), the greater the devotion of resource to non-price competition. Hospitals in more competitive markets were found to duplicate clinical services, have higher spare bed capacity and higher prices, and also offer higher quality. Recent survey articles have concluded that the benefits of competitively induced non-price expenditure tended to be smaller than the costs of its provision.

4.3.13 Prospective Payment Systems ("PPS)

Many of the more recent empirical studies have examined the comparative static effects of the change in funding from retrospective to prospective payment. The rate of increase in costs per case has been observed to fall in hospitals since the introduction of PPS, particularly for those hospitals which depend most heavily on Medicare revenues and operate in competitive markets. This is not surprising, given that competitive hospitals were uniformly found to be the most expensive (and some contributors suggest inefficient) under retrospective reimbursement. The net effect on health sector efficiency of implementing PPS funding is difficult to establish, however, in part because of the associated reallocation of patients to outpatient care - the concomitant increase in outpatient expenditures may have offset L inpatient savings.

4.3.1.4 Selective Discounting

Selective discounting involves insurers/funders negotiating discounts with providers in return for preferential access to the funders customers. Selective discounting has been initiated by a wide range of third-party funders, including self-funded employee insurance programmes, commercial health insurers, government medical insurance schemes, Blue Cross, HMOs and PPOs. Although differences exist in the structure and operation of these organisations, it has been hypothesised that as a generic group they should stimulate more intensive price competition. Under selective contracting in California, the rate of cost increases was lower among hospitals facing a high degree of competition than for their counterparts in less competitive areas. There is mixed evidence, however, regarding the ability of HMOs to stimulate price competition.

4.3.2 US Antitrust Experience

US antitrust experience in the health industry began in earnest in 1939 when President Roosevelts Antitrust Division convicted the AMA for criminal viulation of US antitrust laws. However, the initial flurry of activity was short-lived; a Supreme Court dismissal in

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1952 meant that from 1952 to 1975 there were no cases involving health care financing and only one case involving hospital and medical services brought by either state or federal antitrust authorities.47

The modern era of health care antitrust enforcement began in 1975 when the Ohio Attorney General filed an antitrust case challenging the Ohio State Medical Associations 30 year ownership and control of Ohios largest Blue Shield plan.48 Since then there has been a proliferation of health care antitrust cases. These have covered the full spectrum of antitrust issues including price fixing, group boycotts, exclusive dealing, essential facilities, joint ventures, tying arrangements, predatory pricing, refusals to deal and mergers and takeovers.

It is beyond the scope of this paper to provide a review or even broad summary of this case law. There is, however, one area which we believe is of critical importance to the principal task of the NIPB, and another which provides some useful insights to the task of identifying possible market power problems in New Zealand health care services. The first of these is the important role antitrust appears to have played in facilitating the development of more efficient contractual arrangements between purchasers and providers and the creation of innovative provider arrangements and, in particular, in controlling the market power of the medical profession. The second area of interest relates to the market definition principles M and techniques that have been adopted in health care merger and takeover and monopolisation cases. These two areas of US antitrust case law are briefly reviewed below.

4.3.2.1 Antitrust and Innovation in [IS Health Care Markets

As discussed in Appendix B above, the cost escalation and absence of cost competition which characterised •US health care markets through until the early 1980s spawned a series of innovations in purchaser /provider contracts, including in particular, prospective payment systems and preferred purchaser arra-ngements. Several commentators have argued that antitrust law played a pivotal role in facilitating these new arrangements.

It has been suggested that the growth of innovative health insurance schemes was initially retarded by boycott threats by physician groups. By excluding doctors practising in HMOs and PPOs from membership of medical societies, it appears that groups of local doctors were

47 Gee, E. M. and Proger, P. A. (eds.) (1990), Managed Care and Antitrust: The PPO Experience, American Bar Association, p4. 48 ibid. p 4.

-82- S FIRSt IOSI()N able to impede the development of these organisational forms. Physicians and medical societies also boycotted insurers who used new cost containment measures.49

A series of land mark antitrust actions and decisions have rolled back the efforts of sections of the medical profession to block the adoption and diffusion of new funding and contracting arrangements. For example, the Federal Trade Commission brought down a cease and desist order in 1983 when the Michigan State Medical Society boycotted the local Blue Shield plan.50 Antitrust suits have also been instrumental in preventing PPOs from monopolising the supply of doctors by establishing exclusive dealing arrangements with a large proportion of local doctors.5

In 1975, the Federal Trade Commission challenged the AMAs ethical restrictions regarding contract practice, "free choice", and advertising. 52 In 1982, a landmark Supreme Court decision confirmed that health care practitioners are subject to US antitrust laws and "marked the end of the AMAs contract practice and free choice ethics that had sharply restricted the development of organizations like PPOs with selective contracting arrangements."53

Antitrust review of mergers and takeovers has also been an important aspect of the restructuring. of the US health care industry. In particular, since the mid 1980s, as hospitals have attempted to reorganise in response to greater cost containment pressures, there has been increased interest on the part of antitrust agencies in hospital mergers and joint ventures involving diversification by hospitals into non-traditional areas of business.54

Medical practitioners and other suppliers of labour may in some circumstances have strong incentives to block regulatory, structural or organisational changes that strengthen the cost disciplines facing health care provider organisations and increase the accountability of those organisations to patients and intermediaries. Weak cost pressures increase the scope for organisational slack and the sustainability of poor management practices. Inefficiency and weak management provide greater flexibility for physicians and other groups to negotiate

49 Frech Ill, H.E. and Ginsburg, P.B. (1988), Competition Among Health Insurers Revisited", Journal of Health Politics, Policy and Law, 13, pp 279-291; and Schut, F. 1, Greenberg, W. and Van de yen, W.P.M.M. (1990), Antitrust Policy in the Dutch Health Care System: Relevance of EEC Competition Policy and..US Antitrust Practice, Working Paper. 50 Frech Ill and Ginsburg, op. cit., p 288. 51 ilul, p 288. 52 Ge and lroger, op. cit., p 5. 53 ibid. p 5. Section of Antitrust Law, American Bar Association (1990), Developments in Antitrust Health Care Law, American Bar Association.

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financial remuneration and nonpecuniary benefits which surpass those obtainable in a more competitive environment.

4.3.2.2 Market Definition in US Antitrust Cases

The US Courts have argued that a "properly defined [health care] product market should encompass all products - both items that are presently available and potential entrants - that have a significant positive cross elasticity of demand - [i.e.], all products that consumers perceive as reasonable substitutes for each other."55 In applying these principles, the US courts have recognised that hospitals do not provide homogenous units of output but instead provide a range of services with the market share of individual hospitals varying between services. The courts have also recognised the interdependencies between services. In particular, the "courts have recognised as a coherent market the unique cluster of services provided by acute medical services" 6 while specialised organisations supply many of the services provided by hospitals these cannot substitute for the co-ordinated acute care provided by acute care hospitals.57 The Federal Trade Commission (one of the two principal antitrust enforcement agencies in the US) has, however, recognised that "free-standing - outpatient facilities compete with hospitals for many outpatients."58

The US Courts have also recognised specialist product markets involving limited or no substitutes. These include "adult open heart surgery" and "psychotherapy" (which was defined to include the services of psychologists and psychiatrists).59

The question of geographic market definition has been a contentious one in US antitrust cases and in the competition law literature. The geographic boundaries adopted have varied significantly depending on the nature of the service and between cases. In the leading US case the geographic hospital market was defined at the "Chattanooga urban area" on the basis of patient flow statistics and physician privilege statistics. Other cases have placed greater weight on the anticipated response of patients to hypothetical price increases or quality differences.60 The courts have been divided on whether the geographic market is influenced by geOpolitical designations. 61 Thus, while the courts seem to have agreed that the

55 Stromberg, C.D. (1990), "Health Care Provider Network Antitrust Issues and Practical Suggestions", p 96, in: Gee and Proger, op. cit.. 56 ibid. p 98. 57 Blumenthal, W. (1990), Relevant Markets in the Health Care Industry, p 189, in: Gee and [roger, op. cit.., 58 ibid,plYl. 59 Stromberg, op. cit., p 96. 60 ibid, p 192. 61 ibid,p192.

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geographic market is a "localised" one,62 there is no clearly established basis for applying this concept.63

With regard to the question of market share, opinion letters, policy guidelines and speeches issued by the Federal Trade Commission and other US antitrust agencies, indicate that provider organisations with market shares of 20 percent or less, and possibly as high as 35 percent, are unlikely to invite action by enforcement agencies.64 (It should be noted that the Commerce Commission typically adopts significantly higher market share thresholds for competition concerns than its US counterparts. This arguably reflects, in part, the small size of many New Zealand markets and the market concentration required to achieve reasonable economies of scale.)

4.3.3 Competition Law in New Zealand

The reform proposed by the Government . for New Zealands health care sector is far more fundamental and condensed than the organisational and contractual developments that have occurred in the US over the last 10 to 15 years. To enable the speed of adjustment and scale of restructuring that will be required for the New Zealand reform process to succeed, it will be important to prevent practices and arrangements that will harm the competitive process. The most effective means of achieving this will be to ensure that the funding and regulatory arrangements established avoid unnecessary barriers to entry and provide a competitively neutral environment for alternative providers. Beyond this, we believe it will also be important to ensure that anticompetitive practices within the health sector are subject to New Zealands antitrust legislation, the Commerce Act.

The Commerce Act is based on similar concepts and constructs to the US antitrust legislation. While there are significant weaknesses in the Commerce Act, 65 industry-specific competition rules would, we believe, involve major policy design difficulties and greater risk of industry or professional capture. The Commerce Act is a relatively well-established and understood body of law and the economy-wide responsibilities of the Commerce Commission reduce the

62 ibid. p 193. - 63 There is also little agreement in the academic literature as to the appropriate basis for determining the geographic market. Some academics have suggested that the geographic market be defined by a 15 mile radius around the hospital, others have used the standard metropolitan statistical area and others have rejected both of these approaches, arguing that it is necessary to consider the nature of the relationship between hospitals in an area. See Danuve, D. and Shanley, M. (1989), A Note on the Relational Aspects of Hospital Market Definitions, Journal of Health Economics, 8, pp 473-478. 64 See Stromberg, op. cit., p 100; and Gee and Proger, op. cit.. (l9S8)"Antit rust in New Zealand, The Case for Rcformn. 65 New Zealand Business Roundtable

-85- CS tiitsT BOSTON risk of sectional capture. Further, both the US experience and the existence of highly organised, cohesive professional associations and medical colleges in New Zealand suggest that on a cost:benefit basis the Commerce Act may perform better in the health sector than in many other areas of the economy.

There would, nevertheless, be risks in exposing a competitive health care industry to the Commerce Act. Commerce Commission decisions in all industries are imperfect. The complexity of the competition issues and the importance of non-standard contractural arrangements in providing incentives for efficient provision heighten the risk of poor quality Commerce Commission decisions in the health sector. Ensuring that the Commerce Commission is adequately resourced and forewarned to respond to the new environment will, however, help to reduce these risks.

To establish whether potential areas of competitive concern in New Zealands future health system will be subject to the Commerce Act 1986, CS First Boston engaged Bell Gully Buddle Weir ("Bell Gully") to review this issue. Their report is presented in Appendix E.

The following important conclusions emerge from the Bell Gully report:

if the establishment of CHEs and the transfer of assets and liabilities to them is undertaken pursuant to specific legislation, it will be appropriate to consider whether such legislation should include a provision (such as Section 23 of the State- Owned Enterprise Act 1991) to exclude the potential application of the Commerce Act to such transfers;

In order to ensure that the Commerce Act will apply to CHEs once they are established the following matters require further consideration:

Whether the CHEs should for Commerce Act purposes, be deemed to be separate legal entities. Without such deeming provisions, Bell Gully consider that the restrictive trade practices and business acquisitions provisions of the Commerce Act will not apply where the only parties to the relevant arrangements are CHEs. They suggest, in addition, that it is unlikely that any merger of CHEs could successfully be challenged under the Commerce Act without such deeming provisions;

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• Whether the exemption provisions in the Commerce Act relating to contracts of and for services should be deleted and/or amended so far as they apply to the health care industry;

• Whether there are any practices which should be specifically authorised by legislation so as to exempt the application of the Commerce Act to them.

Bell Gully suggest that legislation be introduced to deem each of the CHEs to be a separate legal entity for Commerce Act purposes. We agree with this suggestion. Bell Gully further advise that the appropriate place for such legislation would be in the legislation governing

CHEs.

There are two exemptions in the Commerce Act relating to contracts for services. The first, Section 440)(c), provides an exemption for any contractural provision by which a person agrees to restrictions as to the work in which that person might engage. Bell Gully note that this exemption would apply if a CHE entered into exclusive dealing or tying arrangements with surgeons or other specialists on a long-term basis. While such arrangements often provide efficiency advantages, and are a feature of many employment contracts, they can also be used to monopolise the supply of a scarce resource (in this case medical specialists). The potential allocative efficiency losses through such monopolisation are the same in nature as the allocative efficiency losses that can result from monopoly behaviour in product markets and, should, in our view be treated in a consistent manner. We therefore recommend that the NIPB make submissions to government seeking the deletion of Section 44(1)(c) from the Commerce Act. Bell Gully suggest that the legislation establishing CHEs be used to negate the application of Section 44(1)(c) to CHEs. While this approach may be acceptable from a legal perspective, from an economic perspective it risks introducing distortions between alternative health care providers (e.g. between CHEs and private providers) and would create a significant inconsistency between health care and other sectors of the economy.

The second exemption provision is Section 44(1)(f). This applies to the remuneration, conditions of employment, hours of work, and working conditions of employees. As noted • above, labour markets raise the same monopoly and allocative efficiency concerns as product markets. Labour market monopolisation involvesthe risk of distortions between alternative types of labour and between labour and other inputs, in principle, labour markets should be subject to the same competition laws as apply in product markets.

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Bell Gully suggest that if CHEs are to be excluded from Section 44(1)(f), detailed analysis should first be undertaken to ascertain whether there may be any labour market practices such as collective bargaining which should remain exempt. We believe that the case on economic grounds for any such exemption is weak and suggest that the NIPB undertake a more detailed assessment of the benefits to the health care sector of repealing Section 440Xc).66

The suggestion of Bell Gully regarding specifically authorised legislation relates to Section 43 of the Commerce Act which provides that none of the restrictive trade practices provisions of the Act apply to matters which are specifically authorised by other enactments. Bell Gully recommend that once the new health care legislation is drafted, it should be carefully scrutinised to ascertain whether it may specifically authorise any practises which should be open -to scrutiny under the Commerce Act or whether in some circumstances specific authorisations might be warranted.

4.4 Competition Considerations in the New Zealand Health Care Market

One of the principal themes running through this report is the importance of thinking of competition in the New Zealand health care system as a dynamic process of reorganisation, restructuring and innovation, rather than as a particular market structure. This perspective focuses attention on the policy and regulatory environment, including funding arrangements, within which providers will operate. In our view, it is these considerations, rather than, for example, whether a particular city has two or three CHEs in July 1993, which will determine the success of the proposed health reforms.

The initial configuration of the government-owned health provider units will nevertheless have a significant.influence on allocative and productive efficiency in the health care sector, particularly over the next few years as private providers gear up to respond to the new environment.

66 Bell Gully refer to the discussion of Section 44(1)(c) in the recent Discussion Document on the Commerce Act prepared by officials from the Ministry of Commerce, the Treasury, the Department of Justice and the Department of Prime Minister and Cabinet. In our view the Discussion Document understates the case for repealing Section 44(1)(c). First, the Discussion Document focuses on the impact of labour practices on product markets and ignores the direct aliocative efficiency costs of monopoly behaviour in labour markets. Secondly, officials note that if collective labour market agreements were subject to the Commerce Act, the parties to those agreements may have to apply to the Commerce Commission for the authorisation of agreements that have anti-competitive effects. However, this would place labour market agreements on the same footing as product market agreements and would be a desirable outcome for labour market arrangements that reduce allocative efficiency.

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In this section we attempt to identify the services that will be provided by government- owned health care providers and to delineate the markets within which those entities will operate. We emphasise at the outset, however, that by its very nature this exercise is fraught with uncertainty and prone to spurious accuracy. The exposure ot New Lealancis centrally-driven public health providers to market incentives for the first time and the highly-dynamic nature of health care technology and organisational arrangements internationally together mean that it is impossible to anticipate the future shape of New Zealands health care industry, other than in the broadest of terms. There is, therefore, a high degree of uncertainty surrounding both the way government-owned health providers will organise themselves and bundle their services in the future and the nature and extent of the competitive constraints those organisations will face from actual and potential competitors.

4.4.1 Identification of Relevant Markets

The health care services of principal concern to the NIPB are those which RHAs will be obliged to offer their clients, i.e. the "core health services". The Government has appointed a National Advisory Committee on Core Health Services to engage in a process of public consultation and provide advice on the composition of the core health services. At the current time, however, no decisions have been made on this issue. For the purpose of identifying the markets within which government-owned health care organisations will operate we have assumed that the core health services will be broadly coincident with the current services provided by area health boards pursuant to their provider contracts with government and current government funding of visits to doctors and for prescriptions.

The services provided by area health boards and the facilities these involve are briefly described in Appendix A.3.4 and A.3.5. In the following discussion we attempt to categorise those services into distinguishable product and geographic markets.

4.4.1.1 Acute Services

- The major infrastructural assets in the public health system are the urban public hospitals. From a competition perspective, the key distinguishing feature of these hospitals , is their - ability to provide trauma/acute and accident and emergency facilites with full 24 hour a day intensive care back up. The group of support services and facilities required to provide 24 hour acute care inpatient services gives rise to the concept of a cluster of acute care services

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which was mentioned in the discussion of US antitrust cases above. As we understand it, the relevant cluster includes critical care, general medical, surgical, nursing, anaesthesia, laboratory, radiology, pharmacy, blood and dietary services and the physical infrastructure and equipment required to support those services. In order to provide acute services to road accident or heart attack victims, for example, a provider must be able to deliver this cluster of services either on a stand alone basis or in conjunction with other specialist providers located on the same medical campus or (in the case of laboratory services, for example) in close proximity.

From a competition perspective there are two key aspects to 24 hour acute care services. The first of these is the requisite physical infrastructure and specialised equipment. In New Zealand, as discussed further below, virtually all of this specialised equipment is available in non-acute private hospitals which currently focus on elective procedures (although generally on a less-than-comprehensive basis). Further the capital costs of establishing acute care facilities are not especially high relative to potential revenues, for hospitals that already have adequate bed facilities. 67 The second aspect is the organisational and human resource capability required to deal at any time with medical emergencies potentially requiring the services of a range of medical and surgical specialties. A multiple car accident on a Sunday evening or large-scale train accident illustrate the potential demands. The provision of acute services therefore involves spare bed and equipment capacity and immediate or short-term access to a range of specialised human resources required to deal with a number of possible contingencies.

The question of whether a non-acute hospital offering a broad range of elective services, including intensive care services in conjunction with, say, open heart surgery, should be considered to be in the same market as a near-by hospital which offers 24 hour acute care, depends on whether the elective care hospital could enter the acute services market in - response to a small but significant and non-transitory increase in the price or reduction in the quality of acute services. The principal requirements for expansion into acute services would be:

• the scale of operations required to justify the 24 hour medical and support staff requirements and the extra organisational and capacity costs necessary to meet the range of contingencies associated with the provision of acute services; and

67 At our request, a major private sector provider prepared an indicative costing for a ten bed intensive care unit. This generated a total cost estimate of slighly less than Si million.

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access to sufficient surgical and other medical specialists to service a 24 hour contingency service.

1 The econometric evidence and conventional wisdom reported in Appendices B and F suggest that the economies of scale for acute care hospitals in the US are generally limited to small scale hospitals (those with less than 100 to 150 beds). Broadly speaking, larger hospitals appear to exhibit constant returns to scale. There is no evidence to suggest, therefore, that in New Zealands major metropolitan centres the market would be too small to support a new privately-owned acute care hospital. Nevertheless, obtaining the requisite scale would be a major organisational challenge and, depending on the contractual arrangements agreed with major purchasers, might involve considerable financial risks.

Discussions with senior health care managers from four separate area health boards indicate S that at three surgeons, three anaesthetists and two general physicians in association with other staff are required to support a 24 hour acute care service. The managers spoken to all agreed that the minimum population required to fully utilise this level of service would be in the 40,000 to 50,000 range.68 The managers also referred to Taumaranui which established an acute care service with a good medical staff even though it draws on a somewhat smaller population base. However, in order to adequately utilise the hospitals medical resources, the hospital has to attract approximately half of its elective surgery patients from outside the region.

The availability of medical specialists and the regulatory arrangements governing specialists are discussed in Section 5.2.5 below. For some services, New Zealands small population will limit the scope for competition within the country. For example, there are only four neurosurgeons in Auckland, three in Wellington and two in Christchurch. However, in such circumstances any lack of immediate competition will reflect the size of the market rather than the availability of specialists per se. Further, as noted in Section 4.4.1.2 below, the market for some highly specialised services is an Australasian or international one. Although the regulatory environment places some constraints on the availability of specialists, our initial assessment is that these constraints should not impose a major barrier to competition from new health care organisations.

The recent review of surgical services in Waitaki, Clutha and Central Otago concluded that a population of 30,000 persons is necessary to support a viable two surgeon general surgery service"; (Committee to Review Surgical Services in the Waitaki, Clutha and Central Otago Districts of the Otago Area Health Board (1991), Report of the Con,mittcc to Review Surgical Services in the Waitaki, Clutha and Central Otago Districts of the Otago Area Health Board).

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On balance, we believe that there is a significant degree of uncertainty as to whether a hospital providing.a wide range of elective surgical procedures would expand into acute services in response to a small but significant and non-transitory increase in the price or reduction in the quality of acute services. The likely response would depend on a range of factors including the size of the local market, the strategy of the RHA and the perceived political risks surrounding the reform process. In light of these uncertainties we have, for working purposes, decided to recognise a separate product market for 24 hour inpatient acute services.

The provision of acute services by government-owned entities will, however, be subject to some threat of market entry by a range of organisations that do not currently provide acute services. The nature and extent of this threat is discussed further in Section 45.2.1 below.

The geographic market for acute service is a localised one reflecting the emergency nature of the service being provided. Even though patients may be transported long distances from remote areas for some acute treatment (for example, by helicopter),69 distant hospitals do not impose a significant competitive constraint on local hospitals in the case of acute services. This view is consistent with the various US commentaries we have reviewed although, as noted above, there is no consensus in the literature regarding the precise basis for delineating regional markets for hospital services.

In principal, two acute hospitals are likely to be in the same geographic market if any difference in the transport costs faced by patients (and funding intermediaries) are a small proportion of the costs of providing the acute services. Transport costs in this context include the inconvenience and any health risk associated with extra travelling time.

On the basis of these considerations and recognising the high cost of most acute services, we believe that the geographic markets for acute services in New Zealand are probably no smaller than a single city (where cities which are independent for local government purposes but located contiguously are regarded as a single entity). In the case of Napier and Hastings, which are only 15 to 20 minutes drive apart, we believe the geographic market includes both cities.

69 Committee to Review Surgical Services in the Waitaki, Clutha and Central Otago Districts of the Otago Area Health Board, op. cit., note that "the advent of modern transport and life support systems now allows seriously ill trauma patients to be resuscitated and then quickly brought to the sophisticated [Dunedin] base hospital where the range of available ,treatments together with intensive care and monitoring facilities improves the chances of long term survival" (p 2).

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4.4.1.2 Non-Acute Hospital Services

The non-acute services provided by government-owned health care organisations comprise non-emergency surgical and medical services, obstetric and gynaecology services, clinical support services and hospital-based mental health and continuing care services (refer Appendix A3.4).

• ., As discussed in Appendix B, an important trend in the markets for these services is the unbundling of traditional services into more focused disciplines and subdisciplines 70 and a corresponding growth in organisational and service diversity. For example, there has been considerable growth in recent years in "alternative site" care, including outpatient surgery, specialist provision of non-acute care, and specialist provision of infusion therapy. Single- site hospitals have made increasing use of a "spoke and wheel" form of organisation, - operating clinics and support services as subsidiary companies. The non-acute services provided by public hospitals will increasingly be subject to competition from specialist, outpatient and other stand-alone service centres.

An opposing view, which is sometimes expressed in New Zealand, is that the provision of many specialised services requires comprehensive acute service back up and that this limits the competitive threat posed by providers of specialist or elective procedures. Acute care back up services do represent an important input to the supply of many specialist procedures. However, as with most other inputs, these can be purchased on a commercial basis from external parties to the advantage of both the supplier and provider of acute care back up. We believe these arrangements will become common place as a competitive health care market takes hold in New Zealand.

The diversity of service delivery options, and the relatively low entry barriers to many forms of niche provision, make it impossible to accurately delineate markets for non-acute hospital services. At one level, these services can be thought of as involving the joint provision of hotel services (accommodation, laundry and catering etc), specialist medical equipment and materials, and people with nursing and other medical skills. As a generalisation, most hospital operations that have established a viable hotel business" and area of health care competency can extend their product range at low capital cost (relative to potential incremental revenues).

70 Also see Jahnke, M.D. (1990), "Health Care Antitrust Dilemmas Related to Contemporary Reimbursement and Network Arrangements, in: Section of Antitrust Law, American Bar Association, op. cit., p 119.

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The step-wise nature of product range expansion and the fact that non-acute hospitals in New Zealand provide or.are capable of providing essentially the full range of surgical and general medical services provided by acute hospitals suggest that there are a broad range of substitution possibilities for non-acute services. For many of these services there are also viable outpatient or day clinic options.

Established hospitals would also face relatively low entry barriers in extending their services to obstetric and gynaecological services (as illustrated by the low tech nature of New Zealands rural maternity homes). Similar arguments apply to continuing care services. For most non-acute surgical and medical services the great majority of requisite clinical support services can be purchased from outside (including on-campus) suppliers or established internally as part of a step-wise (and therefore low risk) expansion strategy.

Finally, mental health services require minimal specialised facilities or equipment (with the exception of secure wards for dangerous and criminal patients) and involve a range of outpatient options. The UK experience suggests that private providers consider high security psychiatric hospitals to be a relatively attractive market segment (partly because of the relatively low turnover of the client population held in such facilities).71

While it would be possible to considerably refine the discussion of non-acute hospital services sketched above and (probably) to delineate a series of overlapping markets which include the non-acute services currently provided by New Zealands public hospitals, we believe that the general market overview provided above is sufficient for the purposes of this report.

71 Cliff Graham, pers. corn., 4 December, 1991..

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The geographic market for non-acute services provided by public hospitals varies considerably between services. For minor and high frequency, low tech services, the geographic market is localised and will tend to be smaller than for acute care, e.g. many patients will be unwilling to travel across Auckland city to receive treatment from a slightly cheaper or slightly better physiotherapist. For highly-specialised, high-cost services, like open heart surgery, travel and location will be a less important consideration in the purchasing decisions of patients and intermediaries. For some highly specialised, expensive services, e.g. bone marrow transplants, the market will be New Zealand wide, Australasian or even broader72

4.4.1.3 Primary Health Services

The main categories of primary health care provided by area health boards are community health, health protection, oral health, health promotion and special programmes (refer Appendix A.3.4.1). In general, these services, like most service industries, do not require expensive facilities or equipment but depend principally on appropriately qualified staff and organisational skills. For the purposes of analysing market power, the product markets for primary health services include both the nurses, medical professionals, paramedics, pharmacists, non-traditional therapists and other groups which already provide primary care and those groups which could readily enter the relevant markets.

Again, while it would be possible to further delineate and define the markets for primary health care, such refinement is not required for the purposes of this report.

The geographic markets for primary health care are essentially local in nature reflecting their community and decentralised orientation.

72 However, the market cannot be defined independently of the actions of the RHA purchasers. RHAs effectively will determine price responsiveness and substitutability on the demand side of the market by their decisions on whether to pay higher prices to hospital A in order to limit time costs for patients in area A, or whether to contract also with hospital B (lower dollar cost, but higher time cost) in area B. In contrast, in private markets it is possible to observe demand patterns and patient flows as indicators of patients willingness to trade between dollar and time prices.

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4.4.2 Market Constraints

4.4.2.1 Acute Seruices

No private hospitals in New Zealand provide 24 hour critical care facilities for acute treatment. Although private hospitals account for over 20 percent73 of the operations performed in New Zealand each year and, between them, are capable of undertaking the great majority of the surgical procedures available in New Zealand, they concentrate on elective/non urgent surgery that does not require unplanned intensive care back up. This is not because of the lack of specialised equipment or medical staff - four private hospitals undertake open heart surgery and private hospitals perform neurosurgery and many other complex surgical and medical services (refer Appendix A.4). Rather, private hospitals do not have the physical capacity, service breadth or specialist back up staff to provide 24 hour emergency care. This situation reflects both the free provision of acute services on demand within the public system and the economies of scale in operating a comprehensive 24 hour acute service. Private supply could thus change as public funding and supply are reconfigured.

If the purchasing of core health services in the future is driven entirely by cost and quality considerations, and public providers are required to earn a normal risk-adjusted return on their assets, the allocation of acute services between the private and public sectors will depend on the comparative efficiency of each. Numerous private hospitals in the US provide 24 hour acute services as does Health Care of Australia in Australia.

For a number of New Zealands larger private hospitals the major impediments to the provision of 24 hour acute services are not capital equipment or bed space, but the organisational and human resource costs of gearing up for 24 hour contingency operations and the political /policy risk that they will not be able to compete on a "level playing field.

Several private hospitals already have intensive care units and a range of other highly specialised equipment. For example, the Mercy Hospital in Auckland recently acquired a magnetic resonance imaging unit. There are 185 doctors covering 21 disciplines accredited to work at the hospital.74 While several of these hospitals would need to invest in extra facilities (e.g. improved blood and laboratory services at Wakefield Hospital in Wellington) to provide 24 hour acute services, these involve step-wise rather than quantum-change

New Zealand Private Hospitals Association (1990), Private Hospitals in New Zealand, A Background Paper, New Zealand Private Hospitals Association, Wellington. The latest available data is for 1988. Mercy Hospital and Health Services 1990-91 Annual Report.

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investments. The organisational skills, capacity and medical staff backup required to provide 24 hour acute services do not entail major capital costs but involve start-up risks which would be borne until sufficient scale was achieved for per unit costs to fall to competitive levels.

The econometric studies and conventional wisdom on economies of scale which are reported in Appendices B and F do not provide any evidence to suggest that New Zealands major metropolitan centres are too small to support new privately-owned acute care hospitals. The US evidence suggests that the major Auckland, Palmerston North, Hamilton, Wellington, Christchurch and Dunedin hospitals exceed the size required to realise available economies of scale and may, in some cases, be inefficiently large. Anecdotal statements by operators of private hospitals in New Zealand and Australia are consistent with this assessment. This suggests that in the major centres it should be possible for the monopoly RI-IA to contract with a private hospital of efficient scale for the provision of acute services. If an RI-IA were to adopt a consistent strategy of encouraging competition in acute services, the entry risks for the private provider might be considerably reduced.

The second major entry barrier mentioned above is the political /policy risk surrounding the Governments health reform. Several major private health care providers we have interviewed believe there is a significant risk that they will not be allowed to compete on a "level playing field". In particular, concern has been expressed to us that public sector providers may not be required to earn a normal return on their (appropriately valued) assets and that RHAs may not adopt neutral purchasing policies as between public and private providers (these issues are discussed further in Section 5.2 below).

Ongoing uncertainty regarding these matters will, we believe, engender a cautious attitude on the part of private sector providers generally and will act as a drag on the speed and extent to which they position themselves to compete in the core health service markets. On the other hand, initiatives which reduce the uncertainty surrounding the reforms will encourage private providers to commit capital and management time to competing for core health services. Such steps would include:

indications of a strong commitment by the Government to the reform programme;

the provision of a more detailed road map, including critical dates, for the reform process;

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meeting early target dates (possibly with time to spare);

high-quality decisions in respect of early personnel and structural decisions; and

credible indications by RI-lAs/RHA establishment boards that they intend to adopt neutral purchasing decisions.

4.4.2.2 Non-Acute Hospital Services

In Section 4.5.1.2 above we concluded that there are a broad range of substitution and market entry possibilities for most non-acute services currently provided by public hospitals. These possibilities include the existing capacity of private sector hospitals to perform elective surgery, the scope for private hospitals to expand their range of services in a step-wise manner, and a range of day clinic and outpatient options.

Most of New Zealands public hospitals have excess bed capacity and other infrastructure. In some instances it will be efficient for these facilities to be leased or sold to private sector operators, perhaps in conjunction with a cost-sharing agreement with the public hospital for shared infrastructure and facilities, e.g. kitchens, laboratories, radiology services and specialised equipment. If properly implemented, the Governments reform proposals will strengthen the incentives of public hospitals to use their assets efficiently and this will encourage a range of joint venture arrangements with the private sector. The reforms will remove some of the bureaucratic constraints (including elected boards) that have impeded the use of such arrangements in the past. While public hospitals will not wish to provide a "leg up" to private sector competitors, competition from other private and public hospitals and pressure from RHAs, will, in many cases, force public hospitals to improve asset utilisation through leasing facilities and by entering into joint ventures.

Indeed, we believe that creating the incentives and providing the flexibility for the rationalisation and more efficient utilisation of existing public health care assets should be one of the major priorities of the provider reform. In general (and with some notable exceptions), the problems with health care provision in New Zealand stem from poor management incentives and practices rather than infrastructure constraints. In many areas there is considerable excess bed capacity and under-utilisation of specialised equipment. The extent to which the deregulation of the health care market results in the efficient rationalisation and reallocation of "surplus assets rather than unnecessary,. costly duplication will be partly dependent on the quality of the incentives and the degree of

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flexibility provided to managers in the public system. (In other areas, assets are poorly located or structured and, in some cases, should be written off.)

To summarise for the main metropolitan areas, existing private sector facilities and • relatively straightforward expansion opportunities for private providers will mean that the public hospitals will face quite comprehensive competition for non-acute surgical and medical procedures.

Appendix A indicates that in general there are private hospitals in population centres above 40,000. However, in the smaller centres, private hospitals tend to be small and to provide a limited range of services. While there are usually few resident specialists in such centres

there is considerable scope for visiting specialists to provide specialist clinics. 75 Under the proposed funding arrangements, small private hospitals and clinics will be able to offer specialist clinics by arranging visiting specialists from the main centres. The public hospitals, particularly those in smaller centres, will also face competition in elective surgery and specialised treatment from private and public hospitals in the main centres. For example, eight percent of Wellington Hospitals admissions are from outside the Wellington Area Health Boards area and include significant numbers of admissions from T Manawatu/Wanganui, Hawkes Bay, Taranaki and Nelson /Marlborough. For the Auckland Area Health Board, 6.5 percent of surgical admissions in 1990/91 were from outside the Boards region; for neurosurgery 30 percent of admissions were from outside the region. While it will not be efficient for patients to travel long distances for minor surgery or medical treatment, the establishment of stronger commercial incentives for public hospitals will encourage more effective inter-regional competition for high technology and expensive secondary and tertiary treatment.

Overall we believe the markets for non-acute services in regional centres are relatively contestable and that the government-owned providers operating in those markets will face a high level of potential competition.

In the case of continuing care and geriatric services, the private sectors market share already

exceeds 50 percent and new entrants face relatively low entry barriers. 76 Similarly, maternity services do not involve high entry barriers, particularly for existing hospital operators. The trend towards de-institutionalised care for mental health and intellectual

For example, see Committee to Review Surgical Services in the Waitaki, Clutha and Central Otago Districts of the Otago Area Health Board, op. cit., pp 16-17. 76 Cummings, J . ( 1991), Competition in Health Services, draft paper prepared for the Task Force on Funding and Provision of Health Services.

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disability services (as illustrated by the Auckland Area Health Boards shared home care for the intellectually handicapped) implies relatively low entry barriers for private sector entrants. When institutionalised care is required, the principal infrastructure requirements are for basic hotel facilities - these need not entail high entry costs, particularly when there is excess bed capacity in the region. (New Zealands low hotel occupancy rates and the scope for transforming some small hotels into continuing care units is also relevant in this context.) In the case of patients requiring secure facilities, there is significant scope for inter-regional competition involving existing publicly-owned facilities, and, on the basis of experience in the UK, private sector operators cannot be ruled out. The proliferation of specialised nursing homes, long term care centres for the chronically ill, clinical laboratories and diagnostic centres in the US, which is discussed in Appendix B, further illustrates the considerable scope for competition in non-acute services.

In summary, we believe that if the Governments reform proposals are implemented on a comprehensive basis, government-owned general hospitals will face a range of effective competitive disciplines for the majority of non-acute services they provide. In our view the critical determinants of the intensity and breadth of these pressures will be the nature of the regulatory barriers facing private sector competitors, the degree of commitment , on the part of RHAs to neutral treatment of private and public providers, and the scope given to public hospital managers to rationalise their existing assets and enter into innovative arrangements with private sector providers. These issues are discussed in Section 5.0 below.

Even in a perfect policy environment though, there will be some gaps in the competitive threats facing public hospitals, perhaps particularly in smaller centres where private hospitals will sometimes face economy of scale difficulties. In such locations, however, this would not distinguish health care from many other industries; there is limited direct competition for many goods and services in smaller regional communities. This is seldom seen as providing a case for special rules or regulations. Moreover, government-owned health care providers operating in smaller centres will be constrained by the regional monopoly position of RHAs and by a range of political and implicit regulatory constraints. These constraints are discussed below in Sections 4.4.3 and 4.4.4 respectively.

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4.4.23 Primary Health Services

As discussed in Section 4.4.1.3 above, primary health care services generally involve relatively low capital costs and are subject to competition from a wide range of professional and semi-professional groups. The private sector already plays a major role in primary health care; participants include general practitioners; private midwives; nurse practitioners; pharmacies; physiotherapists; and non-traditional therapists. The voluntary sector is also fully involved in the provision of primary health care services (refer Appendix A.43).

- The considerable existing capacity in the private sector to provide primary care and the low barriers to expansion and new entrants mean that there is wide scope for competition in virtually all aspects of primary health care.

I 4.4.3 Countervailing Power of RHAs

The Governments reform proposals involve RHAs having regional monopolies until some time during the July 1993 to June 1994 period when it is proposed that individuals will be allowed to leave RHAs to enrol in health care plans. While government-owned health care providers offering specialised services will be able to compete for some patients from outside their immediate regions, until competition from health care plans is allowed providers will face a single buyer in respect of all prospective patients within the boundaries of the local RHA.

In principal, this situation will provide RHAs with considerable monopsony power (market power as a buyer), especially where there is actual or potential ' competition between providers of core health services. However, in practice, the extent of effective market power will depend on the incentives facing RHAs. There appears to be no straightforward model for establishing the objectives and monitoring the performance of RHAs (refer Section 5.2.4 below). This is likely to complicate the process of providing robust incentives for RHAs to be efficient purchasers of core health services. In comparison with the arrangements for RHAs, we believe there are more robust models and accountability frameworks for establishing efficient government-owned health care providers.

If RHAs are not highly accountable for controlling the cost of acquiring a service of given quality, there will be a risk that CHEs and other providers will charge excessive prices or reduce service quality significantly below that technically feasible, given their resources.

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Notwithstanding the difficulties in establishing appropriate incentives for RHAs, we believe that careful policy design and the appointment of high-quality people to the RHAs would engender a reasonably commercial and vigorous approach by RI-lAs in their dealings with providers. Under these circumstances, the monopoly position of RI-lAs will be an important consideration in negotiations between funders and providers.

For those services in which CHEs face little immediate competition, there will be a one-on- one negotiating position involving the RI-IA and CHE. The relative negotiating strength of the two parties will be influenced by:

the ability of the RI-IA to credibly threaten to promote the entry of a new provider to establish competition in respect of the service concerned;

the risks that government will break up facilities (e.g. hospitals) owned by overly aggressive CHEs or that the Commerce Commission or Government will require that CHEs "essential facilities" be made available to outside competitors;

the ability of CHEs to use the political process to maintain market share on the grounds that this would involve job losses or the privatisation of the health system;

the extent to which the negotiating leverage of RHAs in respect 6f contestable services and the need for CHEs to maintain effective customer relationships will constrain opportunistic behaviour by CHEs regarding monopoly services; and

the ability of RHAs to use "benchmark competition", including the prices paid by other RI-lAs for similar services, in negotiations with CHEs.

We comment on each of these considerations below.

As discussed above, there is a high degree of contestability in non-acute services, and product range expansion by private sector providers could easily be facilitated by RHAs. While 24 hour acute services appear to be significantly less contestable, the main centres are large enough to support multiple providers. Moreover, the main entry barrier for sophisticated private hospitals is the scale required to achieve efficient size, and RHAs, as monopoly purchasers, are ideally placed to assist private providers to overcome this. In many instances, therefore, we believe RHAs will be well placed to threaten to promote the entry of a new provider.

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As Telecom and Electricorp have experienced, "dominant" public sector monopolies face tight political constraint3, including the threat of break up. These constraints are likely to he important in a deregulated health care market and will, we believe, prevent blatant monopoly behaviour by CHEs. This issue is discussed in greater detail in Section 4.4.4 below.

The potential for CHEs to use the political process to prevent market share loss will be a significant risk facing RHAs. A logical strategy for RHAs in this context would be to encourage consumers to recognise that RHAs, and not providers, are their agent; market share losses by public hospitals should be presented as coincidental to improved, lower cost services which will improve health outcomes for patients. It remains to be seen, of course, how effective such strategies might be.

Good customer relationships will be critical to CHEs in a deregulated health care market. Blatant opportunism in areas of limited contestability will risk souring relations with RHAs and thereby jeopardising business in more contestable market segments and undermining customer loyalty in the future when a wider range of services will be available from the private sector.

Because RHAs will not be in competition with each other they are likely to share a range of contracting information to improve their understanding of underlying cost functions and market prices. Such benchmark competition may be especially valuable for RHAs purchasing services in regions where market size is a serious impediment to contestability, e.g. 24 hour acute services in smaller cities and regional centres.

Taken together, the five bargaining considerations discussed are likely to favour RHAs over CHEs. The monopsony power of RHAs is therefore likely to impose an important constraint on CHEs over the period in which the RHAs retain their regional monopoly status. Even when individuals are allowed to enrol in private health care plans, RHAs are likely to initially retain high market shares and therefore retain significant market power. The time required to seriously erode the market power of RHAs should provide considerable scope for expansion by private sector providers into services that initially involve little direct competition.

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4.4.4 Political and Regulatory Constraints

CHEs that engage in monopolistic behaviour will be exposed to the risk of government regulatory intervention. This might range from a Ministerial directive, to an explicit behavioural regulation, such as price control, through to some form of structural break up. The latter could involve either the separation of institutions (e.g. two hospitals) owned by a CHE into separate organisations or the requirement that competitors be given access to some of the facilities that underpin the CHEs market power.

If CHEs are given robust commercial incentives, CHEs with considerable market power will attempt to balance the potential short-term gains of monopoly behaviour against the medium-term risks of regulatory retaliation by government. For both commercial and personal reasons, managers are likely to be particularly concerned at the prospect of structural break up and the associated restructuring costs and potential loss of status and personal earnings.

The potential strength and pervasiveness of the threat of regulation is illustrated by the sensitivity to political pressures of the major New Zealand SOEs with high levels of market power. Telecom (both prior to privatisation and now) and Electricorp, in particular, have been influenced by political constraints in setting tariff levels and structures and in determining a range of qualititative issues. This responsiveness to political pressures is hardly surprising given that Telecom and Electricorp have both been subject to the threat of behavioural regulation and major structural break up as a means of dealing with their perceived market power.

CHEs will not, in general, sell their services directly to consumers but will deal with RHAs. The threat of regulation facing CHEs is therefore likely to be less potent than for Telecom and Electricorp which sell politically-sensitive products directly to voters. Nevertheless, RHAs will provide a focal point and voice for expressing to politicians concerns regarding the market power or market practices of offending CHEs. In addition, in comparison with the SOE reform process, the transitional arrangements for CHEs are likely to be both longer and more fluid (refer Section 6.0 below). In practical terms this is likely to increase the opportunities for changing the rules of the game for particular providers in response to objectionable behaviour. This applies to both behavioural regulation, which is likely to evolve through time in any event, and structural break up, which could he imposed or extended at any time during the potentially lengthy establishment phase.

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Having regard to these considerations, we believe the threat of behavioural regulation or structural break up-will impose a significant constraint on those CHEs that have considerable market power in the provision of specific services.

4.4.5 Summary of Market and Political Constraints

For competition purposes, the services provided by area health boards and the facilities these involve can usefully be broken down into acute services, non-acute hospital services and primary health services.

The major potential area of competition concern relates to 24 hour acute care services. No private hospitals in New Zealand provide 24 hour critical care facilities for acute treatment and, depending on the contractural arrangements agreed with RHAs and the perceived political risks, expansion into these services might involve serious financial and organisational risks.

In non-acute and primary health services, existing private sector competitors and the existence of a range of low risk expansion and market entry opportunities mean that government-owned providers will face quite comprehensive competition. The critical determinants of the intensity of this competition will be the nature of the regulatory barriers facing private sector providers, the degree of commitment on the part of the RHAs to neutral treatment of private and public providers, and the scope given to public hospital managers to rationalise their existing assets and enter into innovative arrangements with private sector providers.

In addition to the disciplines imposed by competing health care providers, the monopsony power of RHAs is likely to place important constraints on government-owned health care providers over the period in which RHAs retain their monopoly status. The threat of behavioural regulation or structural break up will impose a further constraint on those health care providers that have considerable market power in the provision of specific services.

Two main conclusion emerge from this discussion. First, the only serious case on competition grounds for breaking up area health boards relates to the major metropolitan areas with multiple 24 hour acute care hospitals. Any decision to establish competing CHEs in such areas must, of course, recognise the costs as well as the benefits of such a break up. The potential costs of break up are discussed in Section 4.5. Secondly, as emphasised throughout this report, the benefits of establishing competing providers and of any break up of area

-105- CS FIRST BOSTON health board assets, will be crucially dependent on the quality of the regulatory environment and incentive arrargements applying to RHAs and health care providers. Over the medium term, these issues will be far more important that the initial configuration of assets chosen by the NllB in determining the economic gains from the reform programme.

4.5 Integration Economies and Restructuring Costs

Specific measures should be implemented to address anticipated areas of high market power only when the economic benefits of such measures are expected to outweigh their economic costs. Broadly speaking, as noted above, the measures available to combat market power can be categorisedas involving either behavioural or structural regulation.

The relative strengths of these two forms of regulation in the context of New Zealands health care, reform are discussed in Section 4.5.1. We conclude that behavioural regulations should not be relied upon extensively, if at all, to address perceived market power in the New Zealand health care industry.

The costs of structural intervention will depend on the extent to which the envisaged break up would impose productively inefficient restructuring costs and organisational arrangements and the ease with which the system will self correct for initial mistakes. The latter will depend in part on the process governing the ongoing restructuring of the health care industry. These issues are discussed in the remaining parts of this section.

Section 4.5.2 summarises the insights provided by the US for the appropriate initial configuration of government-owned health care assets in New Zealand. The summary is based on the more detailed discussion of the US health care market presented in Appendix B. Section 4.5.3 considers relevant econometric, survivorship and anecdotal evidence relating to economics of scale and scope in the health care industry. Sections 4.5.4, 45.5, 4. 5.6 and 4.5.7 consider structural issues relating to financial viability, community of interest considerations managerial resource constraints and process matters, respectively. A summary is presented in Section 45.8.

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4.5.1 Behavioural Versus Structural Regulations

An indepth discussion of behavioural regulation is outside the terms of reference for this report. However, because behavioural and structural regulation are to some extent substitutes (i.e. alternative means of addressing the market power of CHEs), it is necessary to have some regard to behavioural regulation. The principal behavioural rules used to control market power are price and rate of return regulation. There is very wide spread agreement among economists that these forms of regulation generally involve pervasive and ongoing economic costs and distortions. There is also a growing recognition of the costs of applying such regulations in the health care industry?

Because of these costs, it is generally accepted that price or rate of return regulation is likely to be efficient only when there are both severe competition problems and structural break up to address those problems would involve serious losses of economies of scale or scope. In deregulated markets these conditions are most likely to apply in the so-called network industries, particularly electricity and telecommunications. Even here, however, technological change has considerably weakened the case for heavy-handed price or rate of return regulation.

In comparison, in health care, the cost advantages of highly integrated organisations with very large market shares are minimal. The trends towards decentralisation, specialisation and organisational diversity in the relatively competitive US market, discussed in Appendix B, all suggest that a highly-integrated and concentrated New Zealand health care market is unlikely to be efficient in the medium term. We therefore believe that behavioural regulation should not be relied upon extensively, if at all, to address perceived market power problems in the New Zealand health care industry.

4.5.2 Insights from the US

Decisions about an appropriate initial allocation of facilities and contracts, insights as to optimal regulatory structures, and a vision of how the New Zealand health care system might evolve over time, would all be assisted if we could draw from international experience some picture of what a competitive health system looks like. Evidence from relatively open and competitive hulth systems overseas could yield, for example, information about the relativ roles of not-for-profit and for-profit organisations in providing different categories of health care; about the way in which health care institutions faced with competition

77 See Culyer and Posnett, op. cit..

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position themselves in the market, bundle products and exploit market niches; about the size of organisation that-seems to work best in different circumstances; and about the role that can be played by health care chains, or specialist management companies.

In practice, the extensive involvement of governments in the funding, provision and regulation of health care around the world means that there is no one country to which we can look for evidence of the implications of competition on the organisation of the health care sector. The most commonly cited example of a "free market" health care system, the US, is discussed in Appendix B. Even in this case, extensive government involvement, both through the funding of a significant proportion of care and through direct regulatory intervention, means that the evaluation of the efficiency of observed structures must be gauged with caution. From a public policy perspective there are serious weaknesses in the funding and regulatory arrangements applying in the US and our review of the US experience should not be taken as indicating that we believe the US provides a good model for health reform in New Zealand. However, there remains in the US more competition at the level of health care provision than in other OECD jurisdictions. The sorts of lessons that can be learned from the US experience, while broad, are therefore pertinent ones.

The first lesson is that health care systems, where competition is present, are characterised by diversity - and perhaps even increasing diversity.

As, for example, old institutions attempt to adapt their structures and the use of their assets to competition from small clinics or physician practices, hospital owners or trustees weigh up the pros and cons of independence, chain ownership and chain management, and HMOs and other managed care institutions innovate with contracts designed to control quality and cost, diversity . increases. The experience of the US provides a warning against presuming what arrangements "should look like, and in particular about enforcing existing (or some newly chosen) institutional boundaries too rigidly. Rather, this experience suggests institutional forms and boundaries should themselves be exposed as far as possible to the competitive process, so that existing institutions have the opportunity to adjust - perhaps quite radically - to emerging technologies and new demands, in competition with new entrants.

A second lesson is that, while in some areas of health care, treatment has become increasingly technical, capital-intensive and expensive, the scope for specialised small-scale health care institutions with relatively low sunk capital costs is increasing.

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Due in particular to technological developments, an increasing range of treatment can be provided through outpatient clinics, without the overheads in terms of both plant and bureaucracy required by general acute care hospitals. While this trend should not be over- exaggerated, it does have a number of important implications for the feasibility and cost of entry, and therefore competition in the provision of health care. In particular, there need not be scope for construction of a fully-fledged hospital in an existing hospitals service area for the latter to face a potent threat of competition. Technological developments have in this way increased the opportunities for competition across a wide range of care by means of the scale and cost of the organisation supplying the care, rather than simply in terms of the cost of care as practised more or less efficiently by largely comparable institutions.

A third set of lessons derives from current efforts in the US to improve systems for defining and measuring standards of care.

In the US at present, there are a number of government and private sector initiatives aimed at defining appropriate standards of care, following evidence that a considerable degree of ignorance across the medical community has resulted in wide variations in the nature, quality and cost of treatment for comparable conditions. These efforts to define appropriate treatment and corresponding measures of the quality of outcomes reflect the importance of more or less standard definitions of service and quality as a supplement to cost data. They are also likely to yield an important resource of information for countries, such as New Zealand, seeking to reform their health care provision and funding arrangements.

4.5.3 Economies of Scale and Scope

-J The major econometric and survivorship studies and a range of anecdotal evidence relating to the economies of scale and scope and the advantages of chains for acute care hospitals are discussed in some detail in Appendices B and F. The pertinent themes to emerge from those discussions are summarised here.

The most robust portion of the acute care hospital system in the US at present involves hospitals with between about 150 and 400 beds. Accordingly to First Bostons health institution specialists in New York, hospitals with fewer than 100 beds are tending to close, and hospitals with over 500 to 600 beds to suffer repeated financial losses. However, there is some evidence that hospitals with more than 400 beds have increased their market share in recent years.

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It is difficult to draw firm conclusions from the econometric literature on economies of scale within hospitals, in large part because of the difficulty of satisfactorily measuring the diversity of hospital outputs. A consensus has yet to emerge on the appropriate methodology for evaluating hospital cost data, and the existing range of conclusions is attributable at least in part to the diverse nature of the methodologies used. Econometric studies of economies of scale are fraught with difficulties created by the patient-specific nature of treatment, the difficulty of measuring differences in severity and quality, and the difficulty of taking account of complementari ties on the demand side (as between pediatrics and obstetrics, for example). Survivorship studies are for these reasons likely to give a more accurate idea of underlying cost economies but dominant survival patterns appear still to be emerging, in response to changes in technology and reimbursement systems.

While a number of studies have found that the range and quality of care increases with hospital size, some econometric and anecodatal evidence suggests that throughput and department size are more important than hospital size in determining productive efficiency and the quality of patient outcomes.

Teaching hospitals tend to be larger (i.e. frequently greater than 500 beds), to offer a wider range of services, and to have higher costs, than non-teaching hospitals. Econometric studies have attributed the majority of the cost differential to case mix differences, with teaching status per se being a significant but less important explanatory factor.

A number of econometric studies have considered cost complementari ties between different hospital services. However, the measurement of economies of scope is sensitive to how treatment groups are specified, and is complicated by the high degree of heterogeneity that characterises general hospital output. No patterns in economies of scope are apparent. This may, however, reflect the crudeness of econometrically feasible tests of scope economies.

Hospital chains grew in importance through the 1980s with the number of hospitals owned or managed by for-profit chains almost doubling between 1976 and 1982. Chains account for around half of all beds in the not-for-profit sector. However, in practice, hospitals do not divide neatly into those formally incorporated into chains, and single-site hospitals operating in isolation; rather, there is a continuum of arrangements, ranging from single-site hospitals, to contracting arrangements between separately-owned hospitals, to formal chains. Within health management chains, there has been increasing emphasis on local, rather than centralised, management.

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The main conclusions we draw from the available evidence on economies of scale and scope are quite broad and pragmatic, but nevertheless important. These conclusions-can be summarised as follows:

economies of scale are often limited to small hospitals (those with less than 100 to 150 beds), while larger hospitals seem to produce constant returns to scale. Economies of scale appear to be more prevalent within the departments of hospitals than for multi-department hospitals as entities;

the dominant role in New Zealand of government funding and provision combined - with an administrative rather than a business approach to provision have resulted in a more centralised and concentrated system than would have evolved in a contestable market. A competitive New Zealand health care market would involve considerably more organisational and product diversity and specialisation than the - current system;

New Zealands large metropolitan hospitals appear to be larger than is required to achieve significant economies of scale. The evidence on the qualitative advantages of hospitals (as opposed to departments or throughput) of this size is inconclusive;

while there is some evidence to suggest that teaching hospitals benefit from large size (400 to 500 beds or greater) a full assessment of this issue is outside the scope of this report; and

the operation of hospital chains is likely to be a viable business strategy in competitive markets but is unlikely to provide overwhelming cost advantages relative to stand-alone entities or contractural associations between stand-alone entities (given the co-existence of chain and independent hospitals in the contestable segments of most health care markets internationally).

With regard to hospital chains, we believe that the balance of risks favours the NIPB allowing chains to be formed over time if they can be shown to provide efficiency advantages, rather than requiring chains to be established at the outset. For several area health boards, the restructuring costs required to establish new provider units based on a major hospital would be minimal. Further, independent management of individual hospitals will not preclude cooperative arrangements with other CHEs that will provide some of the purported advantages of chains, e.g. joint purchasing arrangements. Further, if, in the future, hospital

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chains do have major management advantages in the New Zealand context, chains could be established at that time subject to Commerce Act approval. (Suggested management arrangements for allowing this to happen are discussed in Section 6.0.) This suggests that risks to productive efficiency of the NIPB not requiring chains to be established at the outset are relatively low. I

In contrast, if the NIPB were to require chains to be established at the outset, it would be difficult, within government ownership, for other organisational arrangements to be tested against chain ownership and to ensure that chains were broken up in the event that the proved to be relatively inefficient, in addition, the establishment of chains (on a national basis, for example) would involve significant restructuring costs which may not be worth incurring. A more flexible approach, which enables the concept of chains to be evaluated over a longer period of time will be less likely to incur unnecessary costs.

In the time available for this study and without undertaking detailed original research on economies of scale and scope in the New Zealand context, we believe it would be inadvisable to draw significantly more specific conclusions in this area. This reflects the complexity of the issues and illustrates the futility of any attempt to "play god" in planning the shape of the health care industry in any detail.

4.5.4 Financial Viability

The NIPB has asked that we address the question of financial viability in the course of developing principles for determining the initial structure of the government-owned health care sector. In discussing this question we focus on business rather than financial viability and assume that all CHEs will be established with financially sustainable debt:equity ratios.

Business viability should not, in our view, be seen as an objective in itself. Experimentation, innovation and risk taking, and the chance of business failure these imply, are central to the process of economic growth and change. Any policy approach that attempts to minimise business failure is likely to be too inflexible and conservative and will impede difficult-to- predict success stories.

The process governing New Zealands health reform should balance the advantages of stability against the need for risk taking. Given the complexity and uncertainty of the proposed restructuring, we believe that a well-balanced process would almost inevitably

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involve some business failures. The procedures for handling these should ideally be established in advance.78

Business viability is a function of both production and demand considerations. A viable business must be organised in a way that enables it to survive in a competitive market in providing the goods and services demanded by customers. The relevant organisational issues in this context include business structure, technology, scale, product bundling, management competency and organisational culture. To survive, a business must possess a bundle of organisational attributes that provides it with a sustainable competitive advantage or core competency relative to its competitors.

• The critical requirement for business survival is arguably a management team with the strategic and operational skills required to identify, achieve and maintain areas of - competitive advantage. This once again highlights the considerable importance of high- quality appointments to CHE boards and senior management positions.

With regard to structural considerations, the New Zealand health care organisations that survive and prosper in a competitive market are likely to be more diverse in terms of size and range of services than the area health boards. In particular, a competitive health care market will be likely to involve a large number of organisations that are much smaller and more specialised than the area health boards.

In general, however, it is not possible (nor necessary) to delineate the likely successful organisations within the existing area health boards. Instead, the NIPB must establish a starting point and a process that allows rapid reorganisation into units whose efficiency advantages will underpin their viability. The initial assessment of the viability of prospective business units should, in general, be determined in detailed business assessments which should consider, among other things, the likely demands of the relevant RHA.

The major case for not delegating this assessment process to provider units relates to those situations where break up may be justified on competition grounds. The strongest case for breaking up the existing area health boards on competition grounds is in the major metropolitan areas where there are multiple 24 hour acute care hospitals. Our review of the

78 The procedures adopted should aim to transfer assets into their most highly-valued uses while recognising any associated restructuring costs. This might involve leasing assets to a private sector provider, selling or writing-off surplus property or establishing a community trust. The management arrangements we propose be used for handling business failures are discussed briefly in Section 6.3.1.

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empirical evidence on economies of scale and scope indicates that larger hospitals in New Zealands major centres probably exhaust available economies of scale. We have not uncovered any evidence in the literature that implies it would be inefficient to have two 24 hour acute care hospitals established as separate businesses in the major centres or that such businesses would not be viable. In the medium term such businesses may well be more viable than the existing arrangements.

In addition to competition concerns, the break up of area health boards might be contemplated now or in the future in order to establish more focused and responsive organisations. This has been an important consideration in the internal reorganisation undertaken by the Auckland, Bay of Plenty and Wellington Area Health Boards in recent years. The logic which has driven these restructuring exercises is broadly consistent with the principles underlying the Governments reform proposals; in each case an attempt has been made to establish efficient, accountable provider units, which would be required (at some stage) to compete in a contestable provider market. The structures adopted by each of those area health boards therefore provide some useful pointers to the organisational arrangements that might make sense from a management perspective in each of the respective areas.

The question of whether the operating units established within, say, the Bay of Plenty Area Health Board would be viable CHEs, will depend largely on the purchasing preferences of the central North Island RHA. Assuming those preferences, including their regional dimension, are broadly consistent with the existing pattern of service provision, there is no reason to suspect that the units would not provide the basis for viable business units.

4.5.5 Community of Interest Considerations

In competitive markets, businesses sometimes deliberately target their services to particular regions or communities. Such targeting often takes the form of local service provision and may also involve having special regard to distinguishing community preferences or aspirations. Responding to communities of interest in this manner is a natural and desirable outcome of the competitive process.

In the case of health care, there are often quite distinct differences in health needs and service delivery preferences between various local communities. The stark contrast between Central and South Auckland in terms of health status and ethnic make up illustrates this point. Responsiveness to consumer health preferences and the cost-effective achievement of

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appropriate health outcomes may, therefore, require organisational strategies, specialist skills, delivery methods, and internal cultures that vary significantly between provider units.

Those area health boards which we have reviewed and which have moved to establish commercially-structured internal business units, have all given some regard to community of interest considerations in defining their business units. In some cases, the strategy and style of the units already reflects the nature and requirements of the communities they serve, e.g. the South Auckland District of the Auckland Area Health Board and the Eastern District of the Bay of Plenty Area Health Board. Again, the way in which those boards have responded to community of interest considerations in developing commercial structures provides useful pointers to the NIPB.

For other boards, where it may be less clear that the logic which has driven internal restructuring is consistent with the broad thrust of the Governments proposals, detailed work may be required during the establishment of CHEs to ensure that the structures adopted have adequate regard to local health issues and delivery preferences (and other criteria for guiding the formation of commercial CHEs).

Once CHEs are established, and assuming RHAs are able to meaningfully signal the needs and preferences of particular groups of consumers, community of interest considerations should continue to be important strategic and operational considerations for CHEs.

4.5.6 Managerial Resource Constraints

A further issue of relevance to the initial configuration of provider assets chosen by the NIPB is the availability of suitably qualified directors and managers. In particular, it has been suggested to us that if a large number" of CHEs are created, it will be difficult to attract sufficient high-calibre board members and directors.

In addressing this question it is important to recognise both the size of the public health system and the nature of the managerial labour market. The area health boards are large organisations in the New Zealand context. Even if the Auckland Area Health Board was divided into three units of equal size, each of the resulting businesses would be very large by New Zealand standards. The size and profile of organisations of this size should be a major attraction to high-quality executives, as long as CHEs are operated on a strictly commercial basis and use conventional remuneration, recruitment and promotion policies.

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However, if CHEs are prevented from adopting market-driven remuneration packages, or are subject to bureaucratic or political impediments in the hiring or firing of staff, high-quality managers will be less inclined to work for CHEs. High performers will be most disadvantaged by remuneration restrictions and by external constraints on performance-based promotion. Such restrictions might, therefore, considerably undermine the quality of managers within CHEs.

A further set of issues concerns the speed at which an adequate supply of high quality managers can be recruited. If undertaken on a comprehensive basis, the Governments health reform programme is likely to result in a major reshuffling and reallocation of managerial resources both within the health sector and between the health sector and outside industries. The application of conventional business principles within the public health sector will, we believe, result in the replacement of low-quality managers, greater recognition of high- quality performers and an influx of managers from outside of the public health system. The latter group is likely to include specialised health care managers from overseas and from private New Zealand health care providers as well as individuals with recognised general management skills. While this process will potentially involve a large number of people, it need not require an extended period of time and is unlikely to delay the overall reform process.

New Zealands SOE reform programme illustrates the scope for the managerial labour market to handle a very large management reshuffling exercise in a relatively short space of time. Given this experience and recognising the highly flexible nature of the managerial labour market we do not believe that the supply of managerial resources should have a major bearing on the initial configuration of government-owned health care entities.

In a competitive labour market the availability of directors is also determined by basic supply and demand considerations. Structural change in the economy and the rise and fall of particular companies results in a continual process of reallocation in the market for directors. Because professional services are highly mobile and because directors are not generally prevented from taking up multiple directorships, the market for directors is able to respond very quickly to structural change in the economy. Again, New Zealands SOE experience illustrates this principle.

It might be suggested that most SOEs are larger and more prestigious than the CHEs that would exist if there was any substantive break up of area health boards and that it would therefore be difficult to attract directors of sufficient quality to CHEs. This argument is

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suspect. In principle, well-structured CHEs should be able to attract directors of a similar calibre to those on the boards of organisations of similar size and complexity. While many CHEs will face a period of intensive internal restructuring, many of the skills required to undertake this will be obtainable from external consultants and advisors. This was a notable feature of the SOE reform process.

Any difficulties associated with attracting adequate high quality directors must, therefore, relate to the specific details of the CHE model and the specifics of CHEs businesses, rather than the availability of directors per Se. The most likely concern in this regard is that government will wish to involve itself in the day-to-day business affairs of CHEs. As discussed in Section 5.3.3 above, any expectation that government will operate in thismanner will be a major deterrent to the participation of high-quality directors. Good directors will be reluctant to expose their reputations to the risk that CHE performance will be adversely affected by government interference.

This situation might be seen as providing a case for limiting the initial number of CHEs so that the CHE directorship requirement can be met from the pool of directors who are prepared to accept the risk of political interference.

We find this argument unconvincing. If a high level of political interference is anticipated, very few top flight directors will wish to sit on CHE boards and political rather than commercial considerations are likely to dominate the board appointments themselves. As discussed in Section 5.3.3, pervasive political interference will jeopardise the application of a commercial provider model, regardless of the quality of the initial director appointments.

A preferable alternative to reducing the number of CHEs would be to somehow institutionalise the concept of an arms-length relationship between politicians and CHE managers in order to make political interference less damaging. The supervisory board discussed in Section 6.0 below provides one means of attempting this.

This model could also be used to augment the supply of directors. Because of the part time nature of most directorships it is unusual for foreigners to shift to New Zealand in order to become a director of a company. If the supervisory board model were implemented, however, the supervisory board could employ full time health care managers, including individuals with top flight int.national credentials, to Sit on the boards of say, six to eight CHEs.

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A further argument that might be made for starting with a relatively small number of CHEs is that government, as shareholder, would have serious difficulties in monitoring the performance of a large number of CHEs. Rigorous performance monitoring and the expeditious replacement of underperforming directors are integral parts of the commercial framework that we propose in Section 6.0 for CHEs. Government faces significant incentive and practical difficulties in monitoring the commercial performance of any business and it is possible that these difficulties would be exacerbated by the need to monitor a large number of entities.

We believe it would be advantageous to deal with such concerns directly by placing special emphasis on monitoring in developing the commercial framework for CHEs and, in particular, by ensuring there are sufficient high quality monitoring resources. We believe the supervisory board model discussed in Section 6.0 warrants close attention in this regard. (We also note that the existence of a large number of CHEs would potentially increase the availability, of comparative performance data and, from this perspective, facilitate monitoring.)

4.5.7 Process Considerations

The preferred initial configuration of government-owned health care assets depends in part on the process envisaged for governing their subsequent management and reorganisation. The following are important aspects of the relationship between the preferred initial structure and the optimal ongoing restructuring process:

the greater the flexibility that will be given to provider units to restructure and reorganise their assets the less prescriptive the NIPB needs to be regarding the initial configuration of assets;

if a robust monitoring process is established the argument for reducing the number of CHEs on monitoring grounds will be considerably weakened;

• if an arms-length relationship between politicians and CHEs can be institutionalised or otherwise enforced, the impact of political interference on the availability of directors should be a less important consideration in determining the initial number of CHEs;

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• for those area health boards whose internal structure is not clearly compatible with the principles driving the health reform programme, there is a case for undertaking detailed work at the transitional board phase (refer Section 6.0) to determine the preferred structure and to apply any principles for break up specified by the NIPB; and

• for those area health boards whose internal structure is clearly compatible with the principles driving the health reform programme there is a case for establishing the major units within those organisations as CHEs during the transitional phase.

Each of these inter-relationships is discussed below.

A dominant theme in this report is the importance of relying heavily on decentralised decision making and widely-held information to drive the restructuring of government-owned health care assets. In general, where the required restructuring essentially involves commercial rather than wider public policy issues (e.g. competition concerns) there are likely to be advantages in delegating detailed decisions to managers operating in an accountable commercial framework. In areas involving serious competition difficulties which can be addressed through structural change without incurring more than offsetting restructuring or operating costs, there is a stronger case for the NIPB prescribing some form of break up.

As discussed in Section 3.3.3 above and in more detail in Section 6.0 below, we believe it is both possible and desirable to subject CHEs to stronger and more focused monitoring - arrangements than have applied to SOEs in New Zealand. The successful development of such arrangements would significantly reduce the importance of political interference, monitoring difficulties and concerns regarding the supply of directors and executives in determining the initial number of CHEs.

With regard to the existing internal structure of area health boards the logic which has driven the internal restructuring of several area health boards is broadly consistent with the thrust of the Governments reform proposals. In Auckland, Bay of Plenty (and possibly Wellington), the development of the existing provider structures appears to have been influenced by underlying cost considerations, including the need for business focus, responsiveness to consumers and competition considerations. The structures developed in these areas provide very useful-pointers for the NIPB.

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In other areas, it may be less clear that the provider units in place provide a rational starting point for the proposed environment, in such cases it may be difficult for the NIPB to easily, and without further detailed analysis, to determine the preferred initial configuration. In these cases, especially if serious competition problems apply, further detailed analysis within parameters laid down by the NIPB may be advantageous.

4.5.8 Summary of Integration Economies and Restructuring Costs

The trends towards decentralisation, specialisation and organisational diversity together with the centralised nature of New Zealands current health care system also suggest that a competitive New Zealand health care market would involve considerably more organisational and product diversity and specialisation than the current system.

None of the econometric, survivorship and anecdotal evidence regarding economies of scale and scope suggests that there would be significant medium-term economic costs in breaking up those area health boards with two or more medium-to-large size 24 hour acute care hospitals. With regard to hospital chains, we believe that the balance of risks favours the NIPB allowing chains to be formed over time if they can be shown to provide efficiency advantages, rather than requiring that chains be established at the outset.

The internal reorganisations already undertaken by some area health boards are broadly consistent with the principles underlying the Governments health reform proposals. We believe that the structures adopted in these cases provide the NIPB with useful pointers as to productively efficient organisational arrangements which will meet the NIPBs competition concerns in the areas concerned.

Where it is less clear that the logic which has driven internal restructuring is consistent with the broad thrust of the Governments reform proposals, we suggest that the provider units responsible for the establishments of CHEs and community trusts be given greater flexibility to determine the initial configuration. However, if in such cases the area health boards have

-12)- CS 1i R.r BOSTON two or more medium or large 24 hour acute care hospitals, the units responsible for the establishment of CHEs and community trusts should be required to separate those hospitals into competing provider units.

These suggestions accommodate or have adequate regard to issues of financial viability, community of interest considerations, and managerial resource constraints. While financial viability should not be seen as an objective in itself, we believe that the approach we suggest would not involve undue risks of business failure (although this question will ultimately depend on the purchasing preferences of RHAs). Community of interest considerations are already reflected in the internal structures of some area health boards and in other cases will be an important consideration in the identification and establishment of CHEs and community trusts.

4.6 Conclusions

The establishment of a competitive health care market in New Zealand will result in a transition to a far less centralised and more diverse industry. However, there is considerable uncertainty regarding the manner and speed in which this process will unfold. It is therefore difficult to accurately anticipate either the nature of the competitive responses that will emerge in the health care market or the competitive constraints that will apply to publicly- owned providers.

The relatively-low capital intensity of many health services and the pressures for decentralisation and supplier fragmentation in New Zealand mean that there is considerable potential for competition in the New Zealand ,health care market. The extent to which this potential is realised, however, will depend on the quality of the accountability mechanisms and regulatory arrangements applying to RHAs and health care providers.

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We therefore believe that competition concerns regarding the health care market will be best met by establishing purchaser and provider arrangements and designing a regulatory environment that encourages neutral treatment of all actual and potential providers, that avoids unwarranted impediments to new entrants, and that provides robust incentives for high levels of commercial performance by provider units and RHAs. In general, we believe these factors will have a far greater impact on the success of the reforms than will the initial configuration of government-owned provider assets.

The major potential area of competition concern relates to 24 hour acute care services. No private hospital in New Zealand provides 24 hour acute treatment and, depending on the contractural arrangements agreed with RHAs and the perceived policy uncertainty surrounding provision by the private sector, expansion into these services might involve serious financial and organisational risks. There is considerable scope for competition from the private sector in non-acute hospital services and primary health care.

Although many government-owned hospitals are likely to face limited competition in acute care services in the immediate future, they will be constrained by the monopsony power of RHAs and the threat of behavioural regulation or structural break up in the event of politically objectionable behaviour on their part. Notwithstanding these constraints, however, we believe there is a case for breaking up those area health boards with two or more medium or large acute care hospitals where this would involve relatively low restructuring costs and limited organisational diseconomies.

Breaking up those area health boards with two or more medium or large 24 hour acute care hospitals would be unlikely to involve foregone economies of scale and scope. While there is an increasing trend towards the operation of chains or groups of hospitals in the US, this form of organisation is unlikely to provide overwhelming cost advantages relative to single-site hospital organisations or to reduce restructuring costs. For several area health boards, the restructuring costs of establishing new provider units based around a major hospital would be minimal. Further, independent management of single-site hospital will not preclude

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cooperative arrangements that provide some of the purported advantages of chains, e.g. joint purchasing arrangements. If, in the future, hospital managers establish that chains do have major management advantages in the New Zealand context, chains could be established at that time subject to Commerce Commission approval.

In contrast, if the NIPB were to require chains to be established at the outset, it would be difficult, within government ownership, for other organisational arrangements to be tested against chain ownership and to ensure that chains were broken up in the event that they proved to be relatively inefficient. In addition, the establishment of chains (on a national basis, for example) would involve significant restructuring costs which may not be worth incurring. A more flexible approach, which enables the concept of chains to be evaluated over a longer period of time, will be less likely to incur unnecessary costs.

-J The internal reorganisation already undertaken by some area health boards is broadly consistent with the principles underlying the Governments reform proposals. We believe that the internal structures in place in these areas should form the basis of any break up -j directives provided by the NIPB to the provider units responsible for the establishment of CHEs and community trusts. Where it is less clear that the logic which has driven internal P1 restructuring is consistent with the broad thrust of the Governments reform proposals, we suggest that the provider units responsible for the establishment of CHEs and community trusts be given greater flexibility to determine the initial configuration of assets. However, if, in such cases, the area health boards have two or more medium or large 24 hour acute care hospitals the units responsible for establishing CI-lEs and community trusts should be required to separate those hospitals into competing provider units.

International experience suggests that competition law has a valuable role to play in facilitating the use of new and innovative forms of health care funding and provision and in regulating the ongoing restructuring of the industry. To avoid unnecessary restructuring costs and to limit the scope for arrangements that damage the competitive process in the health care industry, we recommend that the NIPB seek several changes relating to the Commerce Act to bring CHEs within the jurisdiction of the Act. In addition, we suggest that the NIPB undertake further work on the benefits to the health industry of exposing labour market arrangements to the Commerce Act and of the bet means of achieving this.

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SECTION 5.0: POTENTIAL IMPEDIMENTS TO THE DEVELOPMENT OF EFFICIENT, MARKET-DRIVEN HEALTH CARE PROVIDERS

5.1 Introduction

In this section we consider potential impediments to the development of efficient, market- driven health care providers. We begin in Section 5.2 by discussing potential barriers to competition and restructuring before examining in Section 53 issues involved in establishing robust contracts between providers and funders. In Section 5.4 we review the constraints that the SOE model might impose on the development of an efficient structure of public health care providers.

A number of the potential impediments identified are the subject of separate studies by the NIPB and are not considered in detail in this section.

5.2 Barriers to Competition and Restructuring

We examine below the possible barriers to the restructuring of public providers and the development of competition by private providers.

5.2.1 Regulatory and Political Barriers to Entry

There are currently no major regulatory barriers to entry or expansion by private sector health care providers. Although some legislation creates non-neutralities for private sector operators (e.g. regulations governing private hospitals which specify the ratio of beds to registered nursing staff act as a barrier to the provision of long-stay care where a high level of nursing care is not required), these are not major in nature. They should, however, be reviewed as part of the reform process - although minimum quality assurance standards might be justified in some circumstances, these should apply equally to the public and private sectors.

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In our view, two major potential barriers to entry by private providers and restructuring by the public sector exist. The first is the prospect that CHEs will not be established on a competitively neutral basis. The second uncertainty is the commitment of the Government to fundamental reform of the health sector. These two factors are discussed in Sections 5.22 and 5.2.3. We also consider the importance of competing insurers, the power of medical practitioners and industrial relation issues which might complicate the proposed reforms in Sections 5.2.4 to 5.2.6.

5.2.2 Competitive Neutrality

Private sector operators will be reluctant to enter the health care market unless they are reasonably confident that public providers will not enjoy significant competitive advantages arising from continued Crown ownership. Without the substantial threat of entry, improvements in the productive efficiency of CHEs and improvements in their responsiveness to consumer requirements are likely to be limited. Several of the issues, discussed below, are essential to ensuring competitive neutrality.

5.2.2.1 Treatment of Competing Providers by RI-lAs

The extent of new opportunities for private providers will depend on the approach to contracting adopted by RHAs. It is important that RHAs be neutral in their choice of provider, selecting the organisation providing the desired services at the lowest quality- adjusted cost, irrespective of ownership. The neutrality of RHAs will depend on the way the RHAs are set up and the incentives provided to management to minimise the cost of providing a given level and quality of core health services. They could be required in law to treat public and private providers equally.

At least initially, RHAs will be regional monopolies soliciting bids from competitive providers. An issue which the RHA and the funding reform group need to consider is whether there are merits in making pricing information public.

5.2.2.2 Valuation and Cost of Capital for CHEs

To ensure competitive neutrality, public providers must be established with commercial balance sheets and be required to earn a commercial rate of return. However, accurate valuation of their assets presents a number of problems.

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CS FIRST BOSTON ( ( )Ifi(I(t •iiI

The method of valuation generally preferred by financial analysts - discounted cash flow analysis - assumes That the value of a company is determined by its ability to generate net cash flows in future years, taking into account the time value of money. However, given the absence of information on what health services are expected to be provided by the public sector or the cost or price of these, there will be major problems in applying this valuation approach.

An alternative approach would be to adopt an asset-based method, valuing the assets on the basis of replacement, historic cost or alternative use value. Such an approach could take into account the possibility that if a firm were to start afresh, it might not choose the same level of service capacity or asset configuration. These issues are the subject of a further study being undertaken by the NTPB.

Once the asset value of a CHE has been determined, a debt:equity ratio must be assiguedto it. The debt:equity ratio should be similar to that of comparable private organisations. Information available from private organisations both in New Zealand and overseas should be sufficient to establish the preferred debt:equity ratio. However, the debt assigned to the organisations in the transition might be different to the long-term debt position. This will depend in part on how past debt is treated.

The treatment of past debt potentially presents a difficult issue for the establishment of the CHEs. (The issues are not considered in detail here - they are the subject of a separate study commissioned by the NIPB.) In some cases the debt burden of area health boards is high because managers have failed to keep within operating budgets or have failed to manage finances to reduce the debt. In writing off debt (i.e. government bearing the cost) to establish CHEs on a commercial basis (if this is indeed necessary), it will be important to signal to the new managers that poor financial management will not be tolerated. This . could be achieved for example, by not appointing managers who have been responsible for poor financial performance in the past.

In addition, to ensure neutrality, the CHEs should be required to earn a weighted average cost of capital (return on equity and debt) comparable to that earned in the private sector in activities with similar risk characteristics. This may be difficult to achieve. For example, - it is difficult to ensure that state organisations face the real cost of debt. Although government may remove explicit guarantees of debt and require public providers to borrow from the private sector, investors may well take the view that government would not stand

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aside and allow a major public hospital to fail. Any resulting implicit guarantee would provide CHEs with access to debt at a lower rate than private providers.

The required return on equity should be appropriate to the systematic risk of health care provision and as such should be comparable to that faced by other private sector health care providers. An estimate of the required rate of return can be made using the capital asset pricing model drawing on US data on listed health care providers. However, there are a number of difficulties with this approach. A major problem is that the risk characteristics of providers in the US are very much influenced by the methods of reimbursement adopted by funders. These allocate risk between the funders and providers and are likely to be different in New Zealand. While calculating a cost of capital is straightforward in concept, the limitations of the SOE model, including difficulties in monitoring performance, mean that governments frequently face severe difficulties in ensuring that the businesses they own earn adequate risk-adjusted returns.

5.2.23 Ability of CHEs to Fail

Private sector providers are concerned about the scope for public providers to "predatory price" services where they face competition or, through incompetence get the pricing of services "wrong, and in the process force private sector providers out of the market. They note that given the lack of information on the costs of services and the joint costs involved in producing different services, predatory pricing could be unintentional or readily disguised

Predatory pricing may be a sensible strategy for an organisation if it is confident that government will bail it Out in the event of failure. NZ Railways arguably used this strategy to prevent competition on the Cook Strait run for a number of years. A public organisation need be less concerned about ensuring that pricing covers costs if it is protected from the risk of bankruptcy. Given political sensitivity about the provision of health care services, and doubts over the ability of politicians to make tough decisions at all times, there is a strong likelihood that government would wish intervene to prevent a major hospital failure or would allow a community bail out through establishing a community trust. However, it is important, if competition is to develop, that institutional structures are established that make such intervention more difficult and allow failures where performance is poor. As well, consumer, attention needs to he focused on the RHAs when individual providers are in difficulty - the RHAs must be able to reassure clients that the desired services will be available from other providers, that the failure of one provider is unlikely to adversely

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affect overall health care provision to the region, and that failure will ultimately lead to better outcomes.

Even if public provider assets remain in operation, the dismissal of management teams and boards provides an effective means of ensuring that managers recognise the costs of bankruptcy. In addition, given that many of the important budgetary decisions are made at the clinician level, clinician service teams could also be subject to the threat of dismissal for over spending budgets or failing to meet the goals established. This does not remove the risks for private competitors if the business is automatically re-established on the same basis not it is a viable operation. Given the large scope of the regardless of whether or . restructuring, and the uncertainty over the desirable future shape of providers, an optimal reform process would almost inevitably involve multiple business failures or conversion of providers to different forms, e.g. conversion of an acute hospital to a nursing home.

5.2.2.4 Political Involvement in CHEs

An important part of ensuring competitive neutrality between public and private providers will be minimising political interference in the operations of the public providers (beyond that reasonable for a shareholder in the organisation). Given that many concerns about "fairness" relate to the funding of health care services, the RHAs are likely to be subject to political pressure on many access and quality of service issues. However, political pressure is also likely to be imposed to prevent public providers rationalising surplus assets, leasing or selling them to private providers or closing down hospitals that are not viable. Any action that implies reduced services to some individuals, changes the way services are provided, or affects some of the powerful employee groups, is likely to be met with a strong political reaction. If politicians respond by subjecting management to pressure not to take difficult decisions, or to favour particular groups in a non-transparent way, they will compromise the accountability and the incentives for management performance. The model proposed in Section 6.0 reduces the scope for political pressure on the individual CHEs. Instead, politicians should refer pressure back to RHAs; a major role of the RHA is to act on behalf of Consumers and to reflect their preferences. The RHAs will have to be able to persuade their clients that the closure of a particular provider unit will not affect the quality of services. While RHAs remain monopoly funders the main avenue for consumer pressure will be via the - political process. Once competing health plans are available, individuals will be able to change plans if dissatisfied with the range of services offered by the RHA.

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5.2.2.5 Tax Exempt Status of Not-For-Profits

Our preferred "default" option for the CHEs involves their establishment as commercial organisations. As such, they would be required to pay tax on the profits that they earn. This will place them at a disadvantage vis-a-vis private not-for-profit health care organisations that are tax exempt. in our view, there are no sound tax policy reasons for retaining the tax exempt status of health care services provided by not-for-profit organisations and government should remove this non-neutrality. The tax exemption distorts choices about appropriate organisational form thereby introducing inefficiency. It allows organisations to gain advantages that are not available to other businesses which differ because of their ownership structure. The exemption provides a loophole that can be exploited to extend tax exemption into areas not previously envisaged by government. If government wishes to encourage certain activities, e.g. some forms of charity, this can generally be achieved more efficiently through a direct subsidy. A complete analysis of this issue is outside the terms of reference of this study.

5.2.2.6 Planning Controls

One of the hidden barriers to new private providers in the UK has been planning law. Local authorities opposed to private health care have sometimes used planning controls to prevent capital development.79 This should be guarded against.

5.2.2.7 Compensation of Specialists

Some commentators have suggested that public hospitals have a comparative advantage over private hospitals because the former employ specialists on a salary basis at a relatively low cost. Specialists in the public sector receive in the order of $80,000 to $100,000. Specialists working in the private sector on the other hand, work on their own account, contracting to use the facilities of the private hospital and charge their customers on a fee- for-service basis. We understand that a top specialist operating in the private sector can earn around $500,000 per year.

Dr David Green, pers Comm, 1991.

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The difference in compensation arrangements are possible, it is argued, because working in the public sector provides a wider range of experience, more interesting work, an opportunity to teach young doctors and the possibility of undertaking research. Since this type of experience is available only in the public sector, some specialists are prepared to accept the pay offered by the area health boards. In addition, some specialists are attracted to work in public hospitals in part because of their commitment to the public, rather than as a means of maximising their income.

Three observations can be made about this situation: first, anecdotal evidence suggests that the output achieved by a surgeon in the public sector is lower than in the private sector. For example, in the public system operating sessions are frequently cancelled without prior notice even though theatre staff must be paid irrespective of throughput. This type of outcome is not unexpected when the specialists are not rewarded on the basis of throughput. In addition, there will be a degree of "self-selection involved with those people willing to undertake a larger number of procedures gravitating to the private sector in order to generate higher incomes. As well, surgeons operating in the public sector often demand higher standards of backup and facilities than they receive in private hospitals, e.g. higher number of theatre staff. As a result, it is not clear that the quality-adjusted price per unit of output is lower in the public sector.

Secondly, once the reforms are implemented, there will be increased scope for the private sector to offer a broad range of services, rather than filling the gaps in public provision. As a result, private hospitals may be able to take on some of the more interesting acute work that currently attracts individuals to work in the public sector- Thirdly, public providers are likely to have greater flexibility in the new environment to respond through more innovative contracting arrangements with surgeons (note that already the Nelson /Marlborough Area Health Board has moved to employ its clinicians on a contract basis). The adoption of a more commercial approach to health care provision, may however, attenuate the commitment of individuals to working for the public good rather than direct remuneration.

Overall, it is difficult to predict the employment arrangements that will be adopted in a competitive environment and in particular, whether consultants will continue to be employed on a salary basis in the public sector, and a fee for service basis in the private sector, and whether the arrangement whereby specialists work in both the public and private hospitals will be sustainable. However, it appears unlikely that in the medium term, the public sector will have a major comparative advantage in attracting and paying for specialists.

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52.3 Risks for New Entrants

In the last few months the Government has backed down on a number of major policy initiatives announced in its 1991 Budget. These policy changes have increased uncertainty about the Governments commitment to major structural and politically difficult reform. This concern is reinforced by the lack of any concerted attempt by the Government to "sell" the proposed health reforms to the public, and statements by the Minister of Health suggesting that implementation of certain aspects of the reforms might be delayed.

The uncertainty generated increases the risk for private providers considering the provision of core health services and therefore decreases the likelihood of entry. Potential entrants are forced to bear not only the competitive risk of entry but also the risk that the policy environment will change. The latter is essentially beyond their own control and therefore much more difficult to manage.

Political uncertainty is also likely to affect the form of entry. Private sector operators are less likely to invest in specialised assets with little residual value while there is considerable uncertainty as to whether the Government will •proceed with the reform. Instead, the private sector will be likely to prefer to lease and refurbish existing assets. This option might make sense in some cases anyway given the overprovision of hospital assets in both the private and public sectors. A critical ingredient for the success of this approach is the availability of facilities, particularly surplus public assets. The process adopted for the establishment and management of CHEs must ensure that managers have incentives to lease or otherwise dispose of surplus assets.

Political uncertainty also risks demotivating those individuals in the public system who are implementing changes in conformity with the directions signalled earlier by the Government. Bay of Plenty Area Health Board have, for example, noted that they are reaching the limits of the reform that can be achieved within the current institutional structure. Key managers are currently motivated by the prospect of further change. This motivation could be damaged if the Government were to back off the reform process. Political uncertainty may, on the other hand, provide comfort to those individuals that have not had the courage or commitment to push through difficult restructuring decisions. Lack of certainty over political Commitment and the failure of the government to "sell" health reforms has been identified as a problem in the UK reform process. The UK reform is discussed in more detail in AppenJix C.

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Uncertainty over political commitment to the process of reform may also affect the preferred organisational structure for CHEs (discussed in more detail in Section 3.0 and even calls into question whether or not any changes should be implemented). The SOE process emphasises the importance of establishing an arms-length relationship between politicians on the one hand, and boards and managers on the other. it highlights the importance of appointing individuals for their management and commercial skills. In the absence of political commitment to this approach it will be difficult to motivate managers and hold them accountable for their performance. Government is also likely to experience difficulty in attracting excellent board members and management to the cHEs exacerbating the incentive and accountability problems. At the extreme, if political commitment to a commercial approach is absent it may be preferable to make no changes at all rather than implementing a costly restructuring process which could then be expected to achieve little.

- Commitment to implementing the full set of reforms, i.e. to reform on both the provider and funder sides, is also critical to the success of establishing providers on a more commercial basis. In particular, the RHAs must be established, as far as possible, on a commercial basis and exposed to competition from alternative health care plans. As explained below, in the absence of competing health care plans, the gains from commercialisation of CHEs are likely to be undermined over time.

5.2.4 Importance of Competing Insurers

Major gains from reform of health care funding are unlikely unless the competition between health plans envisaged in the green and white paper is allowed to develop. With monopoly public funding, consumers are constrained from using their insurance purchase decisions to express preferences or dissatisfaction with the type of coverage offered and the ability of the health plan to control costs. A monopoly health plan is therefore unlikely to have strong incentives to act as a prudent purchaser in contracting for services on behalf of consumers. Thus, in the absence of competition between health plans, pressures for productive efficiency in the hospital sector may be weak, undermining the gains from establishing competition in the provision of health care services. In the case of a government-owned monopoly health plan, the difficulties are exacerbated by the relatively weak incentives for monitoring of performance by the owners (taxpayers) of government-owned enterprises.

On the other hand, competition among health plans would achieve the following:

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greater satisfaction of diverse preferences. Consumers may differ in their willingness to accept copayment, or constraints on use in return for lower premiums, and in the types of services they wish to use. The ability of consumers to choose different health plans provides incentives for health plans to meet the preferences of individuals in terms of insurance policy options and to provide such insurance at minimum cost.

competition provides incentives for health plans to apply pressure on providers to improve quality or minimise costs. This pressure reinforces the potential gains from competition at the provider level.

competing health plans provide greater stimulus and efficiency in controlling moral hazard. This applies to the prevention of illness as well as to the use of medical care. However, off setting these gains will be an increase in administrative costs involved in reclaiming money from multiple funders and the method of funding (through the RHA) proposed in the green and white paper. Until competitive health plans are allowed (from July 1993) the RHAs will be monopoly funders of core services. Given the difficulties of:

defining the services that should be provided;

measuring consumer satisfaction with the RHA; and

defining accountability where the monopoly insurer has no underwriting flexibility and limited flexibility in benefit mix;

there will be problems in establishing RHAs on a fully-commercial basis and holding them accountable for their performance. Similar problems have been experienced with the Accident Compensation Corporation ("ACC"). For example, the ACC has failed to take basic steps to match premiums with insurance costs thereby seriously eroding incentives for efficient levels of safety and rehabilitation and distorting resource allocation towards risky individuals, firms and activities. In measuring its efficiency, the ACC places great reliance on minimising administration costs. However, while administration costs are low, expenditure on benefits has increased dramatically in real terms over the years the scheme has been operating. The lack of competition at the funder/purchaser level has been identified as a problem in the UK reform process (discussed in more detail in Appendix C).

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To maximise the performance of the RHAs it will be critical to ensure that their role is defined carefully, their behaviour is monitored closely and skilled people are attracted to work for them. Some performance monitoring can be achieved through information collection and the comparison of the performance of different RHAs. It might also be possible to allow individuals to switch between RHAs; thus undermining the element of geographic monopoly and providing some competitive pressures on RHAs. The achievement of this objective is the responsibility of the Health Reform Directorate.

5.2.5 Power of Medical Practitioners

Medical practitioners will play a major role in any restructured health system. There is a I widespread perception at present that specialist medical practitioners are in "short supply" (at least in some specialties) and concern has been expressed that regulatory limitations on the numbers of specialists may adversely affect the reform process. In particular, it is suggested that anticompetitive behaviour on the part of medical specialists may impede the development of innovative and competitive methods of health care (an outcome that has been claimed for the US). The latter was discussed in more detail in Section 4.3.2 above.

In this section, we examine the regulatory and professional restrictions on medical practitioners and review the evidence on the ability of the medical profession to restrict competitive initiatives.

5.2.5.1 Regulatory Barriers

The main statute regulating the medical profession is the Medical Practitioners Act 1968. The Medical Council, comprised mainly of medical practitioners, is constituted under the Medical Practitioners Act as the licensing authority which determines which medical practitioners can be registered. The Council receives, evaluates and makes decisions regarding all applications for registration. There are several types of registration with prescribed qualifications and training and various restrictions on type and length of practice. The mandate of the Council is comprehensive, providing it with considerable discretionary power in evaluating applications for registration. The Council may reject an application if it considers the person unfit to be registered because he or she is "not of good reputation or character". An applicant refused registration has the right of appeal to the High Court. A register of all registered medical practitioners is maintained by the Council and is open to public inspection.

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It is an offence under the Act for an unregistered person to "practice medicine or surgery.. under the style or title of a physician, doctor, surgeon..." or under any description that implies he or she is qualified to practice medicine. The Act also specifies that certain appointments may only be held by registered medical practitioners.80

Under the Medical Practitioners Act, the Medical Council maintains a register of medical practitioners possessing specialist status. The Medical Practitioners (Registration of Ii Specialists) Regulations 1971 designate the degrees, institutions and colleges (both in New Zealand and overseas) which are recognised as qualifications for the various specialties. The medical practitioner must also be recognised by his or her colleagues as having training, experience, and competence in the specialty before being included in the register. The specialist is expected to, as far as is practicable, confine his or her practise to the specialty. I Specialists are certified rather than licensed and have exclusive right to use the title of specialist, but uncertified persons may offer the same or similar services as long as they do not call themselves a specialist.

Fellowship and/or membership in the following colleges which are statutorily recognised in New Zealand can lead to registration as a specialist: Royal Australian and New Zealand II College of Psychiatrists: Australasian College of Dermatologists; Faculty of Anaesthetists; Royal New Zealand College of General Practitioners; Royal Australasian College of Physicians; Royal Australasian College of Surgeons; New Zealand College of Obstetricians and Gynaecologists and New Zealand College of Community Medicine.

Each college has its own defined entry requirements such as a specified period of hospital or general practice experience. Written and oral membership examinations are carried out by the colleges to test clinical skills. Once the relevant training is completed and the examinations are passed, members are elected to the college. 81 In considering specialists from overseas, the Medical Council takes advice from the colleges on the appropriate standards to apply.

Specialists trained in the UK or Australia generally have little difficulty in achieving registration in New Zealand. Applicants that have recognised qualifications and the required supervised training and experience can be processed by the Council reasonably quickly. However, it is more difficult to assess specialists that have qualifications that are

80 Treasury Working Paper, 1987, pp 12. 81 ibid.

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not recognised under the Medical Practitioners Act or the Registration of Specialists Regulations 1971. Equivalence of supervised training and experience is difficult to determine in the absence of formal certification and, in some countries, less experience is required as part of specialist training. For example, specialists from the US and Canadian undergo a shorter specialist training period and are less likely to meet the requirements of the colleges. As a

1 result, they sometimes need a period of "supervised training" on arrival in New Zealand even though they might have many years of experience.

Specialists without recognised training (i.e. those whose basic medical degree was not obtained in Australia, Canada, South Africa, UK or the Republic of Ireland) and for whom there is no direct entry must pass a sequence of Registration Examinations leading to I temporary and probationary registration. The screening examinations test the candidates standard of basic education, proficiency in English and medicine. A pass in the screening examination allows the candidate to work in a hospital under close supervision. During this period doctors complete their general training but a few embark on specialist training. Further examinations, which test the candidates professional knowledge in basic sciences and clinical topics must be completed during the two year period of temporary registration to complete their general training. The candidates must achieve a pass of the same standard as that required of New Zealand undergraduates at fifth year level.82

Overseas specialists who satisfy the requirements for eligibility to be registered for general practice, or the medical specialties, according to the standards of training, experience and competence set by the Council in consultation with the Colleges, but who do not have basic registerable degrees may be required by the New Zealand Colleges to undertake a years work under supervision as a registrar (i.e. they are exempt the Registration Examinations). However, the number of registrar posts, which is determined by the area health boards, is strictly limited and competition for them by New Zealand trainees is vigorous.83

The Medical Practitioners Act is currently being revised with officials expecting the Minister of Health to introduce a Bill to the House next year. The Bill will free up some of the more restrictive provisions relating to registration of medical practitioners and certification of specialists from overseas. In particular, it will remove the role of the colleges in determining the standards for foreign medical graduates with this role being assumed by the Medical Council. A wider range of countries would be recognised as providing suitable training for specialists. This move should assist in increasing the recruitment of overseas specialists and

82 Medical Council of New Zealand (1991), Annual Report, pp 16-17. 83 ibid.

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reducing the degree of market power which is conferred on existing specialists by the current regulatory regime..

The regulatory restrictions on registration, the demanding standards required by the Colleges for registration, and the procedures adopted by the Council (in particular, their general acceptance of the standards set by the Colleges) are likely to be in part responsible for the apparent shortage of specialists and is likely to confer on them some degree of market power.

However, the pool of specialists . from the UK and Australia who would be qualified to work in New Zealand is large relative to New Zealands requirements, and sufficient numbers could be attracted if remuneration and conditions were sufficiently attractive. The relatively low salary structure adopted by the public sector and the small size of the private market in which substantially higher fees can be earned is in part responsible for the suggested shortage of specialists in New Zealand. In addition, it is likely that the output per clinician could be increased substantially if the incentives for performance in the public sector were improved.

Although the regulatory environment may, to some extent, constrain the supply of specialists, our initial assessment is that the restrictions on supply should not constitute a major barrier to competition from new health care organisations.

5.2.5.2 Medical Ethics and Etiquette

The New Zealand Medical Association ("NZMA") is a company registered under the Companies Act 1955. Its memorandum of association states its objectives to include acting as a corporate branch of the British Medical Association, promoting in New Zealand the medical and allied sciences, and maintaining the honour and interest of the medical profession. Any legally-qualified medical practitioner residing in New Zealand and registered under the Medical Practitioners Act is eligible for membership. It is estimated that around 80-85 percent of registered medical practitioners are members of the NZMA.

The ethical code of the NZMA sets out the definitions, rules and practical applications of ethical. principles. Standards regarding the following are specified:

the doctor-patient relationship, for example a practitioner should not attempt to secure the care of another practitioners patient for him or herself,

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etiquette pertaining to setting up a practice, for example it is obligatory to confer with colleagues already practising in the area; and

the ethics of advertising - it is held to be unethical to advertise except in special circumstances such as commencing, changing or resuming a practice.

These requirements are currently being reviewed by the Medical Association and provisions are likely to be made less restrictive. The ethical requirements can provide a vehicle for anticompetitive behaviour, particularly if membership of the association is valued by medical practitioners.

5.2.53 Antitrust Issues Involving Medical Practitioners

There is some anecdotal evidence of subtle but real pressure being exerted by medical practitioners in New Zealand to oppose competitive initiatives by some doctors. This has been achieved, for example, by general practitioners refusing to make referrals to specialists involved in competitive facilities. One area health board we talked to tried to increase utilisation of its facilities by employing a specialist on a fee-for-service basis to undertake simple surgical procedures, targetting patients from an adjacent area. The initiative was suspended when specialists in the area concerned threatened to "blacklist" the surgeon employed by the board.

As discussed in Section 4.0, the threat of boycott by physician groups has been interpreted as retarding the initial growth of innovative funding schemes in the US. This was achieved by groups of local doctors excluding doctors practising in HMOs and PPOs from membership of medical societies. However, more recently, a series of land mark antitrust actions and decisions have rolled back anticompetitive actions by the medical profession. It will be important to ensure that anticompetitive practices within the health sector are subject to New Zealands Commerce Act.

It is sometimes argued that professional monopoly power is inevitable and government should protect the consumer by establishing a countervailing monopoly, particularly to control professional remuneration. The counter argument is that professional monopoly power results, not from an inherent tendency of markets, but from capture of the state by organised medicine (thus for example, allowing limitation of the supply of doctors). The better remedy is to deregulate medicine, not to entrench the power of the profession by creating a state monopoly service.

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Section 4.3.3 above discussed the changes to the Commerce Act that would be necessary to ensure that the Commerce Act has comprehensive application to CHEs following their establishment.

5.2.6 Industrial Relations J.",

Industrial relation issues will be important in restructuring CHEs but no major legislative barriers to change exist. Instead, inflexible work practices are enshrined in award agreements. The Employment Contracts Act provides the opportunity for CHEs to negotiate flexible staffing arrangements which are more closely related to the requirements of particular institutions. The threat of competition from other CHEs and the private sector will provide a strong impetus for management and employees to negotiate efficient work arrangements.

The 1991 amendment to the Area Health Boards Act states that "the State Services Commission shall be responsible for negotiating under the Employment Contracts Act 1991 every collective contract applicable to employees of area health boards". The State Services Commission ("SSC) must consult with the general manager of every affected board. The Act states that the collective contract is between the SSC and affected employee group. The contract negotiated is binding on the general manager of the board. The SSC can delegate its power to the general manager of a board.

Some area health boards have expressed frustration over the SSCs preference for a national collective document for some employee groups and with its resistance to delegate bargaining responsibilities to the area health boards.

In a competitive health care market there will be no useful role for the SSC in industrial negotiations other than for it to offer its services to CHEs in competition with other bargaining agents. Responsibility for dealing with labour matters should be delegated to the managers of individual CHEs. In this regard it can be noted that negotiations with their employees enabled significant reform of labour practices and enhanced productivity to be achieved.

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5.3 Contracting Issues

The timing of the implementation of (under and provider reform and the contracting arrangements between RHAs and public providers will have a significant impact on the future shape of CHEs and on the success of the provider reform generally. As discussed in Appendix C, contracting issues have been of major concern in the UK reform process. These issues are discussed below.

5.3.1 Coordination of Funder and Provider Reform

Coordinated implementation of the reform of funding and provision will be essential if the benefits of the reform programme are to be maximised and unnecessary transitional costs are to be avoided.

5.3.1.1 Development of Contracting Arrangements

The development of formal and robust contracting arrangements between arms-length providers and purchasers is likely to be one of the most difficult elements of the reform process. Even in a market such as the US that has been exposed to competition over a long period, the process of designing contracting arrangements that provide incentives for cost control and the delivery of the services desired by individuals has been problematic. However, it is difficult to disentangle the problems of designing contracts in the US with tile distortions created by the tax subsidy to health insurance which has mitigated the effect of cost control mechanisms. Sf At the moment, only crude contracting arrangements exist between the Department of Health and area health boards and there is only limited contracting experience within the area health boards. As a result, to gain valuable experience in contract design and enforcement, it is essential that progress on developing contracts occur as quickly as possible. As well, it is essential that purchaser and provider skills are developed in tandem and that reform of providers does not get ahead of the ability of contractual arrangements to ensure that providers deliver the quality and cost of services the RI-lAs and their clients desire.

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5.3.1.2 Impact of Reforming Providers Ahead of Funders

Providers will be operating in an uncertain purchasing environment until RHAs (and competing health care plans) define the services they wish to acquire, how they want them to be delivered and from whom they will buy them. In the absence of this information, there is a risk that costly restructuring will be undertaken which will turn out to be inappropriate for the choices that are eventually made by the RHA. Similarly, opportunities for restructuring may be lost or delayed because of uncertainty over the eventual shape of the demand for services from the RI-lAs. On the other hand, the uncertainty could force the CHEs to focus on their true cost structures and areas of comparative advantage rather than distorting their set up in order to "game" the reimbursement system.

Establishing existing public providers as CHEs before the reform of funding also risks signalling that little change is intended in the way that care is delivered. It may be much easier for RHAs to facilitate radical change in service provision (if this is considered desirable) while provider organisations are in a state of transition. Failure to act quickly might entrench existing provider arrangements and lead to future resistance to charge.

A third problem is that reform of the providers before the funders might result in the most skilled managers from within the health system being attracted to provider units with RHAs then struggling to recruit good personnel. This has been a problem in the lJKbecause of the priority given to provider reform (see Appendix C). However, it does not preclude skilled managers from being recruited from overseas or from outside the health system.

5.3.13 Cost and Quality Control

The current contracting arrangements between the Health Department and the area health boards have been relatively successful in controlling the overall budget cost of health care provision (although this does not take account of costs such as waiting times and the non- provision of valued services). Area health boards are required to keep to their budgets and additional funding is not available when they fail to meet targets. Incompetent boards have been sacked or threatened with sacking for mismanagement of funding (e.g. the Auckland Board was replaced in 1989 by a commissioner). The system is far from perfect; for example, some boards have deferred maintenance of buildings in order to meet operating requirements and in any case budget costs do not necessarily provide a meaningful measure of real social costs. Nevertheless a cap on expenditure has been maintained. It is important that cost

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The contracting arrangements between government and the RI-LAs, and between the RHAs and providers will be important in ensuring that cost escalation does not occur. For:example, the use of retrospective payment systems in the US resulted in serious cost escalation problems. As discussed in Appendix D, the subsequent move to prospective reimbursement and DRG-based payments were designed to restrict cost increases. The slow down in cost escalation in the US in recent years demonstrates some success with this approach. However, reimbursement-based on the average cost per case can encourage hospitals to select the cheaper cases, or the pressure on costs may result in hospitals attempting to cut back on quality. In the US, the prospective payments have been limited to inpatient care resulting in an incentive to transfer patients to outpatients or day care. These issues are discussed in more detail in Appendix D. Despite considerable research effort in the US, a means of incorporating physicians payments in prospective payments has not been developed and they are paid on a fee for service basis. Hospitals in the US have attempted to control physicians through utilisation reviews.84

To avoid the problems experienced in the US, RHAs must design contracts that give providers strong incentives to control costs and ensure that patients receive appropriate treatment. Many of the costly decisions on health care expenditure are made at the clinician level, and because there are no generally accepted or standard responses to different conditions, wide variations in the nature, quality and cost of treatment can be observed for comparable conditions. Thus underservicing, overservicing and inappropriate servicing of patients is a potential problem that must be addressed by the RI-IA. One possible response would be for RHAs to define in greater detail appropriate standards of treatment for different conditions85 (the DRG approach is one possible approach that could be considered). As discussed in Appendix B, there are a number of government and private sector initiatives in the US aimed at defining appropriate standards of care. A review of the standards adopted could yield useful information for New Zealand.

Monitoring treatment might also be enhanced through voluntary information sharing arrangements between RI-lAs. The RHAs could exchange information on costs for different treatments, quality of outcomes and so on and establish a central data base for use by all of the

84 Culyer, A.J. and Brazier, J.E. (1988), Alternatives for Organising the Provision of Health Services in the UK, Working Paper No 4, University of York. 85 Professor North, pers. comm., 30 December, 1991.

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RHAs.86 Cooperation between RHAs might also enhance their countervailing power vis-a- vis the provider units (the impact of the countervailing power of the RHAs is discussed in more detail in Section 45.3).

Cost incentives will be reinforced by government limiting RHA budgets. If the RHAs are unsuccessful in controlling provider costs, the government will come under increasing pressure to increase their funding to ensure that everyone has access to the core services. As part of this review it would be useful to study in detail experience in the US of HMO contracting with hospitals and the selective contracting of the California Medicaid programme.

5.3.2 Transitional Arrangements for Contract Development

Because of inexperience with contracting arrangements and the major difficulty of contracting for desired outcomes rather than outputs, the transition from area health boards in which purchaser and provider functions can be organised within the same organisation, to arms- length contracting between RHAs and CHEs and between the RHAs and government, must be handled carefully.

Strictly speaking.. RHAs should be concerned about health care outcomes rather than with the output of health services (for example the number of operations conducted per se). However, the impact of health care on health status is complex and often very difficult to define and measure, particularly in the short term whereas outputs are usually easily identified. But in contracting for outputs it is difficult to ensure the services are provided having regard to desired outcomes. For example, a contract for hip replacements, unless carefully specified, may provide incentives to maximise the number of such operations rather than to ensure that operations are carried out only if they would enhance substantially an individuals wellbeing. These problems emphasis the importance of the RHAs introducing review procedures, compulsory secp!id.opinions and so on if these are efficient mechanisms.

The difficulties of specifying the outputs providers need to produce to achieve desired outcomes, means that the relationship between funders and providers will involve considerable complexity and uncertainty. The greater the complexity and uncertainty surrounding a transaction between two parties, the more difficult and costly it becomes to design and enforce an explicit contract that tightly controls undesirable behaviour under a range of feasible contingencies. While it is possible to design increasingly complex contracts,

86 ibid.

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this increases the cost of writing, administering, and enforcing contracts and can also reduce the flexibility of the-relationship to respond to unanticipated circumstances.

The strict interpretation of contract terms is more likely when contract parties are operating at arms length. Decisions made by individuals within a single organisation are less constrained by explicit contractual terms and individuals rewards are more likely to be based on their contribution to the overall goals of the organisation rather than to the strict achievement of contractual objectives. As long as the provider organisations are part of the same organisation as the finders, they are more likely to share elements of the same philosophy and to take into account the overall goals of the organisation. Providers are more likely to be rewarded if they achieve goals that advance the interests of the organisation rather than achieving strictly defined contractual terms. (This will have a positive overall outcome only if the organisation has the right objectives - a difficult outcome to ensure.) As a result, in the early stage of contract development, greater flexibility may be achieed by establishing contracting arrangements and sanctions that retain the benefits of contracting within an organisation. As explained in Appendix A, this approach has been successfully trialled by the Bay of Plenty Area Health Board.

However, incentive problems mean that internal contracting arrangements are unlikely to be preferred in the long term. For example, the purchaser provider roles inherently involve a conflict of interest for commissioners (one of the main reasons why the separation has been advocated). As experience with contracting increases through time, the relative costs of contracting will decrease and formal separation to arms-length arrangements will become more appropriate.

In the long term, there may be some costs associated with the enforced separation of funding and provision. These costs are difficult to determine a priori, but the observation of vertical integration in the US for organisations such as HMOs and, in New Zealand, the integration of insurance and hospital provision in the case of Southern Cross indicates that they are potentially significant. On the other hand, non-vertically integrated organisations also compete successfully in the US and New Zealand. 87 In addition, some reintegration can be achieved from the provider level. For example a hospital could contract with other providers so that it could offer a comprehensive range of services, contracting with the RHA on a capitation basis. Such developments may constitute the embryo of new health care plans and should therefore not be inhibited.

87 Danzon, P. and Begg, S. (1991) Options for Health Care in New Zealand, New Zealand Business Roundtable, pSi.

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As long as the insurance function is a public monopoly, its separation from the provision of health services will be desirable in order to stimulate the potential efficiency gains from competition at the provider level. If the efficiency benefits of vertical integration are large, private plans are likely to develop in competition with the RHAs. Eventually, once competition at the funder level develops, RHAs may be allowed to reintegrate the purchaser provider functions (the integration may not necessarily involve only public providers). The proposed separation could therefore be viewed as a transitional phase, modified as necessary in the light of experience with the reform.

5.4 Structure of CHEs

5.4.1 Current Configuration of Public Assets

Our discussions with area health boards indicate that many of the boards are burdened with excess capacity, poorly located facilities, and buildings that are inappropriate to the modern delivery of care. The Audit Office notes that poor estate management by area health boards has resulted in the following:

the acquisition of unnecessary property;

0 new facilities built either too large or too small;

health services not located in the best position;

0 buildings over- or under-maintained;

0 unused or under-used property.88

Land and buildings in the health sector represent substantial capital investments and an ongoing commitment of funds. Capital invested unnecessarily in property diverts resources away from the provision of health services. As a result, it is essential that CHEs are provided with incentives to dispose or lease surplus assets and rationalise existing resources. Unless they have the freedom to achieve this, CHEs will be burdened with extra costs and valuable assets will be underutilised or idle. Note also, that as discussed earlier, the

88 Audit Office (1991), Area Health Boards: Effectiveness and Efficiency of Estate Management, pp 1-2.

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rationalisation of public assets may be important in facilitating entry by new providers. Given the overcapacity of hospital facilities and the political uncertainty facing private operators, the option of leasing or buying existing public health facilities is likely to be preferred by some new entrants. Once they are more comfortable with the political sustainability of the reforms, private investors may be willing to invest in new assets where this allows more appropriate care to be delivered. Given the limited alternative uses for old hospitals, this option of utilising public assets is likely to be optimal from the point of view of government as well.

Claims under the Treaty of Waitangi may prevent some CHEs disposing of surplus assets. These issues will be the subject of a separate study by the NWB. Constraints may also be imposed where assets were donated to boards.

5.4.2 Incentives for Divestment of Assets, Mergers and Takeovers and Contracting Out of Management

As discussed in Section 4.0, a major objective of the reform process is to enable the least-cost transition from the current configuration of public health infrastructure, skills and organisation to the configuration most appropriate to the future pattern of health care demands. If the process adopted allows the structure of providers to change through mergers, break ups and spin-offs of surplus assets, then the initial starting point chosen by the NIPB will be less critical than it might otherwise be. In the absence of such flexibility, the NIPB may have to decide (for reasons of productive efficiency rather than competition considerations) whether as a starting configuration the providers should, for example, be broken into smaller units, or integrated into a national chain.

In Section 3.0, we recommended that the default organisational form for CHEs be a model in which the objectives set for CHEs are purely commercial ones. Shareholder Ministers would act as owners, and managers would be accountable to shareholders through appointed boards. A key issue is whether this model is robust in giving managers and board members appropriate incentives to form larger aggregated groups or to break up organisational structures, establishing entities that are separate from the original organisation.

The adoption of a commercial objective for CHEs, with sound monitoring and rewards for good performance, should provide incentives for managers to 5perate their businesses efficiently. Provided there are no constraints on the flexibility with which managers respond to the incentives given, this, along with exposure to competition, should encourage managers to:

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sell surplus assets (the organisation should retain the returns from the disposal of assets). Some area health boards have already disposed of surplus assets;

• contract out services or inputs that can be provided at lower cost by outside parties, including existing employees (note that in some area health boards, contracting out • of services such as catering and laundry is already occurring as management responds to more stringent budget controls);

transfer assets to community trusts;

enter joint ventures or strategic alliances where this involves managerial, cost or technological advantages (for example, area health boards have banded together for major equipment purchases, but as yet have not actively pursued joint venture options); and

expand the scope or scale of the CHEs operations when this would allow consumer demands to be met more efficiently.

If establishment boards are given the mandate of establishing commercial operations and attracting the best available management teams, they should have incentives to consider as an option contracting out management to private hospital operators.

It will be more difficult, however, to provide incentives for establishment boards and CHEs to consider mergers or-divestments of entire operating entities or major blocks of assets in the absence of a takeover market. In any organisation, private or public, managers often strongly oppose corporate restructuring that would reduce the size of their organisation or result in its merger with another, if this would involve a loss of position or power for the manager. In the private sector, defensive mechanisms by managers are controlled through the takeover market and the market for managers. 1 When management performance is poor in the corporate sector, or where existing managers are missing important opportunities to use resources efficiently, expected future cash flows will be reduced and the share price depressed relative to what could be achieved. Another management team which is better able to utilise the companys assets will be willing to pay more than the existing price to acquire shares and put them to better use. While the takeover mechanism is not costless (for-example poor management teams are able to erect defence

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mechanisms which slow down takeover activity), it does nevertheless, establish a process whereby rationalisation of the structure of an organisation can occur through time.

As government-owned enterprises do not have transferable shares, it is not possible for public enterprise to be taken over through the aggregation of shares. The absence of competition for control removes the possibility of a takeover by an alternative team which recognises a value-creating opportunity. It removes one of the major incentives for managers to consider value-enhancing restructuring options. Instead, a more limited number of restructuring mechanisms for CI-lEs exist. These are discussed below.

Individual CHEs could achieve some economies of scale through contracting between firms. For example they could share facilities or undertake joint purchasing.

Government as shareholder could decide that a merger or spin off would make commercial sense. However, the monitoring arrangements for public enterprises and the arms-length relationship of Ministers from the organisation makes this unlikely. Generally, Ministers are unlikely to have the necessary information, resources or incentives to make such decisions (which is one of the key reasons for them appointing a commercial board to CHEs).

Alternatively, the board of a CHE could decide that a spin off makes sense. However, while in the past some minor divestments of functions by SOEs have been observed, management teams and boards have in general not attempted to set up viable operating units as separate SOEs. Instead, they have tended to favour relatively autonomous operating units within the overall corporate umbrella. The approach is not surprising given the impossibility of completely replicating private sector commercial incentives (and particularly the range of potential shareholders that might perceive a restructuring opportunity) and , the strong tendency for managers and board members of any organisation to favour larger rather than smaller operations. In addition, in the absence of a share price, it may be more difficult for a board to determine that opportunities are being missed.

Another option would be for the boards of separate CHEs to decide, that a merger makes commercial sense. The major difficulty with this approach is that following amalgamation only one board will be required, and some rationalisation of management may take place. As a result, the initiative may be strongly opposed by managers who might lose their positions / and possibly by directors who would lose their board position These individuals would be in a stronger position to block such restructuring than they would under private ownership.

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These options do allow scope for some rationalisation to occur through time. However, the process is likely to be much slower than if the assets were privately owned. This is a major concern and possible problem in the restructuring process given the massive restructuring that may be required and the difficulty of determining a priori the most appropriate arrangements. It means that unless these incentives issues can be resolved, greater emphasis on the initial configuration of provider assets will be important. These issues are addressed in more detail in Section 6.0.

5.4.3 Availability of Skilled Directors and Management

The availability of skilled directors and management has been suggested as a constraint on the structuring of CI-lEs. In our view, and as discussed in more detail in Section 4.0, access to excellent management skills and to experienced directors is unlikely to present a problem as long as CHEs are established as commercial organisations relatively free from political interference.

5.4.4 Duplication of Expensive Services

A concern sometimes expressed is that individual CHEs will compete through purchasing (and duplicating) expensive high technology equipment and replicating services that might better be centralised in one district. This type of behaviour will be constrained to the extent that CHEs have a commercial mandate and must earn a return on investment. It will also be shaped by the contracting arrangements with the RI-lAs which will purchase certain services from a single provider if this is the most efficient approach.

5.5 Conclusions

In our view, the two most likely impediments to successfully restructuring the health care industry are the prospect that CHEs will not be established on a competitively neutral basis and the policy uncertainty surrounding the Governments health reform proposals.

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RI-lAs are neutral in their choice of provider, selecting the organisation producing the desired service at the lowest quality-adjusted cost irrespective of ownership;

public providers are established with commercial balance sheets, and, following any initial restructuring, are required to earn a commercial rate of return on their assets;

CHEs are restructured and, where appropriate, broken up in the event of business failure;

non-commercial political involvement in CHEs takes the form of transparent funding or accounting for the non-commercial activities sought;

the tax-exempt status of not-for-profit health care providers is removed; and

planning controls do not unduly inhibit competition.

The reversal of a number of major policy initiatives announced by the Government in the 1991 Budget and the lack of a concerted effort by the Government to "sell the proposed health reforms, has increased the uncertainty and perceived risk for private providers contemplating entry to the health care market. Private sector providers will be less likely to compete in the markets for core health services while the current level of uncertainty. remains.

In our view, major sustained gains from the reform of the health system are unlikely unless competition between health plans, as proposed by the Government, is allowed to develop. With monopoly public purchasers, consumers are constrained from using their insurance purchase decisions to express preferences regarding the type of coverage offered and the ability of their health plan to control costs. Monopoly health plans are therefore unlikely to have consistently strong incentives to act as prudent purchasers in contracting for services on behalf of consumers. These problems will be exacerbated by the difficulties in defining the objectives of RHAs, measuring consumer satisfaction with their performance, and ensuring RHA accountability. The lack of competition at the funder/purchaser level has also been identified as a problem in the UK health reform.

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coordination between funders and providers throughout the learning process will be critical to maximising the benefits of reform and to minimising transition costs. Inadequate coordination between funding and providers and under-resourced funders have been two of the major problems experienced with the UK health reform. To give providers meaningful information on the future demand for health care services and to facilitate the development of contract design and enforcement skills, it is essential that RI-lAs be established as soon as practicable and that they are adequately resourced from the outset.

Our discussions with area health boards and analysis undertaken by the Audit Office indicate that many of the boards are burdened with excess capacity and poorly located facilities and buildings. Unless CHES are free to sell or lease surplus assets, they will bear extra costs and valuable assets will be underutilised or idle.

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SECTION 6.0: RECONFIGURATION AND MANAGEMENT PROCESS

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7 6.1 Introduction

The discussion in Section 4.0 of the criteria and principles for establishing the initial configuration of government-owned health care assets highlights the importance of the process governing the restructuring of those assets, including the accountability and regulatory arrangements applying to health care purchasers and providers. These considerations are likely to have a far greater impact on the incentives of health care providers than the initial configuration of assets chosen by the NTPB.

Section 4.0 also illustrates that the preferred initial configuration of assets and the most efficient process for governing their ongoing management and reorganisation are interdependent; the preferred starting point depends on the most efficient process and vice versa.

In this section we consider the management, accountability and associated organisational arrangements for governing the reorganisation of government-owned health care assets into market-driven provider units. In Section 6.2 we discuss the critical issues and constraints that the management arrangements will need to address. In Section 6.3 we outline a suggested management approach and structure. Timetabling issues are addressed in Section 6.4 and the strengths and weaknesses of our suggested approach are discussed in Section 65.

6.2 Critical Issues

6.2.1 The Need for a Decentralised Process

The complexity and scale of the changes required to transform New Zealands government- owned health care assets into efficient market-driven provider units rule out the possibility of organising the required changes by way of detailed planning from the centre. Conventional central planning or variants thereof will be unable to gather, process, or efficiently respond to the vast amount of widely-dispersed information relevant to the best way of meeting the demands of purchasers. A highly-decentralised process, which empowers managers and the

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people they work with, will be necessary to achieve an efficient transition. The process should be designed to enable most of the critical decisions regarding organisational arrangements, product bundling, technology, infrastructure, pricing, and marketing to be made by people who are close to, and understand, the relevant information and tradeoffs involved.

6.2.2 The Need to Provide for Diversity

The discussion in Appendix D of competitive health care markets highlights the importance of diversity and dynamism - in terms of organisational form, size and product bundling - in health care services. This diversity arises from increasing specialisation, the growth in outpatient treatment in response to new technologies and medical practices, and innovative organisational and contractural arrangements. As in any market though, the development of new and diverse ways of doing things frequently occurs through experimentation and risk taking. Many new ideas are tried and may fail; the few that succeed lead to business successes that are copied and refined by competitors.

To enable health care providers in New Zealand to develop creative and diverse solutions to health care problems it will be essential to provide them with considerable flexibility to adopt the organisational and structural arrangements that they believe are most effective for dealing with the specific circumstances they face. Thus, while efficiency requires that government-owned health care organisations operate within a disciplined commercial framework, wherever possible that framework should avoid placing restrictions on the strategies and methods health care organisations are able to adopt. The process governing the ongoing management of government-owned health .care organisations should, therefore, provide scope for the unbundling of the initial provider units, the merging of units, joint ventures and strategic alliances with other public and private providers, contracting Out, and the leasing or sale of surplus assets.

Scope should also be provided for diversity in terms of organisational form. The SOE framework as applied in New Zealand is modelled on the incentive and accountability arrangements that apply to the corporate form of organisation, as befitting the large scale, capital-intensive nature of the majority of the organisations to which it has been applied. In comparison, many parts of the health care industry have relatively low capital intensity and rely on specialised human capital as their principal productive input. Parts of the health sector also lend themselves to close community involvement in provision and other elements may best be served by the involvement of not-for-profit organisations.

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01iti(tC11thI

This suggests that in an efficient health care system there is likely to be an important role for 0 r/manager organisations, community specialised profesiOnal partnerships, other not-for-profit organ model To provide for these options it will be possibly, providers and, important not to use a corporate governance model as a restrictive template in the health care - nt of non-corporate sector; this would stifle diverSi and prevent the developme organisational forms in areas where they have efficiency advantages. -

The Need for a Commercial Framework 6.2.3 d for In Section 3.25 we discussed the question of whether the charters initially establishe government-owned health care organisations should be not-for-profit or for-profit in form. We concluded that the theoretical arguments that might justify the use of the not-for-profit form are not strongly applicable to health care institutions and that the prospect of efl5 in support of a for- continuing state ownership reinforces the general efficiency argum likely to provide profit model. We also noted that starting from a for-profit base would be managers with stronger incentive to adapt their organisational arrangements in response to market demands than would a not-for-profit structure. The adoption of a for-profit charter would involve giving provider units the objective of operating as a successful commercial business and subjecting them to the monitoring and accountability arrangements outlined in discussed below, it will be desirable to provide sc Section 3.3.1 (although, asope for the development over time of other organisational arrangements).

advantages in taking a commercial model as ieve there are distinct, While wewned health carebel providers, there is a the starting point for New Zealands government-0 risk of overstating the differences between the for-profit and not-for-profit models. As s to generate an economic surplus to discussed in Section 3.2.1, both forms require organisation IS survive. The essential difference between the two forms is the manner in which the surplus used; in for-profit organisations the surplus is returned to shareholders (in this case d in some form by government) in notfOr-pr0ts the surplus is more likely to be appropriate managers or other suppliers of specialist services or dissipated through ineffiCiett management practices. Further, in the US not-for-profit and for-profit organisations frequently adopt similar corporate and managerial structures and both are essentially

"commercial organisations.

The labels "for-profit and "not-for-profit" tend, therefore, to overstate ti .e differences (although,argued in Section as 3.2.5 abovear a es of organisations in the us between the o ave important advantages for governmeflt profit maximising commercial model is likely to h

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owned health care providers in New Zealand). To avoid confusion over the essential characteristics of the organisations established by the NIPB we believe it will be preferable to describe CHEs as commercial, government-owned health providers rather than as profit maximisers or for-profits.

There is also scope for confusion (both substantive and presentational) over the application of SOE principles in the health sector. What is required is a commercial framework which ensures high levels of accountability and management efficiency, rather than a rigid model that prescribes a particular organisational form. Thus, while we believe that the provider units established initially by the NIPB should be subject to the key elements of the SOE framework as outlined in Section 3.3.1, those units should be encouraged to adopt non- corporate and .hybrid organisational arrangements where this is expected to improve efficiency. Such arrangements might include the creation of non-profit subsidiaries (to facilitate community fund raising, for example), establishing community trusts, forming joint ventures, or leasing facilities on a long-term basis to other providers.

6.2.4 Non-Commercial Issues

It is natural and acceptable that politicians in a parliamentary democracy will be concerned with a range of non-commercial considerations relating to the provision of health care services. Employment and the quality of access to health care are examples of such concerns. The process and structures governing the ongoing management of government-owned health care providers should not impede the pursuit of such concerns but should be designed to ensure that non-commercial objectives can be achieved in a least-cost and transparent manner.

LI As far as health care provision is concerned, the costs of achieving non-commercial objectives will tend to be minimised by providing separate and transparent funding or accounting for non- commercial activities required by government. This approach enables managers to be given clear, non-conflicting objectives and avoids blurring accountability through the imposition of hidden non-commercial costs. For the reasons discussed in Section 3.3, the transparent treatment of non-commercial objectives is essential if high-quality managers and directors are to be attracted and retained by CHEs.

The separation of funding and provision will be integral to the establishment of such arrangements The definition of core health services and the esiablishment of objectives for RHAs provide a process for determining politically-acceptable health care services and outcomes. In principle, this, will enable service provision to be undertaken on a purely-

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commercial basis. Where government wishes to pursue non-commercial objectives which are not caught withinthe purchasing preferences of RHAs, it will be important that the requisite services be contracted for explicitly and, wherever practicable, on a contestable basis. Such arrangements might apply, for example, to a rural health service which government wishes to maintain on either health care or employment grounds.

A further set of non-commercial considerations relates to the appointment of directors to CHE boards. For a variety of reasons, government might wish to ensure that groups such as ethnic minorities, women and health professionals are represented on CHE boards. While the - appointment of individuals with high levels of commercial expertise to CHE boards, and in particular to the position of chairperson, will be critical to the success of a commercial approach, there is scope for a small number of people on each board to be selected on the basis of their non-commercial attributes. In general though, the selection of directors is a commercial task which requires commercial skills and incentives. In our view it is essential that this requirement is not compromised by any non-commercial objectives held by the Government. Again, the transparent treatment of any non-commercial objectives is likely to be the most effective means of preserving the commercial thrust of directorship appointments. A specific approach for achieving this is discussed in Section 6.3 below.

6.2.5 Monitoring Issues

In general, government shareholders have considerably weaker incentives than their private sector counterparts to monitor the commercial performance of the businesses they own. In the private sector, the sharemarket and market for corporate control provide means for individuals and organisations to profit directly by monitoring the performance of businesses, identifying under- and over-valued companies, and taking steps to correct unsatisfactory performance. With government ownership, the gains from such activities tend to be shared across all shareholders (i.e. tax payers) so that the incentives for monitoring are severely attenuated in comparison with private ownership.

The SOE reform process involved the establishment of monitoring arrangements designed to simulate the monitoring mechanisms that arise naturally in the private sector. The key components of this monitoring process include reaching agreement with the shareholding Ministers regarding performance targets specified in annual statements of corporate intent, half-yearly and annual reports, and monitori.gby the State-Owned Enterprises Steering Committee, the State-Owned Enterprises Advisory Unit attached to the office of the Minister of State-Owned Enterprises, and by Treasury analysts. While considerable work

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has gone into developing and applying this monitoring framework, we believe that in general it has been less irttensive and effective than the monitoring that applies to comparable private sector entities.89

A further characteristic of SOE monitoring is that it has generally involved assessing the operating performance of clearly-defined businesses. It has not required the evaluation of major corporate reorganisation transactions such as takeovers, mergers, spin-offs or major changes in organisational form. (While considerable analysis has been undertaken of the possible break up of Telecom and Electricorp, this has been driven by regulatory considerations and has not involved a strong element of shareholder monitoring.) As discussed in Section 5.4.2 above, such transactions often give rise to sharp conflicts between managers and shareholders. These are inherently difficult for government shareholders to control.

Because CHEs will all participate in the same industry, the reform of government-owned health care providers will involve much greater scope than the SOE reform for transactions involving more than one entity. Similarly, the highly-centralised nature of the health system and the lack of network economies (which are important in electricity and telecommunications) suggest that there is more scope than there has been with many SOEs for breaking up existing provider units into independent businesses.

To ensure that there is both scope for and rigorous review of major organisational restructurings, we believe it will be advantageous to adopt more extensive shareholder monitoring arrangements than have applied to SOEs. These should be designed to establish

89 This view is shared by many other parties who have been involved in, or who have reviewed, the SOE reform process. For example, a recent review of the corporatisation of Electricorp prepared for the Treasury noted that:

"the SOE monitoring process, in general, is not as strong as the monitoring that takes place in capital markets where there is tradeable equity. The problem lies in the leverage that the monitors have over the SOEs. While accountability is now tighter with the annual budgetary process, the requirements for Statements of Corporate Intent, and the annual reporting introduced by the SOE Act, the monitoring capability of Government is still weak. Politicians as shareholders are subject to the whims of the political process and, over the long run, have only weak incentives to bring sustained commercial rigour to the monitoring process. Investors have direct property rights in dividends and the market value of the equity they hold. Shareholding Ministers who hold political office do not. Also, the resources that the Treasury makes available for carrying out the monitoring function are relatively small-relative to those of the private sector for a corporation of ECNZs size." (Spicer, Bowman, and Emanuel, op. cit., pp 202-203.

The Treasury itself has consistently expressed concerns about the quality of the incentives for effective monitoring of SOEs. See, for example, The Treasury (1987), Government Management, Brief to the Incoming Government 1987, Government Printing Office, Wellington, pp 109-117.

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monitoring agents with similar resources and incentives to those normally involved in corporate restructuring in the private sector. The monitoring process will also need to ensure adequate ongoing monitoring of CHEs beyond the initial reorganisation phase. E

6.2.6 Competition Considerations

11 As discussed in Section 4.0 above, if the NIPB believes, on competition grounds, that the break up of an existing area health board would provide efficiency gains, it should ensure that a satisfactory form of break up occurs early in the reform process. The preferred means of achieving this will depend on the information available to the NIPB at the outset regarding the least-cost form of break up. If the least-cost form of break up is relatively obvious at the outset, the NIPB should require the relevant provider unit to undertake a prespecified break up of assets. Alternatively, if further analysis of the precise form of break up on competition grounds would be desirable, provider units should determine the break up configuration within clear guidelines given by the NIPB.

To ensure that any subsequent mergers or takeovers involving CHEs do not result in serious competition problems, business acquisitions involving CHEs should be subject to the acquisition provisions of the Commerce Act despite their common ownership by the Crown. (As noted in Section 4.3.3 above, a change to the Commerce Act may be required to achieve this.) As far as CHEs are concerned, such transactions will be able to be driven by purely- commercial consideration once any necessary Commerce Act amendments are in place.

6.2.7 Coordination with Health Care Funding Reform

The importance of coordinating funding and provider reform was discussed in some detail in Section 5.3 above. The most critical aspect of this in so far as the detailed transitional arrangements are concerned will be to ensure that the contracting skills of purchasers and funders are developed in tandem and that the establishment of a commercial focus for CHEs takes place within a robust purchasing environment.

The SOE experience in New Zealand illustrates the scope for transforming essentially non- commercial organisations into businesses within a 12 to 18 month time frame. A similarly rapid transformation is likely in the health sector if government-owned provider units are subject to an effective accountability regime.

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However, the international experience with health care contract design and enforcement (see Appendix C for the UK experience) and the initial experience in New Zealand in this area suggest that a significantly longer period of time will be required to develop the skills and information required for robust arms-length contracts between health care purchasers and providers. There is a serious risk that, in the interim, commercial "success" by CHEs will be achieved through cost inflation, poor quality services, and over-servicing, rather than through genuine efficiency improvements. Such outcomes would not only generate short-term efficiency losses but would also jeopardise the entire health reform programme.

At present, government-funded health care services are, in several important senses, provided within one organisation. The government is the (under and supplier of such services. and organises the supply of health care services through a series of "internal" directives, budget constraints and conventions, in the present system the Minister of Health has some powers which are similar to those of the chief executive of a very large organisation; in particular, he has the power to apply sanctions to individuals whose behaviour is clearly contrary to the objectives of the organisation, i.e. New Zealands health care objectives. While such arrangements tend to become bureaucratic and erode accountability, they do provide an ethic and broad understanding of the objectives of health care which limit the scope for some inefficient outcomes.

Following the separation of funding and provision, behaviour will be determined much more by the details of explicit arms-length contracts than by implicit understandings. This has the potential to provide much sharper incentives and improved accountability but will also mean that providers will tend to be increasingly influenced by the details of contracts rather than by the underlying intention of purchasers. The complexity of contracting for many health care services and the time that will be required to generate a commercial level of contracting expertise (refer Section 5.3 above) mean there is a risk of serious contracting distortions in the first few years of the reform process.

Several initiatives suggest themselves as possible means of controlling this risk. The first of these would be to accelerate the establishment of RHAs. The timetable announced in the Statement of Government Health Policy requires the Policy, Regulatory and Implementation Directorate to commence the establishment of RHAs prior to June 1992. In our view, the establishment process should commence as soon as practicable with a view to having all RHAs in place well before June 1992.

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The second initiative is one that could be undertaken by RHAs and other purchasers (e.g. the ACC) themselves. RHAs will be repeat purchasers of health care services and will be able to use this position to discipline providers who opportunistically violate the intent of health care contracts. In particular, RFIAs could threaten to take their future business away from provider units that exploit obvious weaknesses in explicit contracts to improve their own profitability. This type of sanction exists in all markets involving repeat purchases and might be especially useful for RI-lAs in the first few contracting rounds.

A further means of controlling serious contracting distortions would be self regulation by provider units. If CHEs opportunistically exploit contractual imperfections in the initial contract rounds, the efficiency gains from the reforms will be undermined and public and political support for the reform programme will be threatened. Further, because CHEs will be government owned, there will be considerable scope for reversing the reform process. The prospect of a major policy reversal will represent a serious business threat to fledgling CHEs. The reform process should be designed to shape this threat in a way that reduces the risk of serious contracting distortions in the first few years of the reform process. A suggested approach for achieving this is discussed in Section 6.3.

A further contracting issue affecting the preferred management process is the need to ensure that the current procedures for contracting between area health boards and the government do not impede the development of commercial arms-length contracts between RHAs and provider units. The Minister of Health has recently written to each area health board to provide an initial indication of the output government will wish to purchase from area health boards in 1992/93. This letter will form the basis for detailed discussions, and negotiations between the Department of Health and area health boards which will commence in early 1992. We understand the letter states that "the contracts will be significantly changed so that they can be used to lead the reform process".

It is important that these negotiations and the resulting contracts provide scope for ongoing contractual modification and refinement between RHAs and the new provider units from the time at which these entities are established. To this end, we are encouraged by the recognition by officials within the NIPB that the "1992/93 contract round offers a strategic opportunity to notch up some early wins for the purchaser /provider reforms".

90 Memorandum from Chris Clarke to Ian McPherson and Geoff Swier dated 26 November 1991.

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6.2.8 Business Valuations

Comprehensive business valuations of all major government-owned health care providers will complement the process of reviewing the underlying businesses of those entities and will be an important input to monitoring the commercial performance of CHEs; The NIPB recently appointed consultants to provide advice on appropriate valuation methodologies for government-owned health care providers.

As discussed in Section 5.2.2.2 above, the absence of information on the health services that will be demanded by RHAs and the considerable uncertainty surrounding the pricing of those services will complicate the valuation of cHEs. One means of dealing with this would be to __ have a series of two or more valuations, with each successive valuation refining its .I- predecessor in light of further information on revenue streams and cost structures.

6.3 Recommended Approach

The approach we suggest for the ongoing management of government-owned health care providers is based around the establishment of crown health enterprise transition boards ("CHETBs") for each of the existing area health boards and a Supervisory Board which would set the objectives of all CHETBs and monitor their performance. Each CHETB would determine a commercial configuration of business units for the assets within its control (subject to objectives, directives and guidelines provided by the Supervisory Board) and establish individual CHEs and community trusts. Once established, CHEs would report to and be monitored by the Supervisory Board.

The details of the proposed approach and a discussion of its strengths and weaknesses are provided below.

6.3.1 Supervisory Board

The Supervisory Board would be a commercial organisation and would own all government health care businesses on behalf of the Minister of crown health enterprises ("Minister of CHEs"). The Supervisory Board would be governed by a board of directors appointed by government and would be accountble to the Minister of CHEs. The Supervisory Board would be responsible for:

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the procedures and guidelines to be followed in the establishment of community trusts;

any activities for which the CHETB or CHE seeks compensation from the Crown; and

r any other matters agreed by the Supervisory Board and CHETB or CHE.

All CHEs will be established with appropriate balance sheet structures, with the statement of corporate intent of each CHE specifying its target ratio of shareholders funds to total assets.

In receiving and ratifying major restructuring proposals involving multiple CHETBs or CHEs or the creation of new CHEs, the Supervisory Board would be guided by the criterion of maximising the value of the Crowns investment in the entities involved in the proposed transaction. Supervisory Board analysis of such transactions would involve similar analytical techniques and procedures to those used by well-run companies in the assessment of mergers, acquisitions and divestments.

In the transition phase (i.e. through to June 1993 - refer Section 6.4 below), the Supervisory Board would expect to receive restructuring proposals from a number of CHETBs. Proposals might also be received from private sector parties with an interest, for example, in contracting for the management of particular assets or services or in entering leases or joint ventures with government-owned health care providers.

The Supervisory Board might also wish to invite restructuring proposals from provider units within CHETBs. However, in considering the form and basis of such proposals, the CHETB would need to trade-off the value of the extra ideas and information that might emerge from lower level provider units against the accountability and management difficulties of "going behind the backs" of the CHETBs.

Following the wind-up of the CHETBS, the Supervisory Board would continue to review restructuring proposals from CHEs and external parties. The Supervisory Board would need to consider the trade-off mentioned above in deciding if and how to solicit ideas and proposals from provider units within CHEs.

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In any event, the purpose of the review process would be to simulate the incentives and institutions that facilitate corporate restructurings in the private sector; The absence of tradeable equity in CHEs will make this a challenging task for the Supervisory Board; in particular, the Supervisory Board will need to develop compensation mechanisms which reward managers within the public health system who identify, develop and implement valuable reorganisation initiatives.

The payment of dividends to the Supervisory Board and the provision of additional equity to CHEs requiring further equity capital should also be based on commercial norms and procedures. Thus, the dividends paid by particular CHEs would reflect, inter-alia, their balance sheet strength, cash flow and capital expenditure requirements along with industry- wide norms.

For presentational reasons, the Superviso ry Board may wish to describe the dividends paid by CHEs as a "capital charge". This would be accurate to the extent that dividends are one means by which government, as shareholder, can receive a return on its investment in CHEs. However, it would be extremely important that any capital charge paid to the Supervisory Board by CHEs reflects the commercial considerations which influence dividend payments and was not applied mechanistically. (It may, for example, be efficient for a CHE with very high earnings to have a low dividend payout ratio because of the scope for worthwhile reinvestment in the CHE.) The supply of new equity to CHEs by the Supervisory Board should also be governed by commercial considerations; in general, further equity should only be forthcoming when it is expected to at least earn a normal risk-adjusted return.

Notwithstanding the Supervisory Boards monitoring responsibilities, a highly- decentralised management style on the part of the Supervisory Board will be essential given the size of the reform process and the importance of providing managers with a high degree of autonomy in order to retain their enthusiasm and commitment. The key to achieving this will be to appoint business people of the highest quality to the Supervisory Board. As a further safeguard, the Supervisory Boards statement of corporate intent should require that it adopt a highly-decentralised management approach.

A highly decentralised approach is not only warranted from a business perspective (given the magnitude of the likely changes), but is also important for wider policy reasons. It will he important that CHEs compete as intensively as they would if each was independently owned. A highly-centralised approach involving detailed coordination by the Supervisory Board would be likely to stifle competition between CHEs. Further, as discussed below, the

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reaching agreement with the Minister of CHEs regarding the statement of corporate intent and performance targets of the Supervisory Board. This would include details of any structural break up of assets government requires the Supervisory - - Board to undertake (following the advice of the NIPB) on competition grounds;

providing the Minister of CHEs with six-monthly and annual reports of the Supervisory Board, such reports also being publicly released. (The Minister of CHEs would receive advice on the performance of the Supervisory Board from a specialist monitoring unit - refer Section 63.5 below);

appointing directors to CHETBs and reviewing CHETBs recommendations for CHE board directors on the basis of guidelines specified by government;

negotiating an annual statement of corporate intent with each CHETB. This would include details of any break up of assets required by the Supervisory Board on competition grounds or analysis that must be required to determine the preferred form of break up, if any;

monitoring the commercial performance of CHETBs and ensuring that CHETBs satisfactorily break up assets as required by the Supervisory Board;

acting as an internal capital market in ratifying and, where desirable, facilitating restructuring transactions involving multiple Cl-[ETBs or CHEs or the creation of new CHEs;

acting as a restructuring agent in the event of major business failures by CHETBs or CHEs. Such restructuring would be driven by commercial considerations and, wherever possible, would avoid retaining non-viable business units;

applying the CHE valuation principles developed by the NIPB and negotiating commercial CHE valuations and balance sheet structures with CHETBs;

/ - coordinating the implementation of commercial balance sheet structures for CHEs on the basis of broad procedures developed by the NIPB;

negotiating a statement of corporate intent with individual CHEs that have been separated from their CHETB and monitoring the performance of such CHEs; and

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receiving CHE dividend payments and providing new equity to CHEs requiring additional equity capital.

The Supervisory Board would essentially have a facilitative and monitoring role; it would appoint and monitor directors and set matters of broad policy such as the procedures for establishing community trusts or new CHEs. It would be required (by its statement of corporate intent) to distance itself from the detailed strategic and competitive strategy of individual CHETBs and CHEs. Its management style would, therefore, be highly decentralised.

However the Supervisory Board could not be totally unobtrusive in its dealings with CHEThs and CHEs. Effective monitoring, by its very nature, would require the Supervisory Board to ensure that adequate high-quality information was forthcoming from CHETBs and CHEs and to take corrective action in the event of demonstrably unsatisfactory performance. Such action would normally involve replacing non-performing directors or boards.

The statement of corporate intent would be a central mechanism in the monitoring of both CHETBs and CHEs. In addition to any break up required by the Supervisory Board on competition grounds, the statements of corporate intent for Cl-IETBs and CHEs would specify:

the objectives of the provider;

the nature and scope of the activities to be undertaken;

0 the accounting policies;

the performance targets and other measures by which the performance of the provider may be judged in relation to its objectives;

an estimate of the amount or proportion of distributable reserves that are intended to be paid to the Supervisory Board;

an estimate of any additional capital to be provided by the Supervisory Board;

0 he procedures to be followed for major restructuring transactions involving multiple CHETBs or CHEs or the creation of new C}-lEs;

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role of the Supervisory Board may be a transitional one. Individual CHEs may be required to operate as fully-independent entities beyond the life of the Supervisory Board - a high degree of independence from the outset will facilitate this.

The Supervisory Board would also be required to manage the commercial risks associated with highly opportunistic contractual behaviour by provider units. As discussed in Section 6.2.6 above, it will be in the interests of provider units to avoid behaviour that threatens the overall reform programme. Some provider units may, however, attempt to generate short-term commercial gains by seriously violating the intention of initial, relatively crude contracts with RHAs. Such behaviour would involve political and commercial risks for all provider units and should be of considerable concern to government as the owner of CHEs. We therefore suggest that the Supervisory Boards statement of corporate intent require it to provide CHETBs with broad guidelines regarding acceptable responses to contractual imperfections.

We suggest that the case for maintaining the Supervisory Board be reviewed once the Supervisory Boards restructuring and establishment responsibilities are completed and robust contracting arrangements with purchasers are in place. Specifically, we suggest that a review of the benefits of retaining the Supervisory Board be undertaken after three years and that the Supervisory Boards enabling legislation include a four-year sunset clause. These arrangements would be designed to reduce the risk of the Supervisory Board pursuing empire building motives and would help to maintain the commitment of CHE managers who are concerned about the prospect of a highly-centralised provider system.

The review after three years would also provide an opportunity to assess the strengths of the Supervisory Board as an ongoing monitoring agent. If, in the light of the preceding three years experience, the Supervisory Board compared well with the conventional SOE monitoring arrangements, consideration could be given to retaining the Supervisory Board for a further period of time. In the event that the Supervisory Board was disbanded, all CHE monitoring would be undertaken by a specialised monitoring unit that would report to the Minister of CHEs (refer Section 6.35).

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63.2 Crown Health Enterprise Transition Boards

Each CHETB would take over the management of the assets of an area health board and would be required to establish the most effective configuration of assets for a competitive provider market, subject to guidelines provided by the Supervisory Board. Each CHETB would be responsible for

the day-to-day operations of the health care provider units within its control, including managerial appointments and remuneration and contract management;

reaching agreement with the Supervisory Board regarding the CHETBs statement of corporate intent and performance targets (these would focus on the CHETBs restructuring and organisational functions);

preparing six-monthly and annual reports which would be provided to the Supervisory Board and made available publicly;

breaking up existing area health board assets into competing business units in accordance with directives or guidelines provided by the Supervisory Board;

reorganising and restructuring the assets and activities of the relevant area health board into the most efficient form for the new purchasing and regulatory environment. This could include creating new business units and entering joint venture and lease arrangements with other providers;

developing efficiency-enhancing merger and acquisition proposals involving the assets of other CHETBs and presenting such proposals to the Supervisory Board for ratification. Such proposals might include, for example, the sale of a business unit from one CHETB to another, the merging of a specialist service provided by two CHETBs, or the establishment of an extended chain of provider units;

establishing individual CHEs and nominating CHE directors for approval by the Supervisory Board;

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identifying those assets and services that could be operated most efficiently as community trusts and, within guidelines and ratification procedures laid down by the Supervisory Board, working with relevant community groups to establish community trusts;

-- rationalising, leasing or disposing of surplus assets; and --

negotiating with the Supervisory Board to establish asset valuations and commercial balance sheet structures for individual CHEs.

Each CHETB would have a high degree of autonomy in respect of both strategic and operational decision-making. CHETBs would have a combination of operational and restructuring responsibilities and would need to balance one against the other in developing strategies and timetables for the establishment and restructuring of provider units.

The role of each CHETB would, however, be a transitional one. Once a CHETB had completed the establishment of commercially-structured provider units and met the structural guidelines provided by the Supervisory Board, it would be wound up. The time required to complete this process would be likely to vary from region to region depending on the complexity of each CHETBs task and the quality of their performance. While it will be desirable to have an overall deadline for the transition phase, it would not be necessary that all CHETBs be wound up simultaneously - as soon as a CHETB has discharged its responsibilities, as defined by the Supervisory Board, it could be disbanded. The çHEs established in that region could then operate as stand-alone units which would report to, and be monitored by, the Supervisory Board. (In those regions where only one CHE was created, the role of CHETBs would be similar to that played by establishment boards in the SOE reform process.)

Providing flexibility in this manner would engender an element of competition between CHETBs and should enable the overall structure of the provider entities to be streamlined as soon as possible, reducing the risk of bureaucracy and excessive administration costs.

Similarly, we believe it would be advantageous to establish CHEs as stand-alone entities reporting to the Supervisory Board as soon as the restructering work and CHE board appointments required to achieve this are completed. Thus, a CHETB that formed several CHEs could stagger their establishment as independent entities. This would create an

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incentive for would-be CHEs to take an aggressive and competitive approach to the tasks required to achieveCHE status.

6.3.3 Crown Health Enterprises

As mentioned above, CHETBs. would be responsible for establishing CHEs and making recommendations to the Supervisory Board regarding CHE board members. CHEs would be required to operate as successful businesses and would be monitored along conventional SOE lines. CHEs would be able to establish not-for-profit subsidiaries and joint ventures and, subject to meeting guidelines laid down by the Supervisory Board, create community trusts. CHEs would also be encouraged to investigate and, if appropriate, develop restructuring proposals involving other CHEs or the creation of new CHEs.

CHEs might vary considerably in terms of the range of services they provide and the form of service delivery they adopt. Some CHEs might specialise in particular tertiary services while others might provide a broad range of primary, secondary and tertiary services. Considerably flexibility would be provided to enable CHETB and CHE boards to define the scope of CHE businesses in the manner they believe will provide the greatest commercial advantage.

CHEs would be required to:

agree a statement of corporate intent and performance targets with the Supervisory Board;

prepare half-yearly and annual reports to be provided to the Supervisory Board and made available publicly;

D compete with other CHEs and with private sector providers;

as appropriate, pay dividends to the Supervisory Board;

- establish community trusts in accordance with the guidelines laid down by the - Supervisory Board and work with community groups to establish community trusts;

rationalise, lease or dispose of surplus assets; and

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identify and develop restructuring proposals involving other CHEs or the creation of

- new CHEs and present such proposals to the Supervisory Board.

6.3.4 Ministerial Monitoring Unit

Because the Supervisory Board would be a commercial entity, we suggesf that it be monitored

by a specialist monitoring unit which would report to the Minister of CHEs. The monitoring

unit would be required to:

advise the Minister in discussions with the Supervisory Board regarding the

Supervisory Boards business plan, statement of corporate intent and performance

targets; and

- r analyse the half-yearly and annual accounts of the Supervisory Board and

individual CHEs in order to assess and advise the Minister on the commercial

- performance of the Supervisory Board.

The monitoring unit would not have any management responsibilities. The monitoring unit

would become directly responsible for monitoring all CHEs in the event that the Supervisory

Board was eventually wound up.

The monitoring unit could be established by either extending the scope of the existing SOE

monitoring arrangements or by developing an entirely new unit. The advantage of the former

approach is that it would enable Supervisory Board monitoring to benefit directly from

established government business monitoring skills and experience built up through the SOE

process and would provide for ongoing sharing of resources and learning. The case for a new

unit rests on the specialised nature of the health sector (although this does not necessarily

distinguish health care from telecommunications or electricity, for example), the fact that

CHEs will have their own shareholding minister, and the desirability of strengthening the

standard of monitoring set by the SOE process.

On balance we favour the establishment of a specialist Supervisory Board. monitoring unit

reporting to the Minister of CHEs. However, we believe this unit would benefit from a close

relationship with the entities involved in current SOE monitoring and through sharing ideas

and in some cases resources with those parties.

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Regardless of whether or not the Supervisory Board monitoring unit is established as an independent unit or is attached to or incorporated within the existing SOE monitoring arrangements, its success will be critically dependent on its ability to attract and retain a group of high quality analysts. It will be important that the Minister of CHEs assesses the cost of achieving this in the context of the size and importance of government-owned health providers and the potentially serious financial consequences of accepting a deficient monitoring regime.

6.3.5 Relationship to the Role of the NIPB

The NIPBs terms of reference involve a mix of regulatory, legal, financial, commercial, economic and tax responsibilities. The timetable contained in the Statement of Government Health Policy envisages that the tasks of the NIPB will be completed in time for it to be wound down in the year ended June 1993. While this time frame would overlap with the operation of the Supervisory Board if the approach outlined above was adopted, this need not involve duplication of resources or mixed accountabilities.

The Supervisory Boards responsibilities are designed to be entirely commercial in nature. While the Supervisory Board may be required to break up area health board assets on the basis of directives or guidelines established by the NIPB, those directives and guidelines would be akin to external regulations and would not give the Supervisory Board the authority to make decisions or provide advice on matters of economic policy.

The Supervisory Board would, however, be responsible for implementing several of the tasks included in the NIPBs terms of reference. In particular, establishment of the Supervisory Board and setting in train the management process outlined above would be important steps in discharging the NIPBs responsibilities regarding:

the organisational form of provider units;

D industry structure;

the selection of establishment board members;

U the financial structure and business valuations for CHEs;

U monitoring arrangements; and

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the critical path for the commercial aspects of the provider reform.

While few, if any, of these issues would be fully resolved at the date of the Supervisory Boards establishment, the NIPB would have initiated a process for their resolution and delegated most of the outstanding commercial matters to the Supervisory Board, e.g. the Supervisory Board would become responsible for selecting CHETB directors, establishing appropriate capital structures, valuing CHEs, and monitoring CHETBs and CHEs.

Several other responsibilities of the NIPB would not, however, be resolved through the establishment of the Supervisory Board. These include:

determining and managing requisite changes to health industry legislation;

taxation issues;

-, Treaty of Waitangi issues;

regulatory issues including quality standards; and

the establishment of the Public Health Agency.

The resolution of these matters will need to be undertaken by an agency with policy advisory, rather than commercial, responsibilities. These tasks would involve serious conflicts if undertaken by a commercial entity such as the Supervisory Board and, in some cases, require quite different skills to those of Supervisory Board directors. The most obvious means of handling this would be to retain the N!PB in its present form (although possibly with some personnel changes to reflect the completion of its commercial tasks) to conclude the outstanding tasks specified in its terms of reference.

An alternative, which we prefer, would be to merge the entity responsible for the residual functions of the NIPB with the Policy Regulation and implementation Directorate. The merged entity would report to the Minister of Health. This would be a major step towards addressing the concerns we have expressed throughout this report regarding the lack of coordination between the funding and provider reforms. Effective coordination would be much mote likely if a single agency was responsible for advising government on the policy aspects of both arms of the reform process. Further, there are common themes and issues running through the tasks of the Directorate and the NIPB tasks that would not be passed on to the

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Supervisory Board. These two sets of tasks require similar analytical skills. There are also similarities in the structural and accountability arrangements that are likely to be most effective for the agencies undertaking the policy analysis. It is outside the scope of this study, however, to comment in detail on the structure and mandate that might apply to a merged Policy, Regulation and Implementation Directorate/NIPB.

6.3.6 Auditing

As with any business, auditing of the accounts of the Supervisory Board, CHETBs and CHEs will require commercial auditing skills. To ensure contestability in the audit function and to draw on the international health care experience of the major accounting firms it will be advantageous for accounting audits to be undertaken on a competitive basis and to allOw private sector auditors to participate in this process.

6.3.7 Legislative Constraints

The legal constraints on the process of restructuring provider units have been reviewed by Chapman Tripp Sheffield Young. Their report on these issues presented in Appendix H, notes that establishment Of the CHETBs and Supervisory Board needs legislative sanction for the following main reasons:

to establish funding authority;

to avoid constitutional challenges; and

• to assure risk averse prospective members of boards of the validity of the framework for the task they are invited to perform. - S

Prior to the implementation of legislation, personnel for the Supervisory Board and CHETBS could be designated and could commence work on evaluation and planning of the reforms. It is possible that the interim (pre-establishment) phase of the Supervisory Board could be S administered and funded as part of the NIPB or be funded through Vote: Health. However, the formal establishment and appointment of the boards could not be achieved within the current legislative framework.

A comprehensive redrafting of the relevant legislation, including a full rewrite of the Area Health Boards, Hospitals, and Health Acts would take three months from the making of a

-174- j CS FIRST BOSTON comprehensive set of policy decisions. Such a full review is unlikely to feasible in the time frame envisaged. Instead, the preferred approach would be to undertake the minimum amount of legislative reform necessary to get the reform of providers underway, leaving the balance (which would still be important) for .a later stage of the reform process. Even assuming that the review of legislation is not comprehensive, the timetable for ensuring that legislation is in place by the end of June 1992 is still tight, and its achievement very dependent on the health reform legislation being given priority by Cabinet and Caucus. An alternative, if this timetable cannot be met, is to put the legislation through all stages as part of the Budget programme in late July or early August.

A wide range of other legislation that relates to the health sector and which is administered by the Department of Health should also be reviewed as part of the reform process. The relevant acts and regulations are listed in Appendix I. Legislative change could follow a slower timetable than the reform of providers proposed above. The NIPB intends to review the relevant regulatory and legislative issues in a separate study.

As discussed in Section 4.3.3, legislative change may also be required to ensure that the Commerce Act has comprehensive application to the CHEs following their establishment.

6.4 Timetable and Sequencing Issues

We suggest the following timetable be adopted for the establishment of the Supervisory Board, RHAs, CHETBs, CHEs and community trusts:

February/early March 1992: NIPB advises Minister of CHEs on the proposed management arrangements for provider reform, including the Supervisory Board mandate and any break-up guidelines or directives to be given by the Government to the Supervisory Board.

March/April 1992: Select Supervisory Board members. Supervisory Board commences preliminary evaluation and planning.

Select establishment boards for RHAs.

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April 1992: Appoint Supervisory Board monitoring unit (to advise Minister of CHEs).

May 1992: Supervisory Board agrees draft statement of corporate intent with Minister of CHEs.

May/June 1992: Selection by the Supervisory Board of CHETB directors (each CHETB chairperson possibly being appointed as commissioner for the purposes of the Area Health Board Act).

Supervisory Board provides CHETBs with guidelines for commercial restructuring and any required break-up of area health boards.

July 1992: Appoint Supervisory Board.

Appointment by the Supervisory Board of CHETB directors.

Vesting of area health board assets in CHETBs.

CHETBs commence detailed analysis of preferred organisational arrangements and begin to identify potential stand-alone CHEs and community trusts.

July/August 1992: CHETBs hold initial discussions with RHAs on contractual issues and commence continual process of refining contracts.

CHETBs prepare business plans and agree statements of corporate intent with Supervisory Board.

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August 1992 - March 1993: Supervisory Board and CHETBs negotiate initial business valuations for CHEs and agree on appropriate capital structures.

October 1992: Supervisory Board commences review of first proposals from CHETBs for stand- alone CHEs and community trusts. Supervisory Board reviews first round of CHETB recommendations for CHE directors.

December 1992: First batch of CHE directors appointed and community trusts established.

New CHEs negotiate statement of corporate intent with Supervisory Board.

Commence wind up of CHETBs that have completed their responsibilities.

February 1993: CHETBs six-monthly reports presented to Supervisory Board and released publicly. Supervisory Boards six-monthly report released.

April 1993: Supervisory Board begins review of final CHE and community trust proposals from CHETBs (no further work on structural options undertaken beyond this date by CHETBs other than in exceptional circumstances).

May 1993: Appointment of directors for final batch of CHEs. Further community trusts established if required.

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June 1993: Wind up any remaining CHETBs.

çHEs negotiate 1993/94 statements of corporate intent with Supervisory Board.

August 1993: CHEs present annual reports to Supervisory Board and release publicly. Supervisory Boards annual report released.

Early 1995: Review case for retaining Supervisory Board for a further year.

June 1996: Wind up Supervisory Board unless case established for its retention.

6.5 Strengths and Weaknesses of Proposed Approach

6.5.1 Strengths

The procedural and management arrangements suggested above provide the following potential strengths:

a high degree of commercial focus in the selection of directors and establishment of objectives for CHETBS and CHEs;

• a robust commercial framework which provides strong incentives for CHETB and CHE monitoring;

• an internal capital market incorporating commercial incentives for reviewing and ratifying major merger and acquisition and divestment proposals;

• a commercial monitoring framework for the establishment of community trusts;

• a commercially-oriented moni toring/shareholding entity that provides commercial incentives to control opportunistic contractual abuses by providers during the contract development phase;

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FIRS-1- LosIi)N ( i I i t& I CS

a streamlined and transparent forum (i.e. the Supervisory Board) for government to convey non-commercial objectives and for maintaining a strictly-commercial focus for individual provider units; and

a robust commercial framework for undertaking CHE valuations.

6.5.2 Weaknesses

The major weaknesses of the suggested approach are as follows:

the effectiveness of the proposed management arrangements would be critically dependent on the quality of the individuals appointed to one entity, the Supervisory Board;

the supervision and monitoring of all CHETBs and CHEs by a single entity might facilitate collusion and stifle competition between provider units; and

the managers of provider units might perceive the proposed structure as being hierarchical and bureaucratic to an extent that would preclude a reasonable degree of management autonomy.

6.5.3 Overall Assessment

Any effective management structure for coordinating the reform of government-owned health care providers will need to involve a central unit to coordinate the overall reform process, monitor the performance of large provider units and ratify major restructuring proposals. The strength of the approach proposed above is that it would handle each of these issues within - a highly-commercial framework. A commercial approach to these issues will have major advantages over alternative approaches in terms of both the quality of restructuring outcomes and the manner in which non-commercial considerations are dealt with.

The risk of poor-quality appointments to the Supervisory Board is, in our view, more a question of political commitment than one of potentially poor commercial judgements. The adoption of a single Supervisory Board will enable people of the highest commercial calibre to he appointed to the key entity and will assist coordination and smooth management of the overall reform process.

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The need to give managers of provider units a high degree of autonomy will be an important requirement within any management structure; A high-quality Supervisory Board would recognise this and take early steps to facilitate decentralised and flexible management arrangements.

On balance, we believe that the structure proposed has major operational and strategic strengths and that its potential weaknesses can be kept within acceptable limits.

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APPENDIX A: OVERVIEW OF NEW ZEALAND HEALTH CARE SERVICES

A.1 Introduction

In this Appendix we describe the main features of the current system of financing and delivering health care services in New Zealand. The discussion of the current system is intended to provide a factual background to our analysis and to assist in identifying key issues that might affect institutional design. This Appendix is not intended to provide a full assessment or critique of the current system. Nor does it comment on the quality of the clinical services provided in New Zealand. Rather, it is intended to serve as an indicative overview of the present system, as a background for the main report.

In preparing this appendix, we have drawn on information provided in the couse of meetings with a sample of area health boards, and data provided by the Department of Health, from both published and draft reports. While reasonable efforts have been made to ensure the accuracy of this data, we note that it may be subject to amendment. Any errors that may occur in the data are, however, most unlikely to affect the general conditions of this report.

We begin by examining the current level of health care funding and the contracting arrangements between the area health boards and government. The services provided by the public health care providers are described. We then review the organisational arrangements adopted in a sample of area health boards before describing the private and voluntary sector providers. We conclude by surnmarising some issues that our analysis of the current system indicates should be taken into account in designing the reform process. However, it is important to note that the analysis of the current system is necessarily limited given the timeframe for the project.

A.2 Current Funding Arrangements

A.2.1 Expenditure

Financing for health care is provided by the public and private (including voluntary) sectors. Most payments are made by third party funders, with the majority being channelled through government. The funding of total expenditure in New Zealand of $5,278 million in the year - Al -

Confidential V CS FIRST BOSTON

ending June 1991 is shown below in Table A.1. The table provides comparative figures for 1980

and 1986.1 V

Table A.1 Health Expenditure Trends

1980Source of funding (%) 1986 1991 central government 87.1 82.9 77.0 Accident Compensation Corporation 0.7 V V 3.1 4.2 local government 0.3 0.3 0.5 V private health insurance companies 1.1 1.9 3.5 charitable organisations 0.4 0.5 0.3 out-of-patients pocket 10.4 11.4 14.5

Total health expenditure (million) 1,382 2,919 %GDP 5,278 7.0 6.9 7.4 Categories of Expenditure (%) institutional care 62.9 61.5 56.4 community care 28.4 31. 37.1 public health 6.5 4.2 3.3 teaching and research 2.2 2.5 3.2

The figures show a decrease in central government funding, a significant increase in ACC funding and an increase in private funding through private insurance and direct payments over the period. Relative expenditure on institutional care has declined as service provision has shifted towards community-based services. Public health expenditure has approximately halved over the period.

A.2.2 V V Core Services

To date, the government has not defined the core services, i.e. those health services that everyone should have access to. Instead, as described below, the core services have been defined largely by historical precedent and past expenditure decisions. In contracting with a board, the government defines in broad terms health care objectives and priorities. However the boards have substantial flexibility in deciding the types of services provided, the levels of outputs and how they are delivered.

Current primary health care subsidies essentially reflect historical priorities. Differential subsidies are offered for different services and providers, with the bulk of primary care funding consisting of subsidies for GP services and pharmaceuticals. The government has

1 Department of Health (1991), Health Expenditure Trends in New Zealand: 1980-1997.

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moved in recent years to target assistance more carefully to those it considers are in greatest need (i.e. the very young, elderly and beneficiaries). Nevertheless there remains a number of anomalies in primary care funding depending on where and by whom treatment is received.

The Government has stated in the green and white paper on health reform that it believes there needs to be a more explicit definition of what is included in the core services. The Government will appoint a National Advisory Committee on Core Health Services charged with engaging in a process of public consultation about the core services. As discussed in Section 5.0, the definition of core services will have important implications for the sustainability of some of the existing public health care providers.

A.2.3 Performance Measures

Defining performance standards and quality for the purposes of contracting has proved very difficult in practice. Ideally, the Government would wish to target its health care funding to activities that improve measured health status or life expectancy rather than outputs. However, such measures and their linkage to specific expenditures are extremely difficult to establish and monitor. As a result, the historical focus of performance measures has been on defining outputs, for example the number of operations, number of patients seen, bed days provided, etc. The refinement and further development of these performance measures will be a major issue in separating provider and funder functions.

In the past, area health boards received bulk funding with little accountability for, or knowledge of, the total outputs they produced. The fact that area health boards can now describe the services they provide and their approximate cost represents a dramatic improvement on previous years. Most boards are implementing information systems that provide at least basic financial and output information. These systems will need to be refined and extended over the next few years and will be an essential input to future contracting between providers and purchasers.

A.3 Area Health Boards

A.3.1 Introduction

Most government health care funding is delivered through 14 area health boards, although approximately $1 billion is spent on pharmaceutical subsidies, general medical services

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benefits (for general practitioner "C?" visits) and laboratory benefits (among others). Voted funds which are derived from general tax revenue are allocated to each area health board according to a formula that is based primarily on population, but with adjustments for age, mortality and fertility, other "special" health needs, bed utilisation, cross boundary flows (with explicit tracking and charging for such flows) and the number of private beds in an area In the past additional funding was provided on an ad hoc basis, usually tied to specific projects such as providing community mental health services or reducing waiting lists. Area health boards are responsible for delivering service outputs contracted for by the government. The boards can use the funding to finance their own provider activities or to purchase care from private organisations.

Health care services for area health boards are largely provided directly by the area health boards themselves, with most resources allocated to hospital-based facilities. Although area health boards are free to contract for services from private hospitals and voluntary providers, limited use is made of this power. Some boards are, however, exploring innovative ways of delivering health care, including options involving private sector providers. Some examples are considered below.

The operation of the boards is controlled through the Area Health Boards Act 1983, which provided for the integration of hospital boards and the Department of Health district offices. The primary objectives of the boards as defined by the Act are to promote and protect the public health; to provide health services; to coordinate planning and provision of health services between the private, voluntary and public sectors; and to balance funding between health protection, -promotion, education and treatment services. Each board must promote and protect the health of the residents of its district, assess health needs in the district, and plan development of health services. Boards also have recncrnihfl;h, ç, and health services vested or controlled by them, subject to the powers given to the general manager. A 1988 amendment to the Act requires that each health board appoints on contract a general manager as the administrative head of the board, responsible for the general conduct and the efficient and effective management of the functions and activities of the board, including management of the hospitals, and with responsibility for decisions on appointment, promotion and discipline of staff.

The Act previously provided for establishing boards consisting of 12 members (or 14 in special cases determined by the Minister), who were elected or appointed for a three year term. The elected board members were locally elected, ,which create divided lines of accountability between local electors and central government. The size of the board, the process of their

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election and the conduct of meetings in public each increased the politicisation of the operation of the area health boards, compounding the difficulty of implementing difficult restructuring decisions and functioning in a business-like manner.

The Act also allows the Minister to appoint a commissioner to replace the board. The commissioner has and may exercise all of the functions, duties, and powers of the board. In the past, the threat or actual replacement of the board by a commissioner was used to encourage good performance by board members. The government dismissed the Auckland Area Health Board because of concerns over a range of management issues and appointed a commissioner in 1989. In 1991 the Minister of Health replaced all elected boards with commissioners as part of the process of reform. In some cases, the chairperson of the board was appointed as commissioner, or deputy commissioner; in other cases new people have been brought into these roles.

The commissioners have been charged with ensuring that the area health boards continue to provide health services for the people in their region. A number of commissioners have interpreted their role as one of stewardship, rather than the active pursuit of further reform. In some cases this has resulted in a slow-down in restructuring, and in particular, the deferral of decisions which are difficult politically. Decisions have also been deferred because of a concern (or at least a stated concern) that short-term changes might not be consistent with the overall direction of reform signalled by government. As a result, it is important that the direction of the changes proposed be signalled as early as possible to prevent a halt in the reform process. The Government should reinforce to commissioners that their mandate involves continued restructuring where appropriate.

A.3.2 Area Health Board Contracting Arrangements

Since December 1989, the government has required all area health boards to contract annually with the government to provide essential health services, and any other services which may be negotiated on a case by case basis, for a bulk funding allocation. The aim of contracting is to generate performance-oriented agreements that increase the accountability of boards and increase the quality and quantity of services.

The contracts Set out the primary objectives of the boards as being:

(a) to promote, protect and conserve the public health, and to provide health services;

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(b) to ensure effective co-ordination of the planning, provision and evaluation of health services between the public, private and voluntary sectors;

(c) to establish and maintain an appropriate balance in the provision and use of resources between health protection, health promotion, health education and treatment services".2

As part of the contract with government, boards have prepared annual operating plans which indicate in greater detail the services the boards intend to provide, the allocation of board resources and the management approach. (Formerly, five-year strategic plans were also required.)

The annual operating plans generally provide a summary of the issues, strategic directions such as policy and organisational changes, workforce changes, funding changes, information requirements and changes in the use of physical resources for each of the service groups: child health; health promotion; health protection; maternity; medical services; occupational health; older people; oral health; physical disability; primary health care and emergency services; substance abuse; surgical services; womens health; intellectual disability; and mental health. Information is also provided on expected outputs for each of the service groups.

The contracts require the boards to provide the Minister of Health with regular quarterly reviews on performance in achieving plans during the contract period. The required information includes: financial performance for the quarter and year to date compared with budget; the achievement of targets outlined in the operating plan; the operation and effectiveness of management information systems; and any problems identified in the contract period; a report on financial and service performance for the year; and a report on the measures proposed by the board to improve performance in any areas in which targets have not been reached during the contract period.

The 1991/92 contracts specified the interboard charging regime and required the boards to have operative billing and costing systems to cope with the copayment regime which is to operate from 1 February 1992.

2 contract between the Canterbury Area Health Board and the Minister of Health, 1991/92. A similar provision is used in all of the contracts.

- A6 - 1 Côtificlential CS FIRST BOSTON •1 The contracts specify the amount of funding for the board for the year of the contract. The responsibility of boards to manage within allocated budgets has been increased in recent years. Perverse budgeting incentives have been reduced with boards able to carry a surplus or shortfall in expenditure from one year to the next, subject to limits on the deficit allowed; a surplus in one year does not trigger a reduction in funding allocation in the next year.

The contracts are negotiated and monitored on behalf of the Minister by the Department of Health, which reports to the Minister monthly on financial performance, and quarterly on the service performance of the boards.

In negotiating a contract with a board the Department has regard to the Ministers priorities, the output of services achieved in previous years and services provided by other boards. It attempts to increase the efficiency and output of each board at the margin seeking also reallocation of effort from some services to others rather than defining the full range of services required. Factors such as different case mixes, optimal allocation among case types and quality of care are not captured in the contracting arrangements. The government has not yet attempted to focus on how desired outcomes rather than outputs might be achieved.

At this stage of development, the contracts are expressed in general terms, and service requirements and standards are not specified in detail. For example, for child health in Auckland, outputs are specified as daypatient attendances; inpatient admissions; first outpatient attendance; and follow-up outpatient attendance for each of the major hospitals The Christchurch contract provides greater detail for primary health care services. For example, performance indicators in child health include: number of 14 year olds receiving vision screening; number of school entrants receiving hearing tests; and number of babies checked at nine months of age.

The contracts are negotiated annually, and are not agreed until after the start of a financial year. The governments financial year (the contracting year) commences in the middle of winter which is the busiest period for most hospitals. These factors make planning of the level of services or the availability of funding for capital expenditure slightly more difficult for area health boards. For some services a longer contracting time frame may be appropriate. This will be an issue that must be addressed by the RHAs, particularly if they are not to impede the entry of competitive providers.

The major weakness of the current system is the lack of any real sanction for poor performance by area health boards. In the past, the major threat was that the Minister could replace a

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board by a commissioner. The Department does not seek competitive tenders for services from private providers or encourage competition between area health boards - the threat of competition has not been used as a constraint on board performance, although an element of competition between area health boards has been introduced with the new interboard charging regime.

To date there have been two contacting rounds between the Department and the area health boards (covering 1990/91 and 1991/92). Our impression is that the contracting has helped the area health boards focus on improving the efficiency of their performance; it has increased their consciousness of cost and of the relative priorities of different services. The cost constraints facing the boards have encouraged the adoption of more conventional business practices including strategic planning and objective setting. Boards have had to examine more carefully priorities for expenditure and ways of improving the efficiency of delivering services. The requirement for more information on costs (and the interboard charging regime) has led to the introduction in most boards of information systems. Some boards are planning to ensure that the information systems will be able to cope with the proposed purchaser provider . split. Cost constraints have resulted in a general trend to reduce bed numbers, inpatient days, and the length of stay with increased use of day surgery. The improvement in incentives for good management and the 1988 requirement for appointment of a general manager appears to also have increased the quality of managers. A number of individuals have also been brought in from outside the New Zealand health sector. However, it is important not to overstate the gains that have been achieved to date - information systems are generally at a very developmental stage and contracting as yet specifies outputs and outcomes desired only in very general terms.

The 1992/93 contract round will be used to set the future strategic direction. The Health Reform Directorate will offer advice on Options to the Minister. The actual negotiations will be undertaken by the contract management group within the Department of Health. The objective of this approach is to allow "shadow" RHA/provider contracting. This should allow the RHAs to push area health boards to further develop contracting skills; improve information systems; and increase specificity of contract terms.

A.3.3 Area Health Board Statistics

Statistics on the funding of the different area health boards, their total assets and their debt:equity ratios are presented below in Table A.2.

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Table A.2 Area Health Board Financial Statistics3

I Funding Allocation 1991192 Total Assets Debt/Equity ($m) ($m) (%) Northland 99 77 23 Auckland 671 793 21 Waikato 256 402 21 Bay of Plenty 153 144 14 Tairawhitj 42 66 20 Hawkes Bay 118 ' 97 12 Taranaki 90 61 27 Manawatu/Wang. 212 177 23 Wellington 300 431 39 Nelson/Marlb. 103 109 21 West Coast 42 35 6. Canterbury 354 504 39 Otago 168 220 17 Southland 83 67 19 TOTAL 2691 3183

The Department of Health has developed a methodology for assessing the relative performance of the different boards by treatment. The Minister has approved a methodology whereby minimum tolerance levels for outputs of services are set with reference to the comparative output performance of boards adjusted for variations in resource use. Tolerance zones are adjusted for the different sizes of the area health boards and for different case mixes. Some examples of the analysis undertaken by the Department of Health are presented in Table A.3. The Department uses this analysis in its negotiations with area health boards to adjust outputs upwards or downwards.

3 Material supplied to the NIPB by the Department of Health. Asset valuations are generally historic cost based and are therefore only indicative. Bay of Plenty Area Health Board asset valuation was obtained from the unaudited monthly Commissioners report, October 1991.

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Table A3 Performance Measures4 1990-91

Health Internal Med Medical Gen Surgery Orthopaedic Promotion Inpatients Daypatients Inpatients No. Ops.

Northland 1.41 0.25 1.55 0.99 Auckland 0.93 0.69 1.50 0.49 0.83 Waikato 2.74 1.17 0.49 1.22 0.96 Bay of Plenty 0.93 1.34 0.38 1.37 11.50 Tairawhitj 2.06 1.78 0.64 1.49 1.28 Hawkes Bay 0.01 2.15 0.32 1.59 1.01 Taranaki 0.42 1.56 0.42 1.69 1.07 Manawatu/Wang.0.1 3 1.15 0.72 1.30 1.12 Well 1.05 0.94 0.69 0.88 0.96 Nelson/Marlb. 0.88 2.62 1.25 0.93 West Coast 5.62 1.64 0.22 1.78 1.26 Canterbury 0.64 0.52 1.48 0.84 090 Otago 0.13 1.17 0.88 1.34 1.37 Southland 1.34 0.83 1.17 1.12

A.3.4 Services

The primary, secondary, tertiary, mental health and continuing care services provided by the area health boards are described briefly below. Area health boards have focused attention in recent years on improving primary services and better integrating primary, second and tertiary services. The "service model" which has been adopted by a number of boards involves managing care for a particular service for a particular patient through all three levels of care. Skilled staff are encouraged to move into and Out of the community to deliver a comprehensive service and ensure that specialised knowledge is built up in communities. At the primary care level this involves working together with the private and voluntary sector. Where possible community providers are invited into the hospital setting with the area health boards providing facilities to support and back up community services. The process of providing an integrated service is at an evolutionary stage.

A.3.4.1 Primary Health

A range of primary health services are provided by the area health boards. These services include some of the public health outputs previously delivered by the district offices of the

4 Department of Health (1991), AHB Outputs: Performance Range Data by Board of Domicile.

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Health Department (although this integration is likely to be reversed if the reform 7 proposals outlined in the green and white paper are implemented).

Community Heath

Community health services provided by boards include:

child health services including family health counselling and school visits to assess vision, hearing, health and immunisation status;

surveillance of primary practitioners to restrict the misuse and misprescribing of medicines and to administer benefits and subsidies, as well as inspecting and licensing rest homes and;

community support services including domiciliary care and education services. In most regions those services are provided directly by the boards. In the case of the Canterbury Area Health Board, the community services for the Christchurch region are provided on a contract basis by the Nurse Maude Association.

Special Programmes

Government has identified cervical screening as a health priority and as a result cervical screening programmes are being established in all area health board regions. The government has also funded a number of pilot programmes, including for example a mammography screening programme.

Health Protection

This service includes reporting, investigating and controlling communicable diseases, food and water quality monitoring, monitoring and control of environmental health, toxic substance hazards, occupational health and operation of public health laboratories.

Oral Health

Area health boards provide hospital dental services and services to all enrolled preschool, 1 primary and intermediate school children. The hospitals also administer the benefit scheme for secondary school students, and dental public health specialist services.

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Health Promotion

Most boards have programmes to provide information to assist individuals to adopt healthy life styles. These include activities to improve road safety, to reduce the level of smoking, and to promote health for the Maori people.

A.3.4.2 Secondary and Tertiary Care

The public sector dominates the provision of secondary hospital care and high technology, high cost (tertiary) services. New Zealands public hospitals, which number 155, are administered by the area health boards. These public hospitals provide 19,987 beds or about 79 percent of total beds; 92 percent of general hospital beds and 43 percent of geriatric beds in New Zealand.5 The hospitals and hospital beds by region by sector are shown in Table A.4.

Table A.4 Hospitals and Hospital Beds by Region6

No. of Public No. Private Total Beds per 100,0002 Hospitals 1 Hospitals2 Hospitals Acute Geriatric Northland 8 4 12 390.6 Auckland 280.6 19 66 85 275.6 276.3 Waikato 21 12 33 345.7 Bay of Plenty 228.3 7 12 19 310.2 194.6 Tairawhiti 2 2 4 478.5 Hàwkes Bay 257.2 5 7 12 509.2 255.7 Taranaki 6 4 10 373.0 Manawatu /Wang. 222.5 14 8 22 362.9 213.7 Wellington 9 26 35 296.2 Nelson/Marib. 243.0 10 5 15 324.9 266.4 West Coast 6 6 409.3 Canterbury 580.3 26 23 49 332.5 378.7 Otago 16 9 25 418.1 Southland 325.5 6 5 11 339.3 299.6 TOTAL 155 183 338 332.3 275.2 1. As at 30 September 1990. 2. As at 31 March 1990..

Data as at 30 September 1990, supplied , 6 by Department of Health. Cumming, J. (1991), Competition in Health Services, Funding and Provision of Health Services. draft paper prepared for the Task Force on

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Since 1972 the funding of mental health, psychiatric hospitals and hospitals for the intellectually handicapped has been fully integrated with that of public hospitals controlled by area health boards.

The services provided by these institutions are described below.

Surgical Services

Surgical services include cardiothoracic surgery; dental surgery; ENT surgery; general and abdominal surgery; ophthalmology; orthopaedic surgery; urology; plastic and neuro surgery. The surgery is undertaken either on an inpatient or day-patient basis. Many of the area health boards are increasing the volume of surgery completed on a day basis. Day surgery may be appropriate for a wide range of operations including childhood ENT problems, cataract removals, varicose veins, removal of breast lumps and plastic surgery. The trend towards day surgery is one reason for the present overcapacity of beds observed in both private and public hospitals.

Medical Services

The major illnesses in developed countries are chronic disorders with a few categories (heart disease, strokes, cancer, diabetes, chronic lung disease and arthritis) accounting for the vast majority of chronic illness. These disorders generally are experienced in middle age and progress at various rates. They often remain incurable. The medical services provided by the board include the following:

cardiology: cardiac medical services, with assessment and after care for cardiac surgical patients; -

gastroenterology: diagnosis and treatment of diseases affecting the gast -ro intestinal tract including the liver and pancreas. Inpatient and outpatient services are provided;

I • immunology: includes rheumatological services, auto immune/allergy services, immune deficiency including community educational services. These are largely outpatient based;

infectious diseases: includes advice o management and antimicrobial therapy of infected patients and general advice on control of infections;

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respiratory medicine: investigation and treatment of respiratory diseases on an inpatient or outpatient basis;

dermatology: diagnosis and treatment of skin diseases;

• endocrinology: diagnostic treatment and management of patients with diabetes, endocrine, and/or metabolic disorders. Includes largely outpatient and day patient treatments;

haematology: disorders of the blood including leukernias and bone marrow transplants;

oncology: treatment of cancer is provided on an inpatient, day patient and outpatient basis;

• nephrology: inpatient, outpatient and day patient services are provided for patients with kidney disease including acute and chronic kidney failure; and

neurology: provision of inpatient, outpatient and consultative services.

Obstetric and Gynaecology Services

Inpatient maternity services are almost exclusively provided in public hospitals (the only private inpatient maternity service is provided by St Georges Hospital in Christchurch). Practitioners (including GPs, specialists and midwives) contract with the area health boards to practice obstetric care in board facilities. Ante- and post-natal care are provided by public hospitals maternity units as well as by GPs and domiciliary midwives.

Gynaecological services include colposcopy and infertility services. Services for terminating pregnancies are also provided, generally on a day basis.

Clinical Support Services

Clinical support services include:

• anaesthesia for the management of chronic pain, and for acute or elective surgery;

• sterilisation .of supplies;

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orthotics which involves the supply of appliances for disabled and injured patients, surgical footwear, wheelchairs, incontinence and colostomy aids and walking aids;

nuclear medicine, which involves largely diagnostic work including radionuclide organ imaging, thyroid hormone radioirnmunoassay, other in vivo/vitro radionuclide tests, radionuclide therapy and bone mineral densitometry;

pathology and laboratory diagnostic services. These include biochemistry, bacteriology, virology and haematology laboratory services;

pharmacy;

radiology which provides diagnostic services to inpatients and outpatients and to patients referred by private practitioners. Diagnostic services include X-rays, mammography, computerised tomography, and ultrasound;

physiotherapy, speech therapy, audiology; and

social counselling services.

A.3.4.3 Mental Health Services and Intellectual Disabilities

Mental health services are usually organised around hospitals involving inpatient beds, outpatient and day patient services. Some institution-based care is necessary for seriously disabled patients who, by reason of mental disability, are a danger to themselves or others, but more generally, increasing effort is being made to support individuals in the community.

Intellectual disabilities have in the past frequently been treated in an institutional setting but increasing use is made of community based facilities, e.g. houses with four or five residents staffed by the area health boards.

A.3.4.4 Continuing Care

Continuing care includes services and programmes for those with mental and physical disability including the elderly. The delivery of services involves both hospital and community-based services.

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The boards role in providing continuing care has decreased over time with increasing use being made of private institutions and community-based care, often still funded by government.

A.3.4.5 Other

Ambulance services are generally provided on a contract basis by the private/ volunteer sector.

Hotel and non-clinical services are provided including catering, cleaning, repairs and maintenance.- In a number of boards these services are obtained on a contract basis from the private sector.

A.3.4.6 Expenditure by Service Category for Each Area Health Board

Table A.5 presents comparative information on the expenditure of public funds by national service category for each of the area health boards.

Table A.5

Proportion of Expenses by Service category as at 30 June 1991

Dental Paediatrics Geriatric Psychiatric Intell Obstetric! Handicap Neonatal $(000) % 5(000) % 5(000) % S(000) % $(000)$(000) % 9; Northland 2,116 2.85 5,663 7.61 11,954 16.07 Auckland 11,008 2,881 3.87 0 0.00 7,298 9.81 1.62 24,493 3.61 62,764 9.24 70,978 10.45 Waikato 4,246 -1.72 38,425 5.65 89,171 13.13 8,857 3.59 31,691 12.83 21,811 Bay of Plenty 3,075 2.33 8.83 18,560 7.52 22,012 8.91 10,550 8.00 9,052 6.87 9,915 Tairawhjtj 1,200 3.43 7.52 0 0.00 11,630 - 8.82 2,563 7.32 6,854 19.58 1,614 4.61 Hawkes Bay 2,510 2.81 4,845 5.41 0 0.00 3,525 10.07 Taranaki 12.246 13.64 4,495 4.75 0 0.00 2,043 2.84 7.072 9.83 9,222 1032 Manawatu/ Wang 12,463 1732 4,552 633 794 1.10 4,136 2.08 4,282 2.15 15,226 7.64 6.938 9.64 Wellington 4.891 32,658 1638 33,347 16.73 13,640 6.84 1.77 16,139 5.85 40,506 14.68 31,181 1130 Nelson/Maclb 1,445 1.65 6,117 2.22 20,255 7.34 3,109 3.54 12,951 14.74 9,378 10.68 West Coast 299 0.88 748 14,438 16.44 6,049 6.89 2.21 7,878 23.24 5,885 1736 Canterbury 5,887 1.77 9,990 3.00 -3.148 9.29 2,081 6.14 28,578 8.58 42,237 12.68 30,709 9.22 Otago 2,325 1.48 3,844 2.44 21,868 6.56 Southland 22,465 14.26 12,987 8.24 6,810 432 427 0.68 5.807 9.23 13,594 21.61 10,889- 6.91 3,898 6.20 413 0.66 6,608 1030 Average across Boards 3,258 1.84 7,712 4.35 20,587 11.62 18,176 10.26 10,912 6.16 16,513 9_32

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Surgical Medical Primary Health Health Total Care Promotion Protection Grant

$(000) % $() 9; $(000) 9; $(O00) 9; $(000) 9;

Northland 26,959 36.25 10,939 14.71 5,410 7.27 414 0.56 744 0.01 83,403,000 Auckland 177,617 26.16 161,515 23.79 11,907 1.75 19,600 2.89 11,538 1.70 682,694,000 Waikato 74,045 29.98 48,828 19.77 12,810 5.19 2,860 1.16 1,269 051 262940,000 Bay of Plenty 44,943 34.08 30,866 23.41 6,286 427 2,577 1.95 2,963 2.25 132,998,000 Tairawhiti 9,403 26.86 6,113 17.46 1,330 3.80 1,646 4.71 758 2.17 37,128,000 Hawkes Bay 25,840 28.81 18,570 20.72 10,824 12.10 996 1.12 329 032 103,021,000 Taranaki 21,311 29.61 13,490 18.75 1,836 2.55 953 132 511 0.71 77,195,000 Manawatu/Wang 36,089 18.10 33,606 16.85 24,487 12.28 1,263 0.63 616 031 214,605,000 Wellington 72,309 26.21 50,696 18.38 24,940 9.04 6,990 254 1,831 0.66 307,944,000 Nelson/Marlb 20,815 23.70 12,890 14.68 5,557 633 779 0.87 426 0.49 95,376,000 West Coast 7,158 21.12 4,539 1339 1,805 533 299 0.88 54 0.16 37,833,000 Canterbury 88,747 26.64 72,765 21.84 27,367 8.21 1,275 038 3,777 1.13 363,299,000 Otago 48,170 3057 33,377 21.19 14,807 9.40 918 058 961 0.61 178,863,000 Southland 17,025 27.06 12,909 20.52 1,898 3.02 109 0.17 231 036 72,663,000 Average across Boards 47,888 27.04 36,507 20.61 10,805 6.10 2,906 1.64 1,858 1.05 189,283,000

A.3.5 Facilities

A.3.5.1 Hospitals

A summary of the private and public hospital facilities and the bed numbers by area health board is provided as Annex 1. In the section below we summarise the main characteristics of the different facilities.

Urban Hospitals

The main distinguishing feature of urban public hospitals is their ability to provide trauma/acute and accident and emergency facilities with full 24-hour-a-day intensive care backup. The ability to handle trauma/acute cases requires the provision of facilities staffed 24 hours per day with specialists on call. The operation of such units is very expensive. because of the requirement for staffing irrespective of case load. Some specialised equipment is required although this is not considered the major barrier to providing these services. Sme urban hospitals have a relatively high proportion of trauma/acute cases that must be dealt with immediately rather than being able to be scheduled. For example, 48.5 percent of Wellington Hospitals admissions are acute, 30.2 percent are arranged and 21.3 percent are from waiting lists. Of the total operations undertaken, 28 percent are for emergencies.

Urban hospitals generally provide a relatively wide range of surgical and medical services and in the main centres provide tertiary services such as open heart surgery. They also provide outpatient services and in many cases are moving to offer more day surgery.

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Psychiatric. Hospitals

Psychiatric hospitals provide institutional care for individuals with mental illnesses and disabilities. The hospitals provide continuing care as well as specialised psychiatric and psychological treatment of patients. Expensive technology has not played a prominent role in psychiatric diagnostic or treatment strategies7 with skilled staff being the key input to treatment. In recent years the trend has been towards more Community-based and outpatient care and the establishment of smaller treatment units within hospitals.

Forensic psychiatric services are currently being established throughout New Zealand to provide secure inpatient beds to mentally disturbed persons on remand, disturbed offenders and those mentally ill persons whose particular illness requires the management of violent behaviour.

Rural Hospitals

Rural -hospitals act as a focus for rural health care delivery. They are generally closely integrated with primary health care services provided in a district. The hospitals usually provide maternity care and non-acute inpatient care, long stay geriatric care, and medical and emergency outpatients. Some also provide occupational therapy, physiotherapy, podiatry, dental care, meals on wheels and day care. In some cases they may act as a base for district nursing, home health and health information resource centres.

Geriatric. Hospitals

Hospitals in this category provide continuing care for elderly patients. The emphasis is on providing supportive nursing rather than acute care facilities.

A.3.6 Organisation and Management Arrangements for Area Health Boards

Funding constraints and the introduction of the general management have caused boards to review costs and examine different ways of delivering outputs. The various area health boards are at different stages in improving performance and in progressing towards a

7 Working Party on Mental Health Services (1989), Mental Health: Outline of Service Development for Mental Health for Area Health Boards", Department of Health.

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purchaser provider split. Some boards believe a purchaser provider split has assisted in driving efficiency gains.

The progress achieved by the different boards appears very dependent on the quality of individuals recruited to boards and management. Some boards appear to be lagging behind in reforming their operations and this indicates that the institutional structures do not automatically correct poor performance.

The variable progress in restructuring and achieving efficiency improvements also reflects different philosophies of managers and boards and different opportunities available in different areas. For example, the Southland Area Health Board, regards itself as predominantly a provider rather than a purchaser organisation. This partly reflects the smaller size of the Southland Board, and the fact that only a single major hospital exists in the area. As a result there is more limited scope for a purchaser in Southland to encourage competition between public providers. In contrast, three major hospitals exist in the Bay of Plenty with considerable scope for direct or benchmark competition for some services. In that region, providers have been set up as autonomous units with the area health board acting predominantly as a purchaser. Similarly, Auckland Area Health Board is moving to establish relatively autonomous provider districts based on major hospitals with head office increasingly concentrating on purchaser functions. Wellington has also established autonomous providers with corporate office assuming a purchaser role.

In the section below we examine the responses that some of the different area health boards have made to the funding constraints and the pressure for reform exerted by the government over recent years. We have examined only a sample of area health boards within the very limited time available for this project. This is not intended to be a comprehensive review of approaches adopted by all boards but instead indicates the variety of developments with which the process of reform must cope. Further study is required to ensure that the specific circumstances of each Board are taken into account in detailed development of, the reform process.

A.3.6.1 Combined Purchaser Provider Role

Southland Area Health Board

Southland Area Health Board serves a relatively small but widely dispersed population. One main hospital located in Invercargill provides secondary and limited tertiary services,

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relying on the Otago Board for some specialist services such as cardiothoracic and neuro surgery. Seddon Memorial Hospital in Gore and the Lakes District Hospital in Frankton provide a limited range of surgical and medical services and provide facilities for birthing and geriatric care. Cases requiring specialist care are transferred to Southland Hospital. Other hospitals such as those located at Lorne and Riverton provide geriatric care. Trusts have been established to manage Tuatapere and Winton Hospitals. (The latter are discussed in more detail below.)

The board regards itself primarily as a provider organisation and has not moved to separate purchasing and provision or to consider in detail the implications of the proposed reforms. The management structure -remains centralised at the corporate office level, although a relatively flat management structure has been adopted. Some improvements in the efficiency of hospital operations have been achieved, for example through contracting Out of "hotel(for example catering) services. The Board is currently implementing a management information system intending to improve management of costs and the collection of more patient management information. This will assist in any move towards a purchaser provider split.

Canterbury Area Health Board

The Canterbury Area Health Board was established through the merger of five separate health units. While the board has undertaken significant internal restructuring, it has only recently commenced to separate purchasing from providing of health care services.

The management of the Board is working towards a decentralised service-based divisional management structure comprising the following divisions: primary health; secondary health; secondary extended care; commercial support services and corporate services.

The secondary care division is currently undergoing a reorganisation with the introduction of service management. The service groupings include: surgical services; medical services; obstetric and gynaecology services; combined services; and clinical support services. The management of the Board has moved to delegate accountability and budgetary decision making to service delivery units based on the sub-specialties and departments that make up each service. The Board anticipates that around 100-120 service delivery units will be created throughout the Board. Each will have responsibility for budgets of between $1 million and $3 million.

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I (;oIlfideIltiaI CS FIRST BOSTON The management of the Board is implementing new financial and management information systems which will assist in monitoring qualitative aspects of services and will ultimately assist in measuring health outcomes. The information systems will be essential in the introduction of the purchaser provider split proposed by government. The management of the Board believes its restructuring is consistent with the governments announced reform.

Financial constraints have led the board to reduce inpatient beds, reduce length of stay, and increase the use of day surgery. The Board believes that it would be sensible to centralise all acute medical, surgical and other services on the central hospital site at Christchurch, with other facilities being modified or closed and has moved to achieve this. The Board plans to relocate acute/high technology surgical and medical services from The Princess Margaret Hospital to Christchurch Hospital by early 1992. Day surgery facilities will be opened at Burwood and The Princess Margaret Hospitals. As a result, the opportunities for competition in the provision of acute services have been reduced.

Following the reorganisation, the Board will have significant spare hospital capacity (around 300 beds). It anticipates that it could reduce its hospital stock by the equivalent of one to two hospital sites. Four hospitals are currently being reviewed in this context: Burwood Hospital, Christchurch Womens Hospital, the Princess Margaret Hospital, and Sunnyside Hospital.

A.3.5.2 Moves. Towards Purchaser Provider Split

A number of the area health boards, as part of the restructuring process, have moved towards an internal purchaser provider split. The area health board corporate office has taken or a purchaser role, in theory buying the services the board has contracted to provide from providers, either public or private, that can best meet needs at the lowest cost. Provider units are established as relatively autonomous units and compete, at least to some extent, for funding from the corporate office. The Bay of Plenty Area Health Board is the most advanced in this process. Auckland has also made substantial progress. The Wellington Area Health Board has implemented a similar separation but progress to full corporatisation of providers was constrained by local political resistance.

For the boards implementing these changes, the move to formal separation of purchasing and provision and the establishment of the RHAs is a relatively logical step in an on-going restructuring process. However, even for these boards, contracting is still at an early stage and substantial further development will be required before robust contracts can be written

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between arms-length funders and providers. For those boards that have not moved along this path, the transition will be much more challenging.

Bay of Plenty Area Health Board

The Bay of Plenty Area Health Board was created from three hospital boards (Tauranga, Bay of Plenty and Rotorua) and the health development unit (previously the offices of the Health. Department). The Board adopted the philosophy of separating purchasing from provision at an early stage, explaining its approach to the community in a pamphlet Partnerships in Health first published in early 1990. The board believes that complete separation of purchasing and provision for the Bay of Plenty Area Health Board could be achieved within two years.

-Three provider units based on hospitals at Tauranga, Rotorua and Whakatane have been set up as autonomous units. A separate purchasing unit based on the corporate office has been established. The corporate office provides treasury services to the provider units and has assisted providers in implementing information systems but its main focus is on the purchaser functions of the Board.

The corporate office, acting as purchaser, has established five sections for management purposes. These comprise review; contracts; finance and information; Te Mana Hauora and support services. The review section is responsible for assessing the overall health status of the region, establishing health goals, and assessing how changing service provision affects health status. The contracting section is responsible for developing purchasing plans, negotiating with public and private providers for the delivery of services and monitoring performance. It uses information from the review group to assist in deciding what services it should buy. It also ensures that the services purchased are consistent with the Boards contract with the government. The financial group defines financial and service information required by the Board and the Department of Health and has developed board-wide systems to obtain this information. The fourth group is responsible for establishing and maintaining the contributions of Maori in the Boards planning, monitoring and management processes, providing advice on Maori requirements in the community, and providing advice to Maori groups undertaking health care initiatives. The final unit provides support services to the group.

A major elementof the Boards progress towards purchaser provider separation has been the development of information systems. The Board has implemented general ledger, costing and

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clinical and patient information systems. Interboard charging, which is an important source of revenue for some of the areas providers, and particularly for Rotorua, has provided an important impetus to the development of information systems.

The separation of the three main provider units for management reasons means that their establishment as separate CHEs is unlikely to be particularly costly. Most management functions are already handled by the provider units. The Treasury function provided by the corporate office could either be obtained on a contract basis or devolved to the providers. Some further work is also required to devolve completely information management systems to the providers.

The viability of the provider units as separate CHEs will be dependent on the definition of • core services and the approach to contracting adopted by the RHA. Whakatane Hospital is viewed as potentially vulnerable to competition. However, it is likely to survive if the • RHA chooses to fund services that are relatively close to the population, i.e. if it- makes similar choices to those being made by the area health board as purchaser. The main facility that might not survive explicit contracting and interboard charging is the Queen..Elizabeth Hospital in Rotorua which provides drug and alcohol rehabilitation, and rheumatological

services for patients from a number of boards. The Board considers that demand for fh hospitals services will fall off when the full costs of patient treatment are borne by other boards. R The management team of Tauranga Hospital is enthusiastic about establishing the enterprise.. as a separate CHE and is impatient of some of the controls imposed by the Board. A particular frustration is the handling of personnel matters (award negotiations) by the Area Health Board. A major element of their costs is partly outside their control. Tauranga Hospital management is actively considering the implications of establishing as a CHE and is reviewing the services it would wish to provide in a competitive, environment. Management estimates that at least one third of the services the hospital currently provides are potentially contestable with elective surgery being particularly vulnerable.

Bay of Plenty Area Health Boards Proposed Direction for Further Reform,

The Bay of Plenty Area Health Board has established explicit baseline" contracts with its provider units. The contracts formalise the current services that are provided in terms of outputs, policy issues, strategic goals, and quality standards. The process will not involve

I, -A23- Confidential CS FIRST BOSTON

formal negotiations with providers. The detail in the contracts are similar to that provided to the government in the contract between the area health board and the Minister of Health.

By March 1992, the Board intends further development of the contracting process by preparing "purchasing plais". The purchasing plans will be public documents which specify the services that the Board wishes to buy for a three to five year period. The services defined in the purchasing plan will be able to be provided by any public or private provider.

In July 1992 contracts based on the purchasing plans will be negotiated. The public providers will have to compete with one another for the provision of different services. Private providers will be able to offer services but a formal tendering process is not envisaged at this stage. The 1993 contracting round will be negotiated with the RHA.

The Commissioners for the Bay of Plenty, Tairawhiti, Taranaki and Waikato area health boards are together working towards the formation of the central North Island RHA. Agreement on this objective has been reached by all four commissioners. The commissioners have prepared and presented a paper to the Health Reforms Directorate outlining their proposed approach. This has been further developed by the Bay of Plenty and is described in a November 1991 paper Critical Path for Establishment of Central North Island RHA.

The paper proposes that the four commissioners together with two to three other individuals form the establishment board for the RHA during the period 1 February 1992 to 30 June 1992. A small team of management staff from the area health boards would be seconded to.the RHA and supplemented by contracted specialist expertise as required. The paper proposes that the establishment board implement on a trial basis the national reforms; recommend size, shape and scope of the definitive RHA; support separation of purchaser and provider roles in area health boards; initiate work on purchasing plans and contracts; develop relationships with providers, especially in primary care; and market and manage the reform process locally. The final RHA board would be appointed by 30 June 1992. By July 1993, the RHA should be operational, contracting with the providers. The approach proposed would, be consistent with the announced reforms.

The Bay of Plenty Area Health Board notes that the purchaser provider separation it has adopted has general support in the local community and suggests that it might make sense for the government to "pilot" the approach in the Bay of Plenty.

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Auckland Area Health Board

The Auckland Area Health Board covers Auckland city, South Auckland and North Auckland (including Rodney and Wellsford). Services are largely sited in central Auckland and are poorly placed to meet the needs of the West and South Auckland populations. Auckland, Green Lane, National Womens and the new Childrens Hospitals are all based in central Auckland. Middlemore Hospital in South Auckland is considered out dated, expensive to maintain and poorly sited. Increasing effort is being made in South Auckland to move facilities closer to the community, with clinics being established away from the hospital site.

The Auckland Board is organised under a mix of hospital, district and service managers. Five main provider units have been established: North and West, based on the facilities located in the North Shore and West Auckland; the South Auckland district; Auckland (with separate managers for the Auckland, Green Lane and National Womens Hospitals and district health services); intellectual handicap; and mental health services.

The corporate office provides services to all units where there are believed to be economies of scale from centralisation. Examples include centralised purchasing of supplies, payroll management and warehousing (although the latter has in the view of the South Auckland District, increased their costs). To a large extent, accountability and responsibility for the management of operational units has been delegated to the provider units. The corporate, office is responsible for funding and planning the services it wishes to provide to the region. Increasingly it negotiates with its provider units agreed outputs within agreed budgets.

A number of the provider units are actively considering the changes that would be necessary for their establishment as CHEs. Both the South Auckland District and Auckland Hospital have developed outlines of how and why they might operate as stand-alone CHEs. Auckland Hospital, for example, has restructured management to increase the efficiency of operation. Management at this hospital has adopted a policy of decentralised accountability and delegated authority with decisions being delegated to managers at the "coal face". The hospital is implementing a preliminary service costing system and a system for recording and reporting outputs. Management notes that further priorities include development of performance measurement systems, further streamlining of management and development of a proposal for establishment as a CHE. Management has identified that non acute and non trauma cases are likely to be challenged by other providers competing for funds. The hospitals response is to increase its focus on acute and tertiary services.

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Given the current management arrangements, the separation of the existing provider units into CHEs appears unlikely to involve substantial restructuring costs. There is some concern among management about the costs of breaking up a management team that is working well together. Corporate office provides support and advice to managers undertaking reform at the provider level, and that would be lost by separation. There is also some concern that decentralisation of some of the financial and materials support services might be costly.

Wellington Area Health Board

The Wellington Area Health Board has established provider units on a relatively autonomous basis, with corporate office assuming a purchaser role. The Board devolved responsibility and accountability for service provision to four units: West Coast, Wellington, Hutt and Wairarapa all of which operate relatively autonomously. Services within these regional areas were amalgamated under a single management structure. For example, the West Coast was formed from four separate institutions in the area: Porirua Psychiatric Hospital; Puketiro Centre; Kenepuru Hospital and the Paraparaumu Maternity Unit. Management is organised along a service rather than institutional basis. For example, services for the elderly in the West Coast District are drawn from three of the four institutions.

The Weilbank approach suggested by the Board in 1990 proposed corporatising the provider units and establishing their own boards of directors thereby further distancing them from the corporate office, and allowing greater competition between the units. Some specialisation was envisaged within each of the areas so that some services would not be subject to competition while others would be. For example, acute tertiary services are not provided by the West Coast District or Wairarapa and are provided to only a very limited extent in Hutt Hospital. For non-urgent elective surgery significant scope for competition exists. Although travel distances constitute some barriers to competition, these are not considered insurmountable given the observation that patients are prepared to travel within the district for different services. -

However, political opposition to the move was strong and resulted in the approach being abandoned. In addition, it became apparent to the Wellington Area Health Board that the Government was moving to establish RHAs on a broader regional basis.

-A26- I (onfidentia! CS FIRST BOSTON TI Management now believes that there would be advantages in rationalising the overcapacity and duplication of facilities between the hospitals in the Wellington region rather than encouraging competition. It believes that establishing a single CHE based on the Wellington Hospital would be the most sensible option. Secondary and tertiary services would be concentrated at Wellington Hospital. Even with the concentration of services on Wellington, hospital management believes that the campus could be further rationalised with buildings which cover approximately half of the campus area being surplus to requirements. The approach would allow rationalisation of services that are duplicated at Hutt Hospital and Kenepuru Hospital. Psychiatric services would continue to be based at Porirua and consideration would need to be given as to whether they fit within the CHE or should be established as a separate CHE.

However, little progress has been made in rationalising along the lines proposed. In the past, the board structure, in which board members were drawn from different areas, militated against such a restructuring process. Even without an elected board there is likely to be strong resistance to the reduction of services in particular areas.

A key issue for Wellington, if the more recent approach adopted by the Board is correct, is the rationalisation of surplus and poorly configured assets.

A.3.6 Community Trusts

A.3.6J General

A number of Boards have moved already to establish community trusts under the provisions of the Charitable Trusts Act to operate facilities that would not otherwise be viable, or to change the manner in which services are offered. The rationale for their development appears to have been variable. In some cases it has been driven by the board, in others communities have provided strong support for the facilities. In most cases, the board , has reached the conclusion that the facilities are not economically sustainable without input from the community, either in terms of voluntary labour or donations to fund operating shortfalls.

Community trusts have been formed from existing institutions such as Tuatapere Hospital in Southland, or as the result of new initiatives as in the provision of care to people with intellectual disabilities in Auckland (where a move to small, house-based units have been established).

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The establishment of community trusts appears to have been driven by a variety of considerations:

it has enabled access to Social Welfare funding for long stay care and cheap loan finance from the Housing Corporation for the purchase of buildings, e.g. for the purchase of houses for the intellectually handicapped in Auckland;

it enables the benefits of exemption from tax to be realised;

it has allowed the renegotiation of more flexible staffing arrangements outside of the tight Constraints imposed by the PSA. For example, for intellectual disability facilities in Auckland it has enabled the employment of staff on a five days on, two days off basis rather than the four days on, two days off Currently worked in public institutions. It has also enabled a reduction in penal rate payments.

In addition, the establishment of trusts has allowed:

greater input from the community both in terms of voluntary funding or the contribution of unpaid labour, e.g. the local community in Tuatapere provides food for the hospital; and

• a more appropriate method of delivering care, as is the case in the delivery of services to the intellectually disabled in Auckland. The latter has involved a move from institution to community-based care.

Generally, the trusts continue to receive some funding from the area health boards for the delivery of specified services.

A.3.6.2 Case Studies

Winton and Tuatapere Hospitals

Southland Area Health Board has, in the past three years, worked with two communities to assist in forming community trusts to provide a health service to the communities following a decision by the Board that it could no longer Sustain the costs of the hospitals concerned.

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Until October 1988, the Board had operated maternity hospitals at both Winton and Tuatapere on a 24 hours per day, 365 day per year basis. In August 1988, when faced with an operating funding shortfall, a number of service reduction decisions were made, including the closure of the Winton and Tuatapere Maternity Hospitals. Winton Hospital is close to the base hospital (18 miles) and its birth rate could be easily absorbed by the base hospitals large obstetric unit. The viability of staffing Tuatapere Hospital 24 hours per day was questionable in a district with a birth rate of 30 per annum.

The approaches for establishment of community trusts came from the communities in response to the Boards intended closure of the hospitals. The Tuatapere Hospital Trust was established in April 1990 and the Central Southland Hospital Charitable Trust (Winton) became operational in February 1991.

The community of Tuatapere accepted that it was unrealistic to operate the hospital 24 hours per day but were concerned about the distance of around 90 kilometres to the base hospital in Invercargill. This represented a risk to patients and an inconvenience to family. The Board now contracts with the Tuatapere Hospital Trust to provide a full maternity service for the district.

The Board expects the Trust to provide sufficient staff to ensure the delivery of basic maternity obstetric services including delivery of babies. Payments are made for each birth within the hospital, as well as time spent at Tuatapere Hospital prior to or following a birth at the Base Hospital. The Area Health Board also in effect provides assistance by leasing the hospital facilities to the trust at a peppercorn rental. The safety of patients is catered for within the contract which requires the service provision to meet specific and defined obstetric standards to the satisfaction of the Boards director of obstetric services.

In the case of Winton, the maternity hospital has been converted into a birthing unit. The Southland Area Health Board has explicitly contracted for delivery services for an agreed fee, with the board supplying all material and equipment necessary for the contracted work (with the trust responsible for repairs and maintenance and replacement of equipment). The contract defines the output required, the standard of service, quality of staff, and contract period. The services purchased by the board include antenatal consultations by a registered domiciliary midwife and postnatal care for those mothers domiciled in a specified area.

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Hikurangi Community Clinics Trust

The Hikurangi Community Clinics Trust was formed to meet specific needs for primary health care services for people on the East Coast of the North Island. The Trust was formally incorporated in September 1991. The Trust evolved out of a medical practice comprising a number of community clinics formed as a financially independent entity in 1990. Funding for the clinics was provided by the Tairawhiti Area Health Board; the community; and the Department of Health.

Following the introduction of the General Practices Contract arrangement in 1990, the Trust was able to operate profitably without charging clients. Since the withdrawal of the General Practices Contracts, the future of the clinics and their organisational structure is less assured and options are being developed at present. The Trust is currently exploring the possibility of a partnership with the Tairawhiti Area Health Board.

The Trust currently provides general medical practice services from four centres;

• Tokomaru Bay Community Health Centre; • Tawhiti Community Health Centre (Te Puia Springs); • Ruatoria Community Health Centre; • Tikitiki Community Health Centre.

A total of 7.5 days of clinic days are worked each week. To provide this service medical officers and nurses employed by the Tairawhiti Area Health Board are contracted part time to the Hikurangi Community Clinics Trust. One clerical worker employed by . the Board has 50 percent of her time contracted to the Trust. The cleaning of clinics, grounds and maintenance is undertaken by the Board employees and the Trust is charged on a cost-per-service basis. The Trust employs its own receptionists.

The Trust staff and the Te Puia Hospital staff work closely together. The integration of the services means that clients frequently are treated by the same staff throughout their illness.

Provision of Services to Individuals With Intellectual Disability in Auckland

The move to increase the use of community services for the delivery of assistance to individuals with intellectual handicap is motivated by a desire to better meet the needs of the individuals concerned.

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Auckland Area Health Board has moved to establish a number of houses, specially adapted for the provision of care to the intellectually disabled in Auckland. Area Health Board staff are employed in the houses to meet the residents needs. The care is more "family" oriented.

Earlier this year the Area Health Board established a Housing Trust to purchase and adapt six houses. Funding for the houses is obtained from the Housing Corporation at concessional rates. The loans repayments will be met through the benefit system and the area health board will provide staffing and support to the people living in the homes.

A.3.8 Area Health Board Contracting With the Private Sector

The area health boards are increasingly considering and using contracting arrangements with private providers to increase the effectiveness of the delivery of services whether or not they have separated purchaser or provider functions. The experience to date is relevant to considering likely contracting arrangements with Ri-lAs. Contracting between providers to reduce costs or improve quality is likely to be important once competitive funding arrangements are introduced. -

Examples we have reviewed of contracting between the boards and private providers include the Canterbury Area Health Board and the Nurse Maude Association for the provision of district nursing and domiciliary support services; and the Bay of Plenty Area Health Board and a surgical partnership for elective surgery.

The Nurse Maude Association is a charitable trust set up under its own legislation. The Association has been providing domiciliary support and district nursing services for the Canterbury region since 1920. The formalisation of the relationship with, at that time, the Canterbury Hospital Board, occurred in 1967. Since then, the Association has provided services for an agreed level of annual funding. A more formal contracting arrangement was introduced with the creation of the area health boards and more precise specifications of outputs have been developed. The organisation also obtains funding and volunteer time from the community.

The Nurse Maude Association has been a monopoly provider to the area health board of domiciliary support and district nursing services. The Association recognises that once the RHAs are established it will be subject to competition from other providers but other opportunities will also open up for it. In particular, it will be able to compete to provide

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services outside its current franchise area of Christchurch. In preparation for the increased competition it is moving to improve efficiency. This has included restructuring of the organisation to achieve a leaner structure, moving to multiskilling of employees and ensuring that skill levels are appropriate to tasks performed; decentralising decision-making; improving accountability; and establishing management and information systems for monitoring performance and output.

The Bay of Plenty Area Health Board in 1990 decided to make a concerted effort to reduce its waiting list for urology by contracting for surgeons to carry out procedures on a fee for service basis specified in advance. The procedures selected for contracting out could be specified relatively easily in terms of the likely operating time and the number of days in hospital necessary for recovery. The contract with the Board specified that the patients would be allocated by the board and that operations were to be completed within a specified time period. Any complications that arose for reasons other than the surgery could be referred back to the public hospital but for other complications an adjustment to payment would be made. The surgeons then negotiated with the two private hospitals in the area for accommodation, theatre time, drugs and dressings etc, and with anaesthetists. The Board visited the hospitals to ensure that they met the standards of care that they required.

The arrangement was successful in reducing the urological waiting list by 25 percent (in part by people not electing to have surgery when offered the opportunity).

The arrangement involved the Board operating as the purchaser with a service contract with the surgeons who are responsible for delivering guaranteed outputs. The surgeons involved plan to establish an integrated team comprising two surgeons (and possibly a third); an anaesthetist, a team of theatre nurses, and an operations manager responsible for scheduling operations and to seek further work from the Board. The team will operate at public or

private hospitals. They will subcontract with the private hospitals, other clinics and diagnostic services, and will pay for services obtained from the public hospital.

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A.4 Private and Voluntary Provision

A.4.1 Hospitals8

A.4.1.1 Services and Facilities

Approximately 184 private hospitals in New Zealand provide over 6,700 beds or around 20 percent of the total number of hospital beds in New Zealand. Each year, private hospitals care for more than 80,000 people.

All are required to be licensed by the government, most being covered by the Hospitals Act 1957. Private hospitals are owned by churches and religious groups, welfare organisations, charitable trusts, private companies, doctors, and other individuals. Around two thirds of private hospital beds are owned and operated by organisations which are "non-profits". (The non-neutrality created by non-profit status is discussed in more detail in Section 5.0.) For- profit hospitals are uncommon for surgical services (Wakefield Hospital in Wellington is an example) and are more common for long term and elderly care facilities. A detailed breakdown of private hospital ownership is provided in Table A.6 below.

Table A.69 Ownership and Types of Private Hospitals

Ownership Surgical Hospice Geriatric Maternity Psych Total LSM B H H .B H B H B H B H B

Relig/Church 7 426 1 22+ 49 1921 19# 56 2308

Volunt/ Welfare , 13 520 466 Other Trust 20 741 3 37 7 321 1100 31 1353

Company/Indiv 10 114 72 2442 2 34 84 2550

Total 36 1281 4 59+ 141 5204 19# 3 134 184 6697

H Hospital Nos. B Bed Nos. LSM Long stay medical. + These figures include a 16 bed unit which is part of a surgical hospital. # This 19 bed maternity unit is part of a surgical hospital. * These figures include 137 geriatric beds which are located within eight surgical hospitals.

8 New Zealand Private Hospitals Association (1990), Private Hospitals in New Zealand: A Background Paper, Wellington. 9 ibid, p 3.

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The private hospitals provide a cross section of care including surgical, medical, geriatric, maternity (a single unit), psychiatric and special services such as inpatient hospice care. Most of the hospitals are licensed as private hospitals under the Hospitals Act.

The hospitals provide nursing care and facilities which are then used by surgeons for their private patients. Surgeons and anaesthetists are not employed by the hospitals but work on their own account. Some services are operated on a joint venture basis or by private individuals leasing facilities (e.g. the radiography unit at Wakefield Hospital). The hospital benefits by leasing its facilities and increasing hospital throughput.

As at 31 March, 1990 there were 36 hospitals licensed as surgical /medical hospitals under the Hospitals Act. The surgery undertaken in the private sector ranges from simple procedures such as hernias to major operations such as hip replacements and heart surgery. Advances in medical technology that allow more non-invasive surgery have increased the opportunities for private providers. In general, however, although private hospitals offer a range of services, they tend to concentrate on elective/non-urgent surgery that does not require intensive care backup. Orthopaedics constitute the largest overall category of surgical procedures carried out in private hospitals. Four hospitals currently have facilities to undertake open heart surgery. Wakefield Hospital in Wellington can undertake most acute, complex surgery including open heart surgery, total hip replacements and some neurosurgery as long as it is on a planned basis. It has intensive care facilities to provide backup for scheduled operations. However, it does not provide critical care facilities on a 24 hour basis for unplanned cases and does not generally handle patients that require a number of different surgeons to operate at the same time (generally the latter are trauma patients). The other hospitals providing cardiac surgery are the Mercy Hospital in Auckland, the Southern Cross. Hospital in Christchurch and Braemar Hospital in Hamilton. Some of the hospitals have bought high technology equipment, for example Mercy Hospital in Auckland has both a CAT scanner and an MRJ machine.

The total number of operations carried out by private hospitals in 1988 was 73,738 out of a total of 284,260 private and public operations. This constituted around 26 percent of the total operations carried out in both private and public hospitals. (These figures do of course abstract from the relative complexity of operations in the public and private sectors.) Our discussions with private operators indicate that a number of them would be able to increase output, some by as much as 50 percent, without any additional expenditure on capacity.

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None of the private hospitals provide 24-hour critical care facilities for acute non-planned patients. Although some have the facilities to handle such patients, the costs of providing 24-hour cover with skilled staff for an uncertain work load is too high to make it worthwhile when such services are provided free on demand by the public sector.

Hospital bed numbers for surgical treatment have remained virtually static over the past 20 years although over that period there has been around a 35 percent increase in the number of operations. The length of stay has decreased over the same period. Occupancy rates in the private hospitals are relatively low averaging 55 percent in 1989 (however, the levels are higher during the week and lower at weekends). 10 There have been few new hospitals built in the last five years although a number of stand alone clinics have been established.

Private hospital growth has been most pronounced in geriatric care, reflecting primarily Department of Health policy in addition to the aging of the population. Private hospitals provide about one half of the total beds officially designated for geriatric patients. In 1990, the private sector provided around 5,200 geriatric beds.

Hospice care for the terminally ill has been a relatively recent development. Six in-patient facilities are currently in operation. They all depend to a large extent on community support. for funds and ancillary staffing as patients are not charged fees. Three of the hospices receive some funding from their area health board. Hospice services are also provided on a domiciliary and day care basis.

There is a 100 bed psychiatric hospital located in Dunedin which is approved under the Mental Health Act. There are two psycho-geriatric hospitals located in Wellington licensed under the Hospitals Act. A number of alcohol and drug treatment units exist which have been approved under the Alcohol and Drug Addiction Act.

Private hospital provision has been influenced over the years by public subsidies to and controls on the private sector. Until 1987 patients in private hospitals received a daily subsidy from the government, including in 1986, long-term medical and geriatric benefits. In 1987, the government removed medical and surgical benefits provided to private hospital patients, as well as maternity benefits, and it has progressively removed most subsidies relating to prostheses, medical gases, non-clinical drugs and anaesthetic drugs. At the same time, restrictions on the development of new surgical and acute medical services have been removed.

10 ibid,p6.

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Before 1989 around 30 percent of private hospital funding was provided by the Accident Compensation Corporation. However, in 1989 legislation was passed to enable fee payments to be set by regulations. The regulations prescribe maximum fees which are payable for specific procedures and daily bed rates. The rates are set below the actual fees of most hospitals with patients generally funding the shortfall. The basis for deciding whether a case is approved for treatment in a private hospital also changed from treatment that would require a lengthy wait for public hospital treatment, to treatment that is essential to return the injured client to his or her "primary economic activity. The result has been a reduction in. ACC funding to the private sector by around 40 to 50 percent.

Private surgical and acute medical patients, unless aged 65 or over or covered by ACC, now pay directly or through their private insurance for virtually the full amount of their private hospital treatment.

Geriatric and other patients requiring long-term care receive a daily patient benefit towards their private hospital care. The geriatric benefit has not been increased since 1984. Where there are no public hospital beds available additional assistance may be provided through the geriatric hospital special assistance scheme.

The pattern of provision that has developed indicates a high market share for the private system where a relatively neutral funding regime exists between public and private providers (e.g. for long stay geriatric care) and where gaps exist in the public system, as for example with elective surgery where people do not want to face long waiting lists. It also reflects distortion in benefit entitlements for people in public hospitals, private hospitals and rest homes.

A.4.7.2 Southern Cross

Southern Cross is the major operator of private hospitals in New Zealand. Southern Cross has ten hospitals throughout the country and is in the process of constructing an additional one in Wellington. Each hospital operates as a charitable trust. Approximately 40 percent of all private surgery is carried out in the Southern Cross hospitals.

The Southern Cross units generally provide elective surgery that does not require intensive care backup. However, its hospital in Christchurch undertakes open heart surgery and has associated critical care facilities that operate only when heart surgery operations are

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undertaken. The Southern Cross heart unit is the only such facility in Christchurch and the hospital provides heart surgery services on a contract basis to the Canterbury Area Health Board. Before the establishment of the unit, Canterbury patients were sent to Dunedin for heart surgery. The contract is between the hospital and the area health board with Southern Cross then contracting with surgeons and other specialist staff to provide the required service. The arrangement reflects the existence of specialised facilities at the Southern Cross Hospital (c.f. arrangements where the surgeons contract with a board and then separately contract with a private hospital).

Southern Cross claims that the operation of a chain of hospitals provides it with brand name/franchise benefits. Each hospital is, however, operated relatively autonomously. Management perceive few advantages from centralised purchasing of supplies. The hospitals provide services for Southern Cross insurance patients who are strongly encouraged to use Southern Cross facilities (through price discounting and billing arrangements).

A.4.2 Primary Care Outside Area Health Boards

Primary care services are subsidised through open-ended subsidies paid by the Department of Health. Subsidies vary between zero and 100 per cent and users are generally expected to pay part-charges which contribute towards the cost of some of these services. A number of not-for- profit agencies, like the Plunket Society, also provide primary care services. In general they are funded through contracts with the Department of Health.

Primary care includes services such as general practitioners, midwives, nurse practitioners, pharmaceuticals dispensed through retail pharmacies, physiotherapy, and a range of non- traditional therapies such as naturopathy (many of which do not receive government subsidies).

GPs act as gatekeepers to much of primary and secondary care, through their control over the prescription of many drugs and referrals to specialists. Thus GPs influence over total expenditure is much greater than is implied by their relatively small share of total expenditures.

Most GPs are in solo or group practices although there have been some experiments with innovative methods of delivering care such as the private clinics in Auckland which offered GP,.specialist and 24 hour accident and emergency care.

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Larger practices are supported by practice nurses and some have allied health professionals in the practice. General practitioners provide after hours service their patients to complement day and evening surgeries.

There are a number of specialist doctors in private practices. These include surgeons, physicians, radiologists and psychiatrists. Some may hold weekly or monthly clinics in group practices in other districts. Many work part time in area health board institutions.

Nurse practitioner groups are also increasing although they are constrained by their lack of authority to prescribe drugs. As discussed above, the Nurse Maude society in Christchurch provides a wide range of domiciliary care, largely funded by the Canterbury Area Health Board.

Some restrictions on prescribing have been reduced, so that, for example, midwives can now prescribe drugs that might be required during child birth. Midwives are now working in a variety of settings, such as group or solo practices.

Community pharmacists who dispense doctors prescriptions, sell medicines to treat minor ailments and provide health information and advice are found throughout the country.

A.4.3 Other Voluntary/Private Providers

The voluntary sector includes a diverse range of organisations. Larger organisations include the Plunket Society, Family Planning Society, the Salvation Army and St John Ambulance. Some of the larger voluntary organisations such as Homes of Compassion and the Intellectually Handicapped Society run hospitals, day-care centres, hostels and sheltered workshops. There is also a wide range of organisations catering for the sufferers of specific diseases or disabilities such as the Foundation for the Blind and the Multiple Sclerosis Society. Some, such as the Cancer Society, provide care services as well as educational and research funding. Charities benefit from special treatment by the government; they are generally tax exempt on their income and donations result in a tax rebate. Many of the charities receive substantial government funding.

The Department of Health has about 40 contracts with independent private and voluntary service providers for a total budget of around $60 million. The organisations vary in size from the Plunket Society, which receives funding of around $20 million, to some very small organisations that receive a few thousand dollars only. The reasons for continued funding

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have been in many cases historic rather than resulting from an assessment of maximum value for money, i.e. many organisations receive money because they received funding in the past. In some cases, for example health camps, there is a legislative basis for the funding.

The Department has moved to more rigorous contracting arrangements with these providers, requiring them to provide specified services for a specified price. If the service is not provided to the satisfaction of the Department, the Department can refuse to continue purchasing or to reduce funding. As a result, for the first time the providers face real sanctions for poor performance. The Department notes that while a number of voluntary/private organisations have responded to the requirement for increased accountability by improving information systems and streamlining their organisations, others have found the adjustment difficult tending instead to resort to political pressure to obtain special treatment.

A.5 Condusions/Key Issues

The review of some of the features of the current system of financing and delivering health care services in New Zealand indicates a number of issues that have implications for the design of the reform process. We would emphasise, however, that our review of the current system has not been comprehensive and that the issues we have identified should be regarded as indicative rather than definitive. We have identified the following issues with implications for the reform process:

The budget constraints imposed by the government and the introduction of general management into area health boards have encouraged area health boards to focus on their costs and improving the efficiency of service delivery. At the same time, these constraints have enabled the government to place a cap on this element of public health expenditure.

The introduction of general managers and unit managers to boards appears to have significantly improved the quality of management with some new managers having been brought in from outside the system.

The progress made by area health boards in restructuring their organisations and in considering the implications of separating purchasing from provision varies significantly from board to board. This appears to be attributable in part to the quality of the boards (and more recently the commissioners) and management rather than to

4 -A39- Confidential FIRST BOSTON

underlying structural differences. The variability of outcomes indicates that the institutional arrangements have not always been robust at ensuring good quality managers and board members or enabling poorly performing individuals to be replaced quickly. However, the changes implemented also reflect the opportunities for reform in the different areas.

Some area health boards have established a number of potentially competing providers that could be separated readily into individual CHEs; others have rationalised facilities into a single provider organisation with management along service lines across institutions. In the latter case, it may be costly to separate the institutions into individual CHEs.

• Commissioners, in some area health boards have interpreted their role as maintaining the status quo and have thus deferred reform initiatives. Some have explicitly decided to delay difficult decisions because of the expected political opposition and the observation that the benefits from any restructuring would be obtained outside the horizon of their appointment. This suggests that it is important that reform proceed quickly and that in the interim, commissioners have a clear mandate to continue introducing efficiencies within guidelines established by the government.

Area health boards have developed some expertise in contracting for the provision of services and are all familiar with the concept of separating purchasing and provision. The formalisation of contracting with the Department of Health and interboard charging have both helped to focus attention on the nature of contracts, measurements of output and the development of information systems. However, these contracting arrangements are as yet very preliminary. Information systems are not yet sufficiently developed to enable more meaningful contracting. Most area health boards have contracted with private sector providers to obtain services not provided by the boards hospitals or which are more efficiently provided by the private sector. In recent times, efforts have been made to formalise such contracts and to introduce explicit measures of expected outputs and performance. A few boards have explicitly moved to separate the purchaser and provider functions of the area health board and to introduce explicit contracts between the two.

• Many area health boards have surplus assets or hospitals that are poorly Configured in terms of location and internal arrangements. This is in part the result of a change in the way that services are delivered - greater use of day surgery has, for example, reduced

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the need for inpatient services. The past structure of the elected boards and the political involvement of communities in decision making have also resulted in the development of assets that are inappropriate for the delivery of services and have prevented the rationalisation of redundant assets or the consolidation of services on a smaller number of sites.

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ANNEX 1: DISTRIBUTION OF PRIVATE AND PUBLIC HOSPITALS BY AREA HEALTH BOARD BY SERVICE

A1.1 Introduction

This Annex is based on the draft paper Competition in Health Services prepared in 1991 by J. Cumrning for the Task Force on Funding and Provision of Health Services 1 and provides data on the distribution of private and public hospitals by area by service.

The distribution of hospital beds is, for the purposes of the paper, divided into general beds (surgical, medical, obstetric /maternity psychiatric and mental handicap where provided in a general hospital), and geriatric beds 2. Where a general hospital also supplies geriatric beds, these beds are shown separately.

There are problems with the accuracy of the data, which should be taken as indicative only. The actual number of beds available and their allocation to particular services may be inaccurate. For the purposes of this paper, the actual number and distribution of hospitals and their relative sizes, are the important issues to be noted.

The public hospital data are from Health Statistical Services (1990), Patient Throughput Statistics for the quarter ended 30 September. The private hospitals data are from Department of Health (1990), Private Hospitals in New Zealand (Licensed Under Part V of the Hospitals Act, 1957) as at 30 March 1990. These data may be subject to amendment. 2 Geriatric care includes long-stay care, assessment and rehabilitation, intermediate care, special rehabilitation and frail ambulatory care, but not psychogeriatric care.

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A1.2 Hospitals By Area Health Board

A1.2.1 Northland

Northland has a total of 12 hospitals.

The main general (that is, providing surgical, medical, paediatric and obstetric/maternity services)3 and geriatric hospitals are:

Public Hospitals Beds Private Hospitals Beds

General: General: Rawene 22 Whangarei 4 Dargaville 51 Whangarei 28 Kaitaia 56 Bay of Islands 69 Whangarei 275

Geriatric: Geriatric: Bay of Islands 6 Whangarei 30 Kaitaia 13 Whangarei 54 Rawene 14 Kaeo/Whangaroa 25 Dargaville 41 Kaikohe 54 Whangarei 120

There are no intellectual handicap beds in Northland. The only hospital with psychiatric patients is the Whangerei Base Hospital.

3 The majority of private hospitals do not provide maternity services.

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A1.2.2 Auckland

A1.2.2.1 North Harbour

The main hospitals are:

Public Hospitals Beds Private Hospitals Beds General: General: North Shore 282 Takapuna 41 Warkworth 12 maternity

Geriatric: Geriatric: North Shore 102 Beachhaven 97 Red Beach 71 Milford 66 Bayswater 49 Birkenhead 46 Takapuna 30 Birkenhead 30 Northcote 30 Takapuna 15

A1.2.2.2 West Auckland

The main hospitals are:

Public Hospitals Beds Private Hospitals Beds General: General: Waitakere 40

Geriatric: Geriatric: Waitakere 113 Henderson 10 New Lynn 17 Henderson 40 Te Atatu North 40

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A1.2.2.3 Central Auckland The main hospitals are:

Public Hospitals Beds Private Hospitals Beds General: General: St Helens. 12 medical Remuera 10 Sutherland Unit 71 medical Mt Eden 32 Princess Mary 164 paediatric Epsom 36 National Womens 263 maternity Epsom 60 Green Lane 321 no maternity St Heliers 60 Auckland 573 no maternity Epsom 168 Geriatric: Geriatric: Auckland 80 Remuera 8 Middlemore 56 Remuera 9 Epsom 10 Mt Albert 12 Westmere 13 Westmere 17 Mt Eden - 20 Epsom 22 Epsom 22 Herne Bay 22 Epsom 22 Mt Eden 24 Remuera 24 Epsom 24 Mt Albert 25 Mt Albert 25 Greenlane 29 Herne Bay 30 Epsom 31 Epsom 31 Epsom 32 Herrte Bay 33 Epsom 35 Mt Albert 31 Mt Albert 35 Epsom 40 Epsom 40 Ellerslie 40 Meadowbank 41 Onehuriga 50 Glendowie 53 MtWgtn 64 Onehunga 67 Remuera 81 Mt Eden 89 Pt Chevalier 100

There is one psychiatric hospital in Central Auckland - Carrington which has 275 beds.

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A 1.2.2.4 South Auckland

The main hospitals are:

Public Hospitals Beds Private Hospitals Beds General: General: Howick 8 maternity Manurewa 7 Pukekohe 14 maternity Papakura 16 maternity Otara Spinal Unit 45 medical Middlemore 513 Geriatric: Geriatric: Franklin 18 Howick 16 Pukekohe 32 Papatoetoe 20 Middlemore 56 Mangere 20 Papatoetoe 30 Papakura 38 Mangere 40 Howick 45 Howick 50 Manurewa 60 Mangere 72

There are psychiatric beds at Kingseat (300 beds) and 426 intellectual handicap beds at Mangere.

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A1.2.3 Waikato

The main hospDals are:

Public Hospitals Beds Private Hospitals Beds General: General: Te Kuiti 36 Matamata 6 Taupo. 42 Hamilton 51 Tokoroa 63 Hamilton 53 Taumaranui 75 Thames 99 Hamilton 674

Geriatric: Geriatric: Te Kuiti 14 Ma ta ma ta 16 Mercury Bay 17 Te Awamutu 22 Coromandel 21 Hamilton 24 Thames 22 Cambridge 25 Paeroa 26 Cambridge 29 Te Aroha 32 Hamilton 34 Waihi 36 Cambridge 40 Morrinsville 40 Hamilton 50 Matariki 40 Hamilton 60 Hamilton 52 Taupo 62 Tokanui 78

In addition to the main general hospitals, there are public obstetric/maternity beds in Huntly (10 beds), Matamata (10 beds), Matariki (9 beds), Morrinsville (9 beds) and Waihi (6 beds).

There is also a large psychiatric/intellectual handicap hospital in Tokanui.

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A1.2.4 Bay of Plenty

The main hospitals are:

Public Hospitals Beds Private Hospitals Beds General: General: Opotiki/Murapara 42 medical /maternity Tauranga 23 Rotorua 110 Rotorua 36 Whakatane 150 Tauranga 42 Rotorua .255 Tauranga 378

Geriatric: Geriatric: Katikati 16 Athenree 5 Whakatane 22 Tauranga 20 Tauranga 41 Tauranga Tauranga 30 Tauranga 40 Tauranga 44 Rotorua 45 Rotorua 51 Rotorua 55

A1.2.5 Tairawhjtj

The main general hospitals are:

Public Hospitals Beds Private Hospitals Beds General: General: Te Puia 24 Gisborne 25 Gisborne 179

Geriatric: Geriatric: TePuia 10 Gisborne 20. Gisborne 85

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A1.2.6 Hawkes Bay

The main hospitals are:

Public Hospitals Beds Private Hospitals Beds

General: General: Waipukurau 64 Hastings 5 Waipukurau 66 medical Hastings 6 Wai roa 91 Napier 24 Napier 214 Hastings 24 Hastings 244

Geriatric: Geriatric: Waipukurau 44 Hastings 31 Wa i roa 49 Havelock North 60 Napier 55 Taradale 61 Hastings 58

A1.2.7 Taranaki

The main hospitals are:

Public Hospitals Beds Private Hospitals Beds General: General: Opunake 8 New Plymouth 33 Pa tea 10 medical Stratford 56 Hawera 68 New Plymouth 284

Geriatric: Geriatric: Stratford 12 New Plymouth 22 Patea 24 New Plymouth 32 Hawera 28 Hawera 33 New Plymouth 93

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A1.2.8 Manawatu-Wanganui

The main hospitals are:

Public Hospitals Beds Private Hospitals Beds General: General: Otaki 6 maternity Wanganui 25 Waimarino 9 medical /maternity Palmerston North 37 Pahiatua 12 Palmerston North 39 Marton 12 medical /maternity Levin 14 maternity Feilding 14 maternity/geriatric Taihape 26 medical /maternity Levin 46 psych/surgical Dannevirke 55 Wanganui 173 Palmerston North 407

Geriatric: Geriatric: Pahiatua 14 Levin 10 Wanganui 18 Palmerston North 18 Dannevirke 24 Levin 20 Feuding 30 Foxton 25 Wanganui 75 Wanganui 28 Levin 79 Levin 30 Palmerston North 96

There is also a psychiatric, psychogeriatric and intellectual handicap hospital in Marton (Lake Alice, 235 beds) and an intellectual handicap hospital in Levin (Kimberly, 570 beds).

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Public Hospitals Beds Private Hospitals Beds General: General: Masterton 94 Wellington 4 - Porirua 131 Lower Hutt 6 Lower Hutt 298 Lower Hutt 7 Wellington 514 Masterton 9 Wellington 23 Wellington 39 Wellington 63 Geriatric: Geriatric: Paraparaumu 22 Wellington 10 Masterton 25 Masterton 10 Porirua 47 Wellington 12 Greytown 56 Masterton 15 Wellington 102 Wellington 16 Lower Hutt 147 Wellington 18 Wellington 20 Upper Hutt 20 Lower Hutt 20 Lower Hutt 23 Lower Hutt 24 Wellington 26 Lower Hutt 29 Lower Hutt 32 Wellington 32 Maungaraki 38 Johnsonville 40 Upper Hutt 40 Churton Park 40 Titahi Bay 80

There is a psychiatric hospital of 800 beds in Porirua. j

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A1.2.10 Nelson-Marlborough

The main hospitals are:

Public Hospitals Beds Private Hospitals Beds General: General: Takaka 6 maternity Blenheim Motueka io 12 maternity Nelson 25 Blenheim 90 Nelson 196

Geriatric: Geriatric: Murchison 11 Richmond Motueka io 13 Nelson 21 Collingwood 14 Stoke Nelson 28 40 Nelson 5 Blenheim 56 Nelson 80

In addition, there is a large psychiatric, psychogeriatric, intellectual handicap hospital in Nelson (341 beds) and a further psychogeriatric hospital also in Nelson (154 beds).

A1.2.11 West Coast

The main hospitals are:

Public Hospitals Beds Private Hospitals Beds General: General: Reefton 10 medical /maternity - Westport 18 medical /maternity Greymouth 104 Whataroa 2 Geriatric: Geriatric: Reefton 20 Hokitika 40 Westport 52 Greymouth 78

There is also a psychiatric, psychogeriatric and intellectual handicap hospital in Hokitika (220 beds).

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A1.2.12 Canterbury

The main hospitals are:

Public Hospitals Beds Private Hospital Beds General: General: Akaroa 5 medical /maternity Timaru 24 Chatham Islands 5 medical/maternity Christchurch 74 Darfield 8 medical /maternity Chistchurch 122 md Ellesmere 8 medical /maternity maternity Lincoln 7 maternity Waikiri 9 medical/maternity I I Rangiora 13 medical /maternity Kaikoura 22 medical /maternity Ashburton 70 Christchurch 116 Christchurch 133 Timaru 195 Christchurch 252 no maternity Christchurch 422 no maternity

Geriatric: Geriatric: Geraldine 12 Christchurch 10 Oxford 15 Christchurch 18 Christchurch 24 Christchurch 20 Timaru 35 Rangiora 20 Timaru 36 Timaru 21 Ashburton 39 Timaru 10 Waimate 47 Christchurch 25 Ashburton 60 Christchurch 25 Christchurch 66 Christchurch 27 Christchurch 78 Ashburton 32 Timaru 86 Christchurch 38 Christchurch 105 Christchurch 41 Christchurch 147 Christchurch 43 Christchurch 44 Christchurch 45 Christchurch 54; Christchurch 68 Christchurch 72 Christchurch 73 Christchurch 92 Christchurch 113

There is also a large psychiatric, psychogeriatric and intellectual handicap hospital in Christchurch (Sunnyside, 524 beds) and another large intellectual handicap hospital I (Templeton, 569 beds). There is also a rehabilitation hospital at Hanmer with 117 beds.

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A1.2.13 Otago

The hospitals are:

Public Hospitals Beds Private Hospitals Beds General: General: Lawrence 8 medical/maternity Dunedin Roxburgh 4 12 medical /maternity Dunedin 44 Tapanui 13 medical /maternity Ranfurly - Maniototo 17 medical /maternity Mosgiel 17 medical /maternity Alexandra 24 medical /maternity Balclutha 67 Oamaru 79 Dunedin 480

Geriatric: Geriatric: Ranfurly-Maniototo 5 Dunedin 16 Alexandra 15 Dunedin Owaka 20 20 Dunedin 20 Balclutha 20 Dunedin Milton 23 28 Dunedin 28 Oarnaru 41 Oamaru Dunedin 37 128 Dunedin 42 Dunedin 57 Dunedin 62

There is also a large psychiatric, psychogeriatric, intellectual handicap hospital in Dunedin (Cherry Farm, 431 beds) and a smaller psychiatric hospital in Dunedin (38 beds).

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The main hospitals are:

Public Hospitals Beds Private Hospitals Beds General: General: Lumsden 8 maternity Invercargill 30 Queenstown 13 Gore 82 Invercargill 301 Geriatric: Geriatric: Queenstown 8 Invercargill 12 Gore 13 Gore 15 Invercargill 38 Invercargill 21 Lorne 78 Invercargill 48 Riverton 91

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APPENDIX B: PROFILE OF A COMPETITIVE PROVIDER MARKET

B.1 Introduction

In defining an initial configuration of health care facilities for New Zealand, a key concern will be to avoid imposing structures that turn out to be both inefficient and costly to reorganise. Although, as discussed in Section 4.0, the reorganisation of health care institutions and contractual links between them should, in our view, be left as far as possible to competitive pressures, any initial grouping of facilities and contracts should be designed to avoid impediments to this process.

Decisions about an appropriate initial allocation of facilities and contracts, insights as to optimal regulatory structures, and a vision of how the New Zealand health care system might evolve over time, would all be assisted if we could draw from international experience some picture of what a competitive health system looks like. Evidence from relatively open and competitive health systems overseas could yield, for example, information about the relative roles of not-for-profit and for-profit organisations in providing different categories of health care; about the way in which health care institutions faced with competition position themselves in the market, bundle products and exploit market niches; about the size of organisation that seems to work best in different circumstances; and about the role that can be played by health care chains, or specialist management companies.

In practice, the extensive involvement of governments in the funding, provision and regulation of health care around the world means that there is no one country to which we can look for evidence of the implications of competition on the organisation of the health care sector. The most commonly cited example of a "free market" health care system, the US, is discussed in Section 13.2. Even in this case, extensive government involvement, both through the funding of a significant proportion of care and through direct regulatory intervention, means that the evaluation of the efficiency of observed structures must be gauged with caution. From a public policy perspective there are serious weaknesses in the funding and regulatory arrangements applying in the US and our review of the US experience should not be taken as indicating that we believe the US provides a good model for health reform in New Zealand. However, there remains in the US more competition at the level of health care provision than in other OECD jurisdictions.

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A limited amount of information is available on developments in the UK. A brief discussion is presented in Appendix B.3. Our conclusions on the implications of the US experience for a move to a relatively competitive health care market in New Zealand are set out in Section B.4.

B.2 Nature of Structures That Have Developed in the United States

The US provides the most commonly cited example of how health care institutions evolve in a relatively competitive environment. For this reason, patterns of hospital ownership and organisational structure that we observe in the US might be expected to afford some guidance as to how the health care sector might evolve in New Zealand if our health care institutions were exposed to competition. An understanding of the structures observed in the US could also assist in defining the most appropriate bundling of services and hospitals for an initial or interim health provider structure for New Zealand.

In order to draw lessons from the US experience, however, it is necessary to have some understanding of why health care provision in the US has come to be structured the way it presently is. In particular, it will be important to assess the extent to which observed structures are indeed the result of competition and an associated drive for efficient performance, rather than of legislative or regulatory influence. It will not be possible to define in a precise manner the relative roles of competition and regulation in defining the shape Of the US health system. It will, however, be possible to assess the direction of the effects Of different kinds of regulation (for example, with regard to the incidence of for-profit and not-for-profit hospitals).

An assessment of the likely effects of regulation on the US system should also assist in defining the extent to which undesirable characteristics of the system are the result of adverse intervention, rather than undue competitive pressures. The US experience can therefore provide two sorts of lessons; one about the types of institutions and organisational arrangements that are likely to foster efficiency (and so survive competition), and one about the effects of ill-conceived regulation on health sector performance.

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After providing an overview of developments in the health sector in the US, we describe the incidence and roles of for-profit and not-for-profit health care institutions and, in particular, the reasons for dominance of the latter in the US health care organisations, and consider the effects of federal and state government interventions on these structures.

B.2.1 Overview

There are approximately 5,500 acute care hospitals in the United States; around 14 percent of these (770 hospitals) are investor-owned, for-profit institutions. Over the past decade, many hospitals have closed due to cost containment pressures, changing technology, changes in regulations and reimbursement and changes in physician practice patterns. There has been an accompanying shift from inpatient to outpatient care.

Over the past five to ten years, the major third-party funders of hospital services in the US (Medicare, which funds care for those over 65; Medicaid, which funds health care for low income individuals; and the private health care insurance companies) have substantially revised the way in which they monitor expenditures and pay for services. The most significant development has been a move under Medicare to reimburse inpatient services on the basis of diagnosis related groups of services ("DRGs") paying a predetermined, fixed amount per admission, shifting the cost risk of providing care to hospitals. 1 The importance of this development is indicated by the fact that Medicare patients, on an industry-wide basis, account for approximately 40-50 percent of hospitals average gross revenue. The introduction of Medicare cost containment incentives, combined with closer monitoring of health expenditures by private health insurers and employers, has resulted in increased contractual adjustments and policy discounts to hospitals standard charges for services performed, and significant declines in inpatient relative to outpatient services. In addition, there has been rapid growth in the use of managed care organisations such as Health Maintenance Organisations ("HMOs) and Preferred Provider Organisations (PPOs") - HMO enrollees, for example, increased from 9.1 million in 1980 to 34 million at the end of 1990.

The pattern of health expenditure in the US in 1980 and 1989 is indicated in Table B.1.2

1 The new reimbursement scheme was phased in over a three year period, moving from payment based on a hospitals own history of medical costs to regionally and then nationally determined rates. 2 Source: Levit, K.R. et al. (1991), "National Health Care Spending, 1989", Health Affairs, 10, 117- 130. pp I

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Table B.1 National US Health Expenditures by Category, 1980 and 1989

1980 Spending Category 1989 $bn % $bn % Total expenditure 249.1 100.0 604.1 100.0 Hospital care 102.4 41.1 232.8 Physician services 38.5 41.9 16.8 117.6 19.5 Other professional services 23.1 9.2 58.4 Home health care 9.7 1.3 0.5 5.4 0.9 Nursing home care 20.0 8.0 47.9 7.9 Drugs and non-durable medical products 20.1 8.1 44.6 7.3 Programme administration 12.2 4.9 Public health 35.3 5.8 7.2 2.9 17.5 Research 2.9 5.4 2.2 11.0 Construction 1.8 5.8 2.4 9.6 1.5 Includes dentists Includes net cost of private insurance Source: Levit, K.R. et al. (1991), National Health Care Spending, 1989", Health Affairs, 10, pp 117-130.

B.2.2 Ownership Forms: For-Profit and Non-Profits

In the US, around 85 percent of health care institutions are not-for-profit, either state-owned (as in the case of municipal hospitals) or privately held. The remaining 15 percent are primarily investor-owned, for-profit institutions. In this section, we consider differences in the roles performed by these institutions, and differences in the regulatory framework in which they operate. Our objective here is to assess the extent to which the relative importance of for-profit and not-for-profit institutions is a result of historical circumstance and regulatory or legislative intervention, rather than the outcome of open competition between the two ownership forms.

The market shares of for-profit and not-for-profit health care institutions in the US have changed dramatically over time. Up until the turn of the century, the greater part of hospital care in the US was unprofitable and treated as a charity (the well-to-do were generally treated at home). Around 1900, many physician-owned for-profit hospitals were established, but these were generally small. In 1910, it is estimated that around 56 percent of a national total of 4,539 hospitals were for-profit, though in terms of beds provided their role was less important than this figure suggests. In 1928, 36 percent of a. total of 6852 hospitals

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were for-profit. After 1965, when Medicare was implemented, for-profit institutions proliferated, while the not-for-profit sector remained fairly static. By 1984, when 6782 hospitals were in operation, 14.6 percent were for-profit. Of the balance, 51.5 percent were private, not-for-profit facilities, and 33.9 percent were operated by local, state or federal governments.3

The relative importance of for-profit and not-for-profit institutions differs according to the services being provided. In the mid-1980s, the break-down in some key service areas was as shown in Table B.2.

Table B.2 Proportion of Health Care Providers by Service

Service Measure For-Profit - % Non-Profit - % Public - % Acute care hospitals 749-13.9 3,191-59.3 1,444-26.8 beds 101,377 - 10.9 656,755 - 70.8 169,228 - 18.2 Outpatient clinics facilities 647-13.3 2,793-57.4 1,426-29.3 Skilled nursing facilities facilities 5,846-64.9 2,612-29.0 550-6.1 Home health agencies agencies 2,046-35.7 2,258-39.4 1426-24.9 Source: for acute care and outpatient clinics: 1990 American Hospital Association Survey of US registered hospitals; for nursing home facilities and home health agencies: 1991 HCFA Statistics, published by the Health Care Financing Administration. 1990 data data at January 1991

The location of, and services provided by, for-profit hospitals are clearly influenced by expectations about profitability. For example, for-profits are absent from run-down urban areas, where not-for-profits can operate to the extent to which they receive public funding and/or philanthropic contributions.

In particular since the early 1980s, not-for-profits have come to resemble for-profit hospitals closely in terms of their corporate and managerial structures. 4 As one commentator describes it:

3 Bennett, J.T. and DiLorenzo, T.J. (1989), Unfair Competition: The Profits of Nonprofits, Lanham, Hamilton Press. 4 Studies of the comparative performance of for-profit and not-for-profit organisations in the US, in terms of both the quality and the cost of the care that they provide, have yielded mixed results. These are summarised in Section 3.2.3. ii -B5- Confidential CS FIRST BOSTON

"the voluntary not-for-profit hospitals engaged in a process of institutional isomorphism...; that is, they conformed, homogenized, and adjusted their roles to the specific organisational and financial advantages these hospitals appeared to offer. Corporate reorganisation was touted in the early 1980s to protect and increase a hospitals revenue, to diversify its activities, to avoid government interference, to compete in the marketplace, and to maintain quality of care."5

In particular, hospital chains become more prevalent in the not-for-profit sector, as did specialised provision of high-tech tertiary care in "centres of excellence".

Also through the 1980s, the boundaries between the for-profit and not-for-profit sectors became more blurred:

"In 1986, for example, investor-owned firms managed 131 tax-supported hospitals. In turn, three corporations under secular, not-for-profit control managed 28 investor-owned institutions. A few not-for-profit hospitals have been sold or leased to investor-owned chains... Some not-for-profit corporations have organized for-profit management firms, or subsidiaries selling software, renting medical equipment, or running medical office buildings or parking lots. But for-profit hospitals may run not-for-profit corporations for such functions as community fund-raising. As a result of all these processes, it is less easy than ever before to distinguish a simple not-for-profit voluntary hospital sector, with a supposedly charitable role, from a for-profit sector whose primary purpose is to satisfy investors."6

lnterms of both structures and services provided, there is therefore now relatively little to distinguish between for-profit and not-for-profit institutions, although not-for-profits are more likely to be involved in teaching and research. In particular, despite the traditional roots of the not-for-profit sector in the charitable provision of health care to low income groups, there appear to be only minor differences between for-profit and not-for-profit institutions in the provision of care to the uninsured (a little over 13 percent of the population) and to Medicaid patients (for whom reimbursement may be less than full).7

5 Stevens, R. (1989), In Sickness and in Wealth: American Hospitals in the Twentieth Century, New York, Basic Books, p 335. 6 ibid, p 338. 7 For example, see Herzlinger, R.E. and Krasker, W.S. (1987), Who Profits from Nonprofits?", Harvard Business Review, January/February, pp 93-106. The evidence on the relative performance of not-for-profits and for-profits in this area is, however, mixed. For example, some studies have suggested that for-profits are more likely to structure and locate their activities to reduce their exposure to uninsured and low-income patients. See, for example, the survey of this

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However, it is not possible to infer from the US experience that a high ratio of not-for-profit to for-profit health care institutions is a natural outcome of competitive forces in an industry characterised by special problems of information and trust. Rather, the dominance of the not- for-profit sector reflects in part the influence of successive regulatory and legislative interventions (discussed in more detail in Section 3.2.4), that have favoured them at the expense of for-profit enterprises. These include, for example, non-neutral funding of hospital construction programmes in the post-war period, tax exemptions for not-for-profits, and differential access to low-cost municipal bond-financing.

B.2.3 Organisational Arrangements

In this section, we describe the key features of the ways in which health care institutions are structured in the US. Our concern is both to elucidate trends in organisational arrangements, and to provide selected anecdotal evidence. We concentrate on the period since 1983, when changes in the federal governments funding of Medicare (the adoption of DRGs), accompanied by a movement towards "managed care" in the private insurance market, promoted heightened cost consciousness in the health care sector, and the hospital sector in particular. (These developments are discussed in more detail in Section B.2.3.6 below).

B.2.3.1 Specialisation of Facilities, Product Bundling and the Exploitation of Market Niches

From a broad national perspective, the norm for health care institutions remains the large hospital providing a more-or-less full range of acute care services for inpatients and outpatients, with separate specialisations in such areas as psychiatric and long-term geriatric care. Hospital chains, too, appear to follow this pattern (see Section 13.2.3.2 below).

The parts of the health sector experiencing strongest growth, however, a ,re relatively specialised. As the introduction of DRGs for Medicare patients and the increased use of selective contracting and HMOs has led to increasing pressure to limit hospital costs, hospital stays have shortened, and cheaper (more profitable) alternatives have been sought to inpatient care8 (although there is some debate regarding the savings resulting from these

research in: Schlesinger, M. et al. (1987), "Nonprofit and For-Profit Medical Care: Shifting Roles and Implications for Health Policy", Journal of Health Politics, Policy and Law, 12, Pp 427-457. 8 Payment for inpatient services accounted for around two-thirds of Medicare spending in 1980. Through the 1980s, reduced admissions for medicare patients led to a significant slowing in federal spending on inpatient services. Over the same period, costs in hospital outpatient departments also grew less rapidly than formerly (suggesting that inpatient costs had not simply

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alternatives).9 At the same time, technological developments have facilitated the use of outpatient surgery for a variety of conditions that previously required hospitalisation. One result has been rapid growth in specialised outpatient surgery centres; ambulatory surgery grew from 16 percent of all hospital operations in 1980 to 40 percent in 1986.10 Another has been growth in specialist rehabilitation institutions. Within the same general category of "alternative site health care", there has been growth in specialised nursing home services (substituting for geriatric wards in general hospitals), sub-acute care services, long-term care for the chronically ill, home help and diagnostic centres. In each of these cases, the enterprises involved are predominantly entrepreneurial, for-profit companies sometimes affiliated to not-for-profits, exploiting niches created by changes in funding and technology. Examples include Vencorp and Integrated Health Services, providing, respectively, long- term acute and sub-acute care; Medical Care International and Surgical Care Affiliates, providing outpatient surgery; and Ren Corporation, Vivra and Health Infusion; which are outpatient infusion therapy companies.

Within the more traditional hospital system, there has also been some increased specialisation in the provision of high-technology acute care. This has been driven in part by the standardisation and regulation that has accompanied the use of DRGs for Medicare, and in part by the requirements of HMOs and other managed care insurers for relatively low-cost, high-quality services. In addition, there has been increased use of a "spoke and wheel" structure for single-site institutions with, for example, the main hospital providing acute care, and wholly- or partly-owned subsidiary clinics, physiotherapy units and the like providing primary and rehabilitative care.

The US experience in this area suggests that the effect of the competitive process is to produce not one, recognisably "optimal", set of organisational arrangements, but rather a highly varied set of organisational forms, tailored to different initial structures and different needs, that evolves over time. This suggests a need for caution in the New Zealand refOrm process about adopting any one model for grouping (or separating) health care institutions too rigidly.

been shifted onto the outpatient sector). By contrast, growth in federal spending on physician charges did not slow substantially, with accelerating growth in the volume of services provided appearing to offset reductions in payment rates. See: Christensen, S. (1991), "Did Legislation Slow Medicare Spending?", 1980s 9 Health Affairs, 10, pp 135-142. A major US health care insurer and hospital manager we spoke to said that following the introduction of DRGs, procedures shifted to an outpatient basis were charged at around 150 percent of what they would have cost as inpatient services. For non-profits; inpatient margins decreased by around 5% while outpatient margins increased by around 10%. This suggests that, at best, the data is inconclusive on the net cost impact. 10 Shortell, S. M. et al. (1990), Strategic Choices for Americas Hospitals: Managing Change in Turbulent Times, San Francisco, Jossey - Bass, p 7.

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B.2.3.2 Chains vs. Single Hospitals

Hospital chains grew in importance through the early 1980s. For example, the number of hospitals owned or managed by for-profit chains almost doubled between 1976 and 1982.11 Large chains have occurred in both the for-profit and the not-for-profit sectors. In 1987, for example, the ten largest hospital chains included such for-profit chains as the Hospital Corporation of America (471 hospitals out of a national total of 5659), National Medical Enterprises (133 hospitals), American Medical International and Humana, and also government chains such as the New York City Health and Hospitals Corporation, and - voluntary not-for-profit chains run by the Sisters of Providence in Seattle and by the Sisters of Charity. As one commentator describes it:

"[Tihe hospitals scope has expanded, centralized and gone beyond the local community, and ... managers of all types of institutions have embraced the managerial rhetoric as they continue to optimize revenue. Sisters of Charity Health Care Systems reported gross revenues of almost $738 million in 1986; its president, Sister Celestia Koebel, described 1986 as a year to negotiate for expansion and position for growth".12

For-profit hospital management companies, owning and managing chains of hospitals, have been most successful in the western states and in the south-east. Within these chains, specialisation appears common. American Medical Holdings, which operates in 12 states, has 38 acute hospital facilities and one psychiatric hospital (a total of 8,710 licensed beds). National Medical Enterprises, which operates primarily in California, has 37 hospitals (6,660 licensed beds) specialising in psychiatric care and rehabilitation. Community Health, operating in six states in the southern US, operates ten rural hospitals with a total of 996 licensed beds. Summit Health operates 12 hospitals (1,648 beds) in four states, specialising in nursing homes and home health care. Heathtrust Inc, which owns 85 acute care hospitals (11,555 licensed beds) in 21 southern and western states operates primarily in smaller communities, and is the sole provider of acute care in about 40 communities. At present, management company-owned hospitals account for 83 percent of investor owned hospitals in the US (including Puerto Rico), and 85 percent of beds. 13 While the dominant form of chain involves ownership of the participating hospitals, there are also instances in which specialist hospital management companies manage, but do not own, a number of hospitals.

11 Gray, B.H. (1983), An Introduction to the New Health Care For Profit in Gray, (ed), The New Health Care For Profit: Doctors and Hospitals in a Competitive Environment, Washington DC, National Academy Press, pp 1-16. 12 Stevens, op. cit., p 336. 13 Federation of American Health Systems, 1991 Directory.

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One such example is Quorum, formerly part of the Hospital Association of America, which undertakes management contracts for both for-profit and not-for-profit hospitals.

Chains account for around half of all hospital beds in the not-for-profit sector. The main not- for-profit chains include Lutheran Health Systems, with 37 hospitals, Daughters of Charity (35 hospitals), Catholic Health Corporation (32 hospitals) and Kaiser Foundation Hospitals (29 hospitals). Table B.3 provides data on the nature of hospital chains in the not-for-profit sector.

Table B.3 Not-for-Profit Hospitals in Multi-Hospital Health Care Systems, 1990

Owned Leased or Contract Category Managed Managed Catholic Total hospitals 459 72 beds 531 116,052 7907 123,959 Other church hospitals 88 11 beds, 99 18,517 731 19,248 Other non-profit hospitals 669 137 beds 806 168,079 12,018 180,097 Total non-profit hospitals 1216 220 beds 1436 302,648 20,656 323,304 In Source: American Hospital Association Guide to the Health Care Field, 1991 edition.

In practice, hospitals do not divide neatly into those formally incorporated into chains, and single-site hospitals operating in isolation; rather, there is a continuum of arrangements, ranging from single-site hospitals, to contracting arrangements between separately owned hospitals to formal chains. In the not-for-profit sector, for example, the Voluntary Hospital Association provides loosely-linked not-for-profit hospitals, which together provide around 24 percent of all hospitals services, with joint purchasing capacity, information systems and management expertise.

Through the late 1980s until the present, there has been rationalisation within chains, with some hospital facilities being sold off. For, example, American Medical Holdings (formerly I

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- American Medical International), facing net operating losses, sold 37 hospitals between 1989 and 1991 (realising around US $1 billion),14 as part of a strategy to focus its resources on a • group of core hospitals selected according to location, market share potential, reputation for quality care and strong management. The Hospital Corporation of America spun off 104 of its smaller hospitals through an employee stock ownership plan, and refocused its activities on • acute care hospitals and a system-wide emphasis on quality. National Medical Association divested a number of its more poorly performing acute care hospitals to focus on speciality hospitals and long-term care. This period has also seen a significant amount of merger and acquisition activity, in both the for-profit and the not-for-profit sectors.

There has been increasing emphasis within health management chains on local, rather than centralised, management. For example, Healthtrust, a for-profit which operates in a variety of geographical markets, has each hospital managed on a day-to-day basis by a chief executive officer. The medical, professional and ethical practices of each hospital are generally supervised and regulated by that hospitals Board of Trustees, which includes practising physicians, members of the community and representatives of the companys management, as well as by the hospitals medical staff. The company provides a variety of management services, most importantly information systems support, national purchasing contracts, physician recruitment assistance, government reimbursement assistance, strategic planning and central financial and other systems. Similarly, American Medical International and Hospital Corporation of America attempted to place more emphasis on local control and increased responsibility for local chief executives.

A study of developments in a number of hospital chains between 1984 and 1987 summarised its findings as follows:

"In recent years, the systems have entered... a phase best described as refocusing or renewal... At present, each is trying to figure out how best to run a multidivisional organisation in an industry still fragmented and rapidly changing.. Each is attempting to integrate primary, secondary, and tertiary levels of care in primarily local and regional markets. Each recognises the need for strong physician partnerships to achieve these linkages. Each is experimenting with different levels of centralisation and decentralisation of planning, decision-making, and support functions. In the process, management structures have been streamlined as the

These included all 20 of its international hospitals.

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corporations try to position themselves to move more quickly to meet the challenges of a demanding environment."15

Within hospital chains, separate incorporation of member hospitals is the norm, in particular in the not-for-profit sector. This in part reflects the impact of medical malpractice liability, in that incorporation at the level of individual hospitals reduces the risk that the assets of the chain as a whole will be put at risk by malpractice suits. 16 Further, since ownership rights in the not-for-profit sector are not clearly defined, merger and acquisition activity tends to be more complex.

The econometric evidence on the productive efficiency of chains vis-a-vis independent hospitals is summarised in Appendix F. The trend towards chain hospitals is difficult to explain on the basis of this evidence, although the studies concerned suffer from severe measurement difficulties and should be interpreted with considerable caution.

B.2.3.3 Organisation Size

Data on the size distribution of not-for-profit and for-profit hospitals are provided in Table B.4.

Table B.4 Distribution of Hospitals by Bed Size, 1990

No tForProfjt For-Profit" No. of %of No. of %of Bed Size Hospitals Total Hospitals 6-24 Total 75 2.4 27 2.0 25-49 408 12.8 164 50-99 11.9 634 19.9 515 37.3 100-199 778 24.4 457 200-299 33.1 562 17.6 146 10.6 300-399 331 10.4 42 400+ 3:0 403 12.6 31 2.2

Source: American Hospital Association Annual Survey of Hospitals, 1990. Source: Federation of American Health Systems, 1991 Directory (includes Puerto Rico).

Shortell, et. al., op. cit., p 54. 16 Horty, J.M. and Mulholland, D.M. (1983), "Legal Differences Between Investor-Owned and Nonprofit Health Care Institutions", in Gray, op. cit., p 23.

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The most robust portion of the acute care hospital system in the US at present involves hospitals with between about 150 and 400 beds. According to First Bostons health institution specialists in New York, hospitals with fewer than 100 beds are tending to close, 17 and hospitals with over 500 to 600 beds to incur repeated financial losses. (This may in part reflect the fact that larger hospitals tend to be in urban areas where there are often more problems with under-compensated Medicaid care and uncompensated care for uninsured patients). At least in some cases, hospitals above this size are attempting to rationalise by implementing the kind of spoke and wheel structure described in Section B.2.3.1 above.

It is difficult to draw firm conclusions from the literature on economies of scale within hospitals, in large part because of the difficulty of satisfactorily measuring the diversity of hospital output. A consensus has yet to emerge on the appropriate methodology for evaluating hospital cost data, and the existing range of conclusions is attributable at least in part to the diverse nature of the methodologies used. Econometric studies of economies of scale are fraught with difficulties created by the patient-specific nature of such treatment (heart surgery on a diabetic is categorically different from heart surgery on an otherwise healthy patient) the difficulty of measuring differences in severity, and the difficulty of taking account of complementari ties on the demand side (as between pediatrics and obstetrics), for example. Survivorship studies are for these reasons likely to give a more accurate idea of underlying cost economies but dominant survival patterns appear still be be emerging, in response to changes in technology and reimbursement systems. From the studies of economies of scale and scope surveyed in Appendix F, two general conclusions emerge:

that economies of scale are often limited to small hospitals (those with less than 100 beds), while larger hospitals seem to produce at Constant returns to scale. Economies of scale appear to be more prevalent within the departments of hospitals than for multi- department hospitals as entities; and

U that measurements of economies of scope are sensitive to how treatment groups are specified, and is complicated by the high degree of heterogeneity that characterises general hospital output. No patterns in economies of scope are apparent. This may, however, reflect the crudeness of econometrically feasible tests of scope economies.

S 17 Cottage hospitals providing a limited range of non-acute services, contracting out for a range of support services, and operating under a slim management structure, however, may function efficiently with less than 100 beds.

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A distinct issue is the extent to which economies of scale can be reaped through the organisation of hospitals within chains, by eliminating some portion of fixed costs at the level of the individual hospital. Here one commentator notes that chains can:

"offer an individual hospital a variety of central management services, such as purchasing, accounting, data processing, risk management, and design and construction. The companies are also able to cut other aspects of the hospitals administrative overhead and can often reduce the overall staffing of the hospital by as much as 20-30 ercent."8

The use of a chain may also promote economies by facilitating specialisation by reasonably close member hospitals in the provision of high-cost tertiary services (implicitly, reducing the costs of contracting between hospitals for the provision of these services). This was the case, for example, with the joining together of 55 (not-for-profit) hospitals previously operated separately by the Daughters of Charity. However, here, as is the case with studies of economies of scale in individual hospitals, the empirical literature is not conclusive on the extent of economies which can be reaped from organisation into chains. 19 Further, many of the economies cited above may be reaped without formal organisation into chains, for example under loose associations such as the Voluntary Hospital Association. Mixes of these traditional approaches are now becoming common.

B.2.3.4 Integration of Insurance and Provision

One of the major events of the 1980s in the US health care system was the growth of what is referred to as "managed care" as an alternative to traditional indemnity insurance. The most straight-forward form of managed care institution is the HMO, which is funded on asimple capitation basis by members, and which provides health care to those members through its own network of providers, whom it pays on a mixed capitation /bonus formula. HMOs may be

"individual practice", "group", or "staff HMOs. 20 These basic kinds of HMO offer relatively limited choice to their clients as to which physicians and which hospital services they use. Rather more choice is afforded by "open-ended" HMOs (which offer some choice at

18 Siegrist, R.B: (1983), "Wall Street and the For-Profit Hospital Management Companies", in Gray, op.cit., p 47. 19 See, for example, Pattison, R. and Katz, H. 1983, "Investor-Owned and Not-For-Profit Hospitals, New England Journal of Medicine, 309, pp 347-353. However, this study is based on 1980 data, so does not capture the restructuring of chains after the Medicare funding reforms of 1983. 20 An individual practice HMO contracts with individual practices for the provision of health services (and the practices network for hospital services). A group HMO contracts with physician groups rather than individual practices. A staff HMO may actually own one or more practices or hospitals, and pay its physicians a salary, rather than a capitation fee.

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the point of service, but less comprehensive benefits for care received outside the network) and preferred provider organisations (PPOs), which take a wide variety of contractual forms but are effectively discount (as opposed to capitation) arrangements with networks of physicians, and use utilisation reviews to control costs.

The importance of managed care institutions such as HMOs is reflected by the fact that 75 percent of employers now offer at least one HMO as part of their benefit package to employees, and HMOs serve approximately 14 percent of the population. 2122 As at 1 January 1991, 556 HMOs were in operation. The largest (Kaiser Foundation Health Plan, Inc./Northern California and Kaiser Foundation health Plan, Inc/Southern California, both "pure", group model plans) together have 4.7 million members. Growth in the HMO sector as a whole is fairly steady, but growth in membership of open-ended HMOs is strong (38.8 percent in the 1990 calendar year).

Managed care institutions (including both HMOs and PPOs), pay providers on the basis of prospective fees for pre-defined treatment categories, rather than reimbursing them for actual costs incurred. This approach is also becoming increasingly common for Blue Cross employee insurance plans, and most commercial insurance plans. The result, as with the Medicare reforms, is increased pressure for cost control by hospitals and other provider institutions.

Actual ownership of health care facilities by HMOs remains relatively rare; the great majority, as noted above, are in the form of individual practice HMOs, contracting with physician practices. For this reason, their impact on the organisational structure of health care institutions is indirect rather than direct; by their physician selection and funding criteria they can have a profound influence on the incentives of health care institution managers to organise and manage their facilities in certain ways, but they do not actively direct these decisions.

8.2.3.5 Clinics and Primary Care Facilities

The key developments in the organisation (and role in the overall health care sector) of clinics and primary care facilities since 1983 follow from both the cost-containment efforts of

21 As of January 1991, 34 million people were enrolled in HMOs of some form, 54 percent of them in not-for-profit HMOs, and 40 percent of them in individual practice HMOs. 22 The incidence of not-for-profits in the HMO sector is rooted at least in part in historic legislative advantages.

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existing hospitals, and the growth of managed , care institutions on the funding side. These include:

an increased emphasis on outpatient services and the use of specialist clinics for the provision of outpatient care; these clinics are predominantly for-profit organisations and are often owned by physicians;

restructuring by large, single-site hospitals to provide care through clinics operated as subsidiaries to the hospital company (rather than as departments of the hospital);

within the primary care sector, growth in the importance of HMOs and PPOs; and

• more emphasis by hospitals on vertical integration (by ownership or contact) with physician groups (aimed at reducing the risk of losing admissions to competitors).

B.2.3.6 Impact of Legislative and Regulatory Environment

The discussion of the relative dominance of not-for-profits in the US health care sector placed some emphasis on government intervention, including continuing differential tax treatment. In this section, our concern is with the extent to which government interventions, and changes in those interventions, have shaped health care provision in the US in both the for-profit and the not-for-profit sectors.

Medicare/Medicaid

Medicare, a federal health insurance programme for those aged 65 and over and the totally disabled, and Medicaid, a federal/state health insurance programme for low income individuals, between then account for approximately 50 percent of hospital revenues in the US. As originally structured, Medicare (in particular) encouraged a rapid expansion in health care services from the mid-1960s to the late 1970s, most strongly in the for-profit sector. Through its use of a cost-reimbursement approach, it has also been argued to have encouraged profligacy on the part of hospital management, including an inattention to cost- saving mechanisms, and an emphasis on service enhancing rather than cost reducing.

Correspondingly, changes in Medicare funding in 1983 to a prospective payment, DRG basis, is seen as a major driver of efforts through the late 1980s for cost-containment by hospitals and a

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shift in the balance between inpatient and outpatient services. 23 Over the last 25 years, therefore, the mode of government funding of health care can be argued to have had a significant impact on the level of health care provision, the structure of health care Iinstitutions, and the incentives of management to pursue efficiency in the delivery of health care.

- Approximately 50 percent of Medicaid funding comes from the federal government, the balance being made up by state and local governments. Overall it accounts for approximately 10 percent of hospital revenues.

Participation by health care institutions in the Medicare and Medicaid programmes is not compulsory. However, participating hospitals are required to take all patients requesting services under this form of funding . 24 Participation requires both certification and increased regulatory scrutiny of hospital practices. For example, the Social Security Act mandates procedures to ensure that services rendered to Medicare and Medicaid patients meet recognised professional standards and are medically necessary. For Medicare, there is a federally funded Peer Review Organisation ("PRO"); negative PRO reviews may result in denial of reimbursement, fines or exclusion from the programmes. The great majority of hospitals participate in Medicare and most participate in Medicaid.

General Regulation

Hospital operations in the US are subject to a variety of federal, state and local regulation,. relating to the adequacy of medical care, equipment, personnel and the like, through to fire prevention, rate-setting, and compliance with environmental protection laws. Various licences and permits are also required for the use and storage of narcotics, the operation of pharmacies, and the use of radioactive material and certain equipment.

Some states have also required hospitals or their owners to obtain a certificate of need from regional and/or state health planning agencies as a precondition to acquisition, construction, expansion or modification of a hospital, or the addition of equipment or new services • involving, capital expenditure in excess of certain limits. (Failure to obtain the necessary approval could.mean the inability to complete an acquisition or change of ownership, the imposition of civil or even criminal sanctions, the revocation of the facilitys licence, or the

23 This shift has been argued to be distortionary, to the extent that it has focussed on controlling hospital, as opposed to overall health care costs. 24 Evasion may, nonetheless, occur, for example by choosing to locate in areas in which use will be relatively low, or by selecting the services provided to exclude some categories of patient.

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inability to receive Medicare or Medicaid reimbursement). In practice, certificates of need were effective primarily in reducing competitive entry, rather than in rationalising investment in the sector. Certificates of need are now not widely required, except in the case of nursing homes.

Some states (including Arizona, Florida, Massachussets, New York and Virginia) have rate or budget review legislation for hospitals. For example, in Florida, there is a budget review process and a ceiling on revenue increases per admission, defined against an administratively determined cost of health care index. Other states have adopted taxes on hospital revenue and/or imposed license fees to fund indigent health care.

There is also some voluntary regulation, carried out by branches of professional associations. Almost all US hospitals are accredited by the Joint Commission on Accreditation of Hospitals and/or the American Osteopathic Foundation, which impose extensive standards on internal organisation and the operation of hospital boards and management.25

Intervention in the Insurance Market

The incentives for efficient provision of health care have also been affected by interventions in the insurance market. The most significant of these has been subsidisation of employee health insurance schemes by means of tax breaks. The primary effect of the resulting subsidy on employee health insurance has been to increase the overall demand for (relatively embracing) health insurance, and to favour investment in service-enhancing(rather than cost- reducing) health-care technology.

The presence of a subsidy of this kind suggests that employers and employees would have relatively weak incentives to monitor the efficiency with which health care was delivered; the perceived benefits of improvements in efficiency, flowing through to reduce premia, could be expected to be reduced in proportion to the tax subsidy. The tax subsidy has been a major factor fuelling prices, quality and "technology in the US. However, the presence of a subsidy does not explain why insurance companies themselves appear to have been relatively slow, at least up until the early 1980s, to pursue cost containment through direct pressures on hospitals to adopt efficient practices.

25 The rigour of such screening processes has been questioned in some quarters; see, for example: Bogdanich, W. (1991), The Great White Lie, New York, Simon & Schuster.

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One possible explanation, that private sector insurance companies did not have a sufficient share of overall health funding to be able to affect hospital behaviour or reap the benefits of improved practices, does not appear to be sufficient. Two developments which are likely to have had some impact in changing insurance company practice in the 1980s are:

an increased cost consciousness on the part of employers, who have faced increasing domestic and international competition, and for whom health benefit costs have • become a favourite target; employers have increasingly turned to prepaid health care (such as HMOs and PPOs) to achieve a degree of cost predictability; and

increasing competition within the insurance industry following:

(a) antitrust cases that countered some of the effects of professional association pressures against the formation of HMOs;

(b) the cessation of federal grant and loan support to the HMO industry early in the 1980s, leading to more direct competition between the HMO sector and established private sector health insurers, and growth in other forms of managed care such as PPOs; and

B.3 Information From the UK

Table B.5 gives the breakdown between non-profit and for-profit hospitals in the UK in 1979 and 1990, and indicates an increase in the relative importance of for-profits over the period. There are no systematic studies comparing the performance of non-profit and for-profit hospitals in the UK. There is anecdotal evidence that for-profit chains are more ruthless in .1 imposing high charges on insurance companies, but their standards are high and, generally, they have set the pace in improving the quality of private medicine in Britain. The low- quality providers tend to be the independent provincial hospitals, many of which have been taken over by the chains.27

26 59 percent of employers (covering a significantly larger proportion of employees) now self-insure for employee health care. The high proportion of self-insurance reflects differential regulation of self-insurance and commercial insurance. While commercial insurance companies are liable - to (often far-reaching) state regulation on coverage, self-insurance plans are exempt from state regulation. 27 David Green, per. comm., 1991.

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Table B.5 Breakdown Between Non-Profit and For Profit Hospitals in the TJK28

1979 1990 Category Number of % of No of % of Number of % of No of % of Hospitals Total Beds Total Hospitals Total Beds Total Charitable Religious 32 21.5 1857 28 20 9 1174 11 Charitable 23 155 1769 26.5 21 9.5 1676 15 Chant Grps 33 22 1149 17 42 19.5 1573 14.5 Charitable Total 88 59 4775 71.5 83 38 4423 40.5 For Profit US Groups 3 2 366 5.5 4 2 443 4 UK Groups 4 3 156 2.5 74 34.5 3237 30 Indept 55 36 1374 20.5 35 16 1239 11 - European - 20 9.5 1564 14.5 For-Profit Total 62 41 1896 28.5 133 62 6483 59.5

TOTAL 150 100 6671 100 216 100 10906 100

B.4 Implications for a Competitive Market in New Zealand

"[Hiospitals have symbolized American ideals, combining as they do science, philanthropy, and social obligation with technological innovation and the power of the purse. The central role of voluntary hospitals has also fostered the impression that the United States has private hospital service. In fact,... there has been a long- accepted interdependence of voluntary (and-for-profit) hospitals with government institutions and governmental policies... As a result, well before Medicare and the other Great Society programs of the 1960s, the United States could be described as a welfare state which has acquired a universal reputation as arch-defender of the free enterprise system "29

The extent and variety of intervention in the US health care system mean that the pattern of institutions that it produces, and the behaviour of these institutions, cannot be treated as depicting the effects of market competition and an associated drive for efficient delivery of consumers health care requirements. Further, to the extent that the interventions that have been made in the US differ from those that would be chosen as part of an optimal regulatory regime for New Zealand, the pattern of health care provision that has arisen and is evolving

28 Independent Hospitals Association, Acute Hospital Survey: Ownership Summary. 29 Stevens, op. cit., pp 351-352.

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in the US cannot be taken as indicative of the sort of system that might evolve in New Zealand as a result of health sector reform.

- This does not mean, however, that nothing can be learned from the US experience about the attributes of different kinds of health care provider. In considering the for-profit/not-for- profit distinction, for example, we can observe the relatively rapid adaptation of for-profits to new market opportunities,, whether geographical (the rapid expansion of for-profit hospitals as the western states were opened for settlement) or government-driven (the relatively rapid expansion of for-profit institutions in response to the introduction of Medicare, and the dominance of the for-profit sector in the expanding outpatient services market) We can also draw lessons from the increased use of chains, hospital management companies, specialisation of tertiary care facilities and decentralisation of large single-site institutions in response to cost-containment pressures through the later 1980s. The variety present in the US system, and the continuing evolution of this system, highlights, however, that there is no single model for organisational success in the health care sector. In seeking to understand from the experience of other countries how the New Zealand health care system might evolve in a competitive environment, and how existing health care institutions might best be configured, considerable caution is needed.

One reason for caution is the extent (and variety) of intervention in health care systems in all developed countries. As described in Section B.2, even in the US, where health care providers are more exposed to competition than in any other OECD country, the pattern of hospital ownership and organisation that has emerged bears the stamp of past and present government actions. A second reason for caution is that any snapshot of a health care system is likely to conceal many subtleties, and in particular to conceal the way in which, as technologies develop and demands shift, the nature and focus of health care institutions themselves change.

The sorts of lessons that can be learned from the US experience, as discussed in this section, are broad but nonetheless pertinent ones.

The first lesson is that health care systems, where competition is present, are characterised by diversity - and perhaps even increasing diversity. -

Diversity increases as for example, old institutions attempt to adapt their structures and the use of their assets to competition from small .clinics or physician practices, hospital owners or trustees weigh up the pros and cons of independence, chain ownership and chain management,

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and HMOs and other managed care institutions innovate with contracts designed to control quality and cost. The experience of the US provides a warning against presuming what arrangements "should" look like, and in particular about enforcing existing (or some newly chosen) institutional boundaries too rigidly. Rather, this experience suggests, institutional forms and boundaries should themselves be exposed as far as possible to the competitive process, so that existing institutions have the opportunity to adjust - perhaps quite radically - to emerging technologies and new demands, in competition with new entrants.

A third set of lessons derives from current efforts in the US to improve systems for defining and measuring standards of care.

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APPENDIX C MARKET DEFINITION, MARKET CONCENTRATION AND ENTRY BARRIERS1

Cl Introduction

Economic analysis of the market power of firms operating within a particular market structure, and of the potential allocative efficiency losses deriving from that structure, generally involves the use of the constructs of market definition, market concentration and market entry barriers. These constructs are used to assist in organising information relevant for assessing the nature and extent of the constraints on the use of market power. These constraints comprise the supply and demand responses that would result from non-transitory and non-trivial price increases or quantity reductions. By identifying the way competitors and consumers would react to such a price increase /quality reduction, the analysis attempts to assess the ability of the suppliers to raise prices above costs, i.e. to exercise market power

C.2 Market Definition

The market çlefinition exercise provides the basis for estimating market share and market concentration measures and for analysing entry barriers. Market definition involves distinguishing between those market constraints that are "within the market" and those that are left to be considered in the analysis of entry barriers. In applied antitrust, there are conventions for deciding whether a competitor, technology or product is sufficiently substitutable to be included "in the market" rather than as something which "lowers" entry barriers. At a conceptual level, however, the key requirement is that the evaluation of the market constraints is thorough rather than where the market boundary line is drawn.

In defining markets, conventional competition analysis distinguishes between product markets and geographic markets. The product market defines the substitutable products and services that are included "in the market" and the geographic market defines the geographic boundary within which suppliers of these goods and services must be located to be included "in the market".

1 This appendix draws on Jennings, S. and Vautier, K.M. (1988), "Review of Competitive Trading in New Zealand: The Commerce Act 1986", New Zealand Recent Law, 14, pp 95-107 and the references cited therein.

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C3 Market Concentration

Market concentration measures are intended to summarise several relationships which affect the market power of firms. The smaller the percentage of total supply controlled by a firm, the less likely it is that the firm will be able to raise prices by restricting output, since the existing suppliers will be less likely to "go along with" any price increase. Explicit or tacit collusion also becomes more difficult as the number of firms required to control a given percentage of output rises.

However, market concentration provides only a rough indicator of these considerations. For, example, the share of sales in a market may overstate the constraints on market power II imposed by existing firms since these firms may not be able to easily increase supply in response to higher market prices. Similarly, economists understanding of oligopoly is far too crude to make accurate or robust assessments of the relationship between market structure (e.g. how concentrated the market is) and the likelihood of successful collision.

It is extremely important in the current context to recognise the limitations of market concentration measures and to understand exactly what they summarise and what they leave out. The considerable scope for dynamic demand and supply response that will follow the implementation of the Governments proposed health reforms means that many of the strongest constraints to the exercise of market power will not easily be captured within conventional market concentration measures.

C.4 Market Entry Barriers

The analysis of entry barriers provides a basis for organising the information on market constraints which is not recognised in defining the market and estimating market concentration. For example, if excess capacity, such as unused beds in a hospital, is not recognised as a discipline when defining the market, the constraint excess capacity imposes on the exercise of market power should be taken into account in the analysis of entry barriers. Similarly, the analysis of entry barriers should recognise the constraints imposed on incumbent suppliers by potential new entrants and the potential for other firms to increase or modify their services by altering their productive facilities or method of service delivery (to the extent that constraints are not considered in the market definition exercise).

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The analysis of entry barriers highlights the tension between the view of competition as a rivalrous process and the description of competition as a particular market structure. The market structure approach tends to engender a pejorative view of factors which impede entry by potential new competitors; such "entry barriers" involve departures from the perfectly competitive model and provide the basis for the market power of firms that do not have a large number of similar competitors. However, this approach fails to recognise the positive economic role that many entry barriers provide; entry barriers are necessary to provide incentives for economic agents to invest in new ideas and to establish valuable brand names and market reputations. More fundamentally, the establishment of a system of private property rights requires "entry barriers" to a vast range of assets, including physical capital such as buildings and plant. Analysis of entry barriers in the New Zealand health care market should, therefore, distinguish between the impact of entry barriers on the market power of existing suppliers and the important role such barriers will play in creating and maintaining investments in physical and intangible assets throughout the health system.

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APPENDIX D: EXAMINATION OF THE EFFECT OF COMPETITION ON HOSPITAL EFFICIENCY

D.1 Introduction

This appendix briefly reviews the empirical evidence regarding the impact of competition on health care providers in the US.

As a prelude to discussing the role of competition in the health sector, it is useful to highlight the following key features of hospital output:

output generally has quantitative and qualitative dimensions. In addition to price competition, hospitals may compete on a non-price or a qualitative basis;

health outputs are typically heterogeneous in nature;

• the benefits associated with the consumption of hospital outputs are sometimes impossible to observe directly or measure indirectly; and

• individual consumers have imperfect product knowledge and often rely on the physician as their agent in making health decisions. Patients are not able to discern all qualitative differences in hospital output. In practice, the physician is unlikely to represent the interests of the consumer perfectly. Self-interested behaviour by the physician may include excessive diagnosis and treatment in periods of relatively light market demand. The extent to which physicians can generate demand for their own services is known as supplier induced demand ("SID"). The empirical significance of this is unresolved in the literature. 1 It depends on the reimbursement system, which affects providers incentives. Therefore experience in one country (e.g. the US) is not

It might be suggested that SID is likely to be more prevalent in the US, than in New Zealand. The litigious nature of US society may mean that doctors undertake "defensive medicine", ordering unnecessary tests and treatment to avoid charges of negligence (see Higgins, J . (1988), The Business of Medicine, MacMillan: London, pp 220-221).

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necessarily predictive of New Zealand experience under different reimbursement systems.

This appendix focuses on the relationship between provider competition and hospital efficiency. The US literature is concerned principally with productive efficiency, in particular with hospital costs. One form of competition will be more productively efficient than another if it can provide output of equivalent quality at lower cost.

While a simple concept, productive efficiency is difficult to evaluate practically. First, as noted above, hospital output has important qualitative aspects which are impossible to measure accurately. Further, in order to isolate the effects of competition on the operation of health care providers, it is necessary to control for all other factors that might be responsible for inter- hospital cost variation. These factors include case mix, location (urban hospitals may face higher rentals and wages for example) and ownership form. Although increasingly sophisticated econometric methodologies have been employed to control for these factors, it seems unlikely that all non-competition systematic cost differences have been controlled for.

The remainder of this appendix reviews the empirical evidence on the impact of competition in the. US health care sector. Conclusions, and a brief discussion of the implications for New Zealand, are presented in Section D.3.

D.2 Empirical Evidence Regarding Competition in the US Health Care Sector

The US, health sector is unique in that it has featured for some time a significant degree of competition among both funders and providers.2 US hospitals compete for patients directly and indirectly by competing for physician affiliations which in turn affect patient numbers.3

2 As noted, this appendix focuses on provider competition. In some situations, the impact of funder and provider competition on the efficiency of the health sector cannot be considered independently. In the case of the selective contracting environment, for example, price competition between providers arose as funders competed for customer affiliations. 3 Empirical work has confirmed that the affiliation of particular physicians to hospitals is . a significant determinant of the hospitals market share (Erickson, C. M. and Finkler, S. A. (1985), "Determinants of Market Share for a Hospitals Services", Medical Care, 23, pp 1003-1018).

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The primary conclusion regarding the impact of competition within the US health sector is that the outcome of alternative structural configurations at the provider level is heavily contingent on the regulatory environment and the nature of the system of reimbursement between funders and providers.

Much of the literature has focused on the impact differing funding mechanisms have on hospital operations and costs. The US literature emphasises strongly that the nature of the contracts governing the relationship between funders and providers needs to be closely examined when evaluating the impact of competition in the hospital sector.

Because the provision and funding of health services in New Zealand is significantly different to that in the US, US results need to be carefully evaluated before they can be interpreted prescriptively within the New Zealand context.

It is useful to briefly recap on certain aspects of the recent history of the US health sector to provide a contextual understanding of the US empirical results. As discussed in Appendix B, most hospital patients in the US are admitted by community-based physicians affiliated with the institution in question. Hospitals permit the physician access to hospital facilities, in exchange for the right to bill patients for hospital services. Hospitals may compete for patients directly via price and non-price means, or indirectly by exploiting the principal-agent relationship4 between patient and physician. Given imperfect consumer health knowledge, the physician may strongly influence the consumers choice of hospital.5

The 1970s were characterised by a considerable increase in the level of US health expenditure, both in absolute terms and as a proportion of GDP. Hospital care historically makes up the largest segment of health care expenditures. The increasing demand for health insurance was

4 Imperfectly informed patients rely on physicians for diagnosis and advice on health care consumption. As an imperfect agent, the physicians cost-adjusted advice will be inferior to that a perfectly informed patient would make. 5 In technical terms, these relationships can be characterised as a nested principal-agent problem within which the physician has both demand and supply side participation. The US physician has quite a distinct role to that of the typical New Zealand hospital physician. The relationship between the patient and physician influences patients ' incentives to demand health care, while the relationship between the patient and provider yields the incentives to the provider to supply care. As in any principal-agent relationship, contractual obligations outline risk-sharing, incentive, and task- prioritisation properties. This review focuses principally on the impact of one incentive within this framework, that of competition between providers for the patient. The underpinning of health demand by private insurance, and on the supply side, the nature of the relationship between funder and provider, are also important, however.

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underpinned by private health insurance and the tax subsidy thereof; consumer responsiveness to rising health expenditures and insurance premiums during this period was diminished as consumers often did not pay for insurance premiums directly. 6 Much personal medical insurance in the US has been financed by employers who have benefitted from large tax breaks, with the employee historically contributing little coinsurance. In addition, as an imperfect agent to the patient, the physician may have imputed a smaller weight to price considerations than the patient.

The escalation in health expenditures may also be traced to features of provider cost reimbursement. 7 Prior to 1982, a retrospective repayment system was the principal form of hospital funding. With full retrospective cost adjustment and consumer price insensitivity, hospitals competition for physicians /patients was generally along non-price dimensions such as quality of care, location and clinical and non-clinical amenities. Competition among providers for physician affiliations /patients under this funding approach was associated with larger non- price expenditures, higher costs incurred per day and per case among hospitals in the most competitive markets.

Eventually, health funders (including the government, private and commercial insurers) sought means to ameliorate burgeoning US health expenditure levels. The responses included:

prospective payment sys ;hat (PPS") which prescribe a fixed rate of provider remuneration per patient case. Remuneration is detailed for specific diagnostic related groups ("DRGs) or specified as a capitation payment. In principle, prospective provider remuneration offers providers stronger incentives to control their own expenditure per case than retrospective repayment systems. This scheme was first adopted by Medicare, the government scheme of medical insurance for the elderly; and

U selective contracting, where irtsurers/funders negotiate discounts and provision for utilisation reviews with providers in return for preferential access to the

6 In 1980, over 90 percent of expenditure on hospital services was met by public and private insurers, with approximately two-thirds of all expenditures being paid by third parties (Arnould, R.J. and DeBrock, L.M. (1986), "Competition and Market Failure in the Hospital Industry: A Review of the Evidence", Journal of Health Politics, Policy and Law, 43, pp 253 - 292). 7 One study sug ested, howeverhat, theg change in case mix had a greater impact on health expenditures over the period of sudy,t 1961-1967, than demand growth and supply factors (Salkever, P. (1972), A Microeconomic Study of Historical Cost Inflation", Journal of Political Economy, 80, pp 1144 - 1166).

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insurers/ fund customers. Unlike the fixed rate PPS approach, providers may compete for patients via price.

Given the sensitivity of empirical work to the specific (under-provider relationships in place, the impact of competition cannot be discussed independently of the funding scenarios. Another feature of the demand for health care to consider is the extent of patient coinsurance. A survey of coinsurance characteristics of insurance plans offered by employers found that the proportion offering full coverage of "room and board" charges declined from 75 to 50 percent between 1983 and 1984. The proportion providing full coverage for surgery declined to 27 percent in 1984, from a level of 45 percent in 1979.8

It is also valuable to outline at the outset the sense in which "competition" is used in the literature, in order to provide some perspective on the applicability of the US results to the New Zealand context. Hospitals are considered to be competitors if they draw upon the same patient pools. These pools are usually delineated geographically.9 One of the common features, then, of "competing" hospitals is that they are geographically proximate.10

Summaries of the major competition-related efficiency conclusions from the literature for each of the main funding scenarios follow.

8 Reported in Arnould and DeBrock, op. cit.. 9 Geographic location is particularly important to the definition of the market boundaries; the community physician responsible for patient referrals is often modelled as operating between hospitals where regular travel is practicable. A physician travelling radius of 15 miles/24 kilometres has often been used to identify the number of US hospital competitors. () A number of US papers have chosen to proxy market competition simply by the number of competitors in the market. This is a relatively limited measure of competition; more sophisticated measures of competition might take into account the distribution of market shares (a measure of concentration), the types of hospital ownership in the market, the extent of HMO affiliations and the presence of entry level regulations.

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D.2.1 Retrospective Repayment Systems

The weight of evidence indicates that full retrospective cost adjustment provided incentives for hospitals to compete across non-price dimensions. Generally, more competitive markets were associated with larger non-price expenditures, higher costs incurred per day and per case among hospitals. A brief review of some of the evidence will follow, not all of which is consistent with the broad consensus outlined above.

A study of 1084 hospitals employing 1972 data found hospital costs increased monotonically with the number of competing hospitals within a 15 mile radius. 11 Hospitals with more than 10 (neighbouring) competitors experienced costs 20-21 percent higher than their single-neighbour counterparts. In a less competitive environment, hospitals on average exhibited greater patient volumes and lower costs. The econometric methodology employed controlled for several hospital- specific features including the length of stay, number of beds, ownership type and case mix. A subsequent study applying the same methodology to a larger sample of more recent data confirmed the tenor of the results.12 After controlling for the cost endogeneity of some inputs (such as wage costs), the difference in cost per case widened to 35 percent.

Other studies of the impact of market structure on the operations of the hospital sector found that in competitive markets there was greater duplication of clinical services, 13 higher reserve margins, 14 higher prices, 15 higher quality16 and a tendency to accommodate patients/physicians desires for longer hospital stays. 17 In general, under retrospective funding, hospital health expenditures in markets with many hospitals exceeded those in areas with fewer hospitals, other things being equal.

11 Robinson, J. and Luft, H. (1985), "The Impact of Hospital Market Structure on Patient Volume, Average Length of Stay and the Cost of Care", Journal of Health Economics, 4, pp 333-356. 12 Robinson, J. and Luft, H. (1987), "Competition and the Cost of Hospital Care, 1972-1982", Journal of the American Medical Association, 257, pp 2676-2681. 13 Joskow, P. L. (1980), The Effects of Competition and Regulation on Hospital Bed Supply and the Reservation Quality of the Hospital", Bell Journal of Economics, 11, pp 421-447; Luft, H., Robinson, J., Carnick, D., Maerki, S. and McPhee, S. (1986), "The Role of Specialised Services in Competition Among Hospitals", Inquiry, 23, pp 83-94. 14 Joskow, op. cit.. 15 Joskow, op. cit.. 16 Joskow, P. L. (1983), "Reimbursement Policy, Cost Containment and Non-Price Competition", Journal of Health Economics, 2, pp 167-174. 17 Robinson J.C., Luft, H.S., McPhee, S.J . and Hunt, S.S. (1988), "Hospital Competition and Surgical Length of Stay", Journal of the American Medical Association, 259, pp 696-700.

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The rate of diffusion of technological innovation is another aspect of non-price competition which has been investigatTed. 18 The link between market structure and the adoption of technological innovation is not clear, however - some studies found that technology diffused more slowly in more concentrated markets; others found that diffusion was slower in more concentrated markets; while a mixture of relationships have been found in a number of other studies.19

One study avoided the difficulty inherent in adjusting for heterogeneous hospital output by focusing on the implications of competition for the efficient provision of nuclear medical facilities. 20 The study attributed the relative inefficiency of competitive hospitals to their tendency to duplicate competitors specialised facilities and generate excess capacity.

Studies have also examined the impact of consumer information on the ability of consumers to discern differences in quality. A study using 1970 data 21 found that price competition was related to the level of information about health services held by consumers, but that such information was less important in determining hospital quality. 22 However the effect was only significant in explaining laboratory charges. This study also found that hospital quality declined and price- cost margins were higher in more concentrated markets. Less price competition was found in more concentrated markets.

A recent study has presented a slightly different perspective on price and quantity competition, finding evidence of both price and quantity competition amongst Medicare funded hospitals in

1977_1978. 23 Price and quantity competition were found to be greater in markets that were less concentrated. This implied that competition led to lower costs per unit of quality-adjusted output, although the magnitude of the concentration effect was found to be small. -

18 Theoretical work has begun to investigate the differences in incentives and the implications for the adoption of innovations in markets and organisational hierarchies. See for example: Dearden, J., Ickes, B.W. and Samuelson, L. (1990), To Innovate or Not to Innovate: Incentives and Innovation in Hierarchies", American Economic Review, 80, pp 1105-1124. 19 Frech Ill, H.E. and Woolley J.M. (1991), "Consumer Information Price, and Nonprice Competition Among Hospitals", Chapter 11 in: Health Economics Worldwide, Zweifel, P. and Frech III, H.E. (eds), Kluwer Academic Publishers: Netherlands. 20 Wilson, C. and Jadlow, J . (1982), "Competition, Profit Incentives and Technical Efficiency in the Provision of Nuclear Medicine Services", Bell Journal of Economics, 13, pp 472482. 21 Frech [II and Woolley, op. cit.. 22 This is reasonable; with an increased understanding of the quality of the product, consumers are better able to evaluate competing products on the basis of price. The study comments that as consumer awareness of health treatment is expected to improve, price competition among hospitals is likely to increase. 23 Noether, M. (1988), "Competition Among Hospitals", Journal of Health Economics, 7, pp 259-284.

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A general conclusion from the study of retrospective payment systems is that increased competition resulted in greater cost and quality but that the additional non-price expenditures were often not matched by commensurate improvements in efficiency. 24 The characteristics of private medical insurance in the US at the time are generally recognised as having contributed to this result.

D.2.2 Prospective Payment Systems

Under PPS, a proportion of the risk surrounding the level of cost is shifted to the provider. Providers may be paid a sum prescribed in a schedule premised on industry cost averages for specific diagnostic classes, a capitation payment, or on the basis of some variation of these approaches. In competitive conditions, if the funders payment exceeds the cost to the provider of treating the patient, the excess would be expected to be dissipated over time through increased non-price competition between existing and new providers. If the payment is set beneath the providers current costs of provision, expenditures would be expected to be curtailed to ensure break even in the long term.

Much of the empirical evidence concerning PPS has focused on the comparative static effects of the change in funding from retrospective to prospective funding for Medicare patients, rather than the impact of competition on hospital costs per se.25 The rate of increase in costs per case has been observed to fall in hospitals since the introduction of PPS, particularly among those hospitals which depended most heavily on Medicare revenues (which correlated strongly with the hospitals that operated in the most competitive markets). 26 This result is not surprising given that competitive hospitals were uniformly found to be the most expensive (and some suggest inefficient) under retrospective Medicare reimbursement. For studies reporting a fall in costs per case after the introduction of PPS, the main explanation for this appears to be a decline in

24 For example, see the discussion of excessive expenditure in Joskow, op. cit. and Culyer A.J., and Posnett, J.S. (1990) "Hospital Behaviour and Competition" in Culyer A.J. Maynard, A.K. and Posnett, J.S. (eds), Competition in Health Care: Reforming the NHS, London: MacMillan. 25 As such, a review of the results is relegated to a footnote. Some studies find that the change in the funding approach significantly reduced real costs per case (Robinson, J . and Lijft, H. (1988), "Competition, Regulation and Hospital Costs, 1982 . 1986", Journal of the American Medical Association, 260, pp 2676-2681), while others can not detect any significant difference (Melnick, C. A. and Zwanziger, J . ( 1988), Hospital Behaviour Under Competition and Cost-Containment Policies. The Californian Experience, 1980 to 1985", Journal of the American Medical Association, 26O, pp 2669- 2675). Culyer and Posnett, op. cit., describe the reallocation of resources within the health sector induced by this funding change. 26 Culyer and Posnett, op. cit.; Feder, J., Hadley, J. and Zuckerman, S. (1987), "How Did Medicares Prospective Payment Systems Affect Hospitals?", New England Journal of Medicine, 317, pp 867-873. ( ;onhRIcntitI CS FIRST BOSTON

average length of hospital stay.27 A study of Californian hospitals found that the principal cost-reducing aspect of PPS arose from the reduction in the number of admissions.28

It is necessary, however, to recognise the potential negative effects on health sector efficiency of implementing PPS funding. These include:

PPS can provide hospitals with incentives to treat the least-costly patients within each DRG category only. The incentive to reduce average case severity means that reduced expenditure trends cannot be attributed solely to improved productive efficiency;29

although the rate of increase of expenditures may have declined for inpatient costs, the reallocation of patient treatment to outpatient care and the concomitant increase in outpatient expenditures may have offset this trend,-30 and

it is not clear if the quality of care has remained constant during the transition to PPS funding.

Studies, while cognisant of these issues, have (not surprisingly) been unable to quantify the net efficiency effect of PPS.

D.2.3 Selective Contracting

Selective contracting describes the practice among insurers/third party hinders of negotiating discounts with specific providers, in return for preferential access to the insurers/providers patients.

Selective contracting has been undertaken by a wide range of organisations and third-party funders, including self-funded employee insurance programmes, commercial health insurers, government medical insurance schemes (notably Medicare), Blue Cross, HMOs and PPQs.

27 Feder et al., ibid. 28 Melnick and Zwanzigcr, op. cit.. 29 Some studies have found evidence consistent with the hypothesis that the greatest pressure to reduce the length of patient stay was in the most competitive markets (Sager, M.A., Easterling, D.V., Kindig, D.A. and Anderson, O.W. (1989), "Changes in the Location of Death After Passage of Medicares Prospective Payment System", New England Journal of Medicine, 320, pp 433439). 30 Culycr and Posnett, op. cit.; Melnick and Zwanziger, op. cit..

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Although differences exist in the funding and operation of these organisations and programmes,31 it is widely hypothesised that in general selective contracting elicits a greater degree of price competition from providers than traditional funding approaches. Discounted provider services are offered to such organisations on the basis that the funder/provider directs patients to the discounting hospital (chain).

Insurers/funders attempt to attract clients to their scheme with a range of price and non-price features. Empirical studies have tested the hypothesis that selective contracting increases the ability of insurers/ fund ers to control provider costs and strengthen price competition among hospitals.

One study attempted to isolate the impact of selective contracting on hospital costs. After controlling for the effects of the introduction of PPS, the rate of increase in costs per discharge in highly-competitive Californian hospitals was found to be 3.5 percent lower than the rate of increase among less competitive hospitals. The study also found that after the introduction of PPS funding and selective contracting, real total inpatient costs increased by less than 1 percent among low-competition hospitals, while costs in highly-competitive Californian hospitals declined by 11.3 percent from 1983 to 1985.32 This change was accompanied by marked increases in outpatient costs, however, as patients were increasingly referred to outpatient facilities. 33

31 For example, HMOs assume the financial risk for unexpected payment expenses, while PPOs transfer this risk to the purchaser. HMOs restrict reimbursed services to plan providers, while PPOs allow patients to visit non-plan providers. HMOs have a contractual obligation to provide medical services, not solely hospital treatment and have a wider range of treatment options than under PPS. HMO members provide a flat annual fee. Substantial variation in operating form can occur even within each of these broad generic groups (Eastaugh, S.R. (1987), Financing Health Care: Economic Efficiency and Equity, Auburn Publishing: Massachusetts; Feldman et al. (1990), Effects of HMOs on the Creation of Competitive Markets for Hospital Services", Journal of I-len/ti, Economics, pp 207-222). 32 Melnick and Zwanziger, op. cit.. The selective contracting Californian Medicaid system, Medi-Cal, was auhorised to accept bids from short-term acute hospitals in 1982. In 1983 Californian law was changed to permit selective contracting for both public and private insurers. 33 A recent paper suggests, however, that there has not been a simple shift of hospital inpatient costs to the outpatient sector during the 1980s under Medicare funding (Christensen, S. (1991), "Did 1980s Legislation Slow Medicare Spending", Health Affairs, 10, pp 135-142) Outpatient costs were reported to have increased at a rate beneath the trend established between 1975 and 1980. This increase in outpatient costs may still be consistent with that reported in the paper by Melnick and Zwanzigcr, op. cit.. A key distinction between the two papers is that Melnick and Zwanziger examine only Californian hospitals, while Christensen examines Medicare disbursements across the US.

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Another study found that by 1986 the differences in the average costs per admission among

Californian hospitals could no longer be attributed to the competitiveness of the local market.34

This contrasted strongly to the US as a whole, where average costs per admission in the most

competitive markets were still 23 percent higher than comparable hospitals in the least

competitive markets.35

The empirical evidence examining the relationship between the presence of HMOs and price

competition is mixed. Early work questioned the ability of HMOs to reduce medical care

expenditure.36 It has been suggested that HMOs need to develop a working relationship with

providers before being able to initiate price competition. A number of non-price concerns may still

play a role in attracting patients (and hence the choice of hospital to be included in the HMO),

such as the location of the service. 37 However a recent study has found evidence of patients being

chanelled to the least-cost hospital by staff network plans.38

D3 Conclusions

The principal conclusion regarding the impact of competition within the US health sector is that

the outcome of alternative structural configurations at the provider level is heavily contingent on

the regulatory environment and the nature of the system of reimbursement between funders and

providers:

under retrospective funding, hospitals in a competitive environment tended to expend

more resources on non-price competition (On facilities and amenities, and the duplication

of specialised facilities and clinical services) than their counterparts in less

competitive markets;

34 Prior to the introduction of PPS and selective contracting, hospital costs were observed to increase monotonically with the competitiveness of the hospital market. 35 Robinson, J. and Luft, H. (1988), "The Impact of Hospital Market Structure on Patient Volume, Average Length of Stay, and the Cost of Care", Journal of Health Economics, 4, pp 333-356. Evidence was found that as competition tended to increase, so did the level of costs. 36 Several papers which make this argument are surveyed by Altman, S.H. and Rodwin, M.A. (1988), " Halfway Competitive Markets and Ineffective Regulation: The American Health Care System", Journal of Health Politics, Policy and Law, 13, pp 323-339. 37 Feldman et al., op. cit., cite evidence that HMO selection of the preferred provider was principally motivated by location and range of service, with price being a secondary concern. 38 Feldman ci al., op. cit..

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with the change to PPS funding of Medicare inpatient charges, the rate of increase in hospital costs in competitive markets tended to decrease. The net effect upon hospital efficiency is unclear however;

there is mixed evidence regarding the ability of HMOs to stimulate price competition; and

under selective contracting in Californian, the rate of cost increase was lower among competitive hospitals than their less competitive counterparts. Hospital costs across competitive and non-competitive settings could not be distinguished statistically three years after the introduction of selective contracting and PPS.

A number of caveats must be borne in mind when considering the implications of the US experience, with competition for New Zealands health reform. First, aspects of the US results are attributable to the underpinning of demand for health services by the unique insurance circumstances in the US. Secondly, the competitive experience in the US has been heavily influenced by the regulatory environment and the nature of contractual relationships between funders and providers. New Zealand is likely to differ significantly from the US in these regards. Thirdly, the measure of competition used in most of the studies is not immediately relevant to the New Zealand situation; as an extreme example, there are not many hospitals in New Zealand with more than ten competitors in a 24 kilometre radius. Together, these points emphasise that considerable care is required in drawing inferences regarding the New Zealand health care system from the US competition studies.

-D12- APPENDIX E BELL GULLY BUDDLE WEIR REPORT ON COMPETITION LAW AND HEALTH CARE IN NEW ZEALAND BARRISTERS 6 SOLICITORS I.B.M. Centre. 171 Featherston Street. Wellington. New Zealand. Postal Address: P.O. Box 1291. Wellington. New Zealand. ...., Retevence M N Berry/J H Shirtcliffe 0X 8204. Fax: 14) 473-3845. it Reference: Telephone (4) 473-7777.

23 December 1991

Mr S A Jennings Director CS First Boston NZ Limited P0 Box 3394 WELLINGTON

Dear Sir COMPEImON LAW AND HEALTH CARE IN NEW ZEALAND You have, on behalf of the National Interim Provider Board, instructed us to undertake a preliminary review of New Zealands competition laws in the context of the proposed restructuring of the health care industry.

In undertaking this review you have instructed us to assume that the Government will be the core provider of funding and that the Regional Health Authorities will be the core purchasers of health care services. In the case of the providers, we have been instructed to assume that an Establishment Board will review and rationalise the current operations of the public hospitals prior to the transfer of the assets and liabilities of these organisations to the Crown Health Enterprises. You have asked us to focus on competition issues relating to the Crown Health Enterprises on the assumption that these organisations may be corporate entities, all being wholly owned by a common holding company, which company will in turn be owned by the Minister of Crown Health Enterprises. The attached memorandum sets out the results of our review. However, for convenience, wi summarise our main conclusions in this letter: (1) The United States Experience The only country in which there has been detailed consideration of the application of competition laws to the health care industry is the United States. In our memorandum we discuss how the courts in that country have dealt with the following range of practices: (a) Price fixing by physicians; (b) The boycott of new entrants by encumbent providers (via their provider organisations); (c) Exclusive dealing arrangements (eg. that providers will only join one provider organisation and that that organisation will only deal with a limited number of providers); (d) Tying arrangements (eg. patients undergoing surgery at a hospital being required to obtain anaesthesia from a small group of providers with whom the hospital has an exclusive contract); (e) Referral practices; (f) Peer review and utilisation controls;

A directory coneain.ng a list of partners may be obtained from our offices at - Auckland. Wellington. f.ianukau. -2-

(g) Monopolisation; and (h) Exclusion of allied health care providers. In addition to these practices, there is also extensive case law in the United States concerning hospital mergers. (2) Commerce Act 1986 Subject to our comments in (3) below, we consider that the provisions of the Commerce Act are adequate to cover the potential problems in the health care industry which have been demonstrated to arise from United States experience. (3) Matters Requiring Further Consideration (a) We assume that the establishment of the Crown Health Enterprises and the transfer of assets arid liabilities to them will be undertaken pursuant to specific legislation. It will be appropriate to consider whether such legislation should include a provision similar to Section 23 of the State-Owned Enterprises Act 1991 so as to exclude the potential application of the Commerce Act to such transfer. (b) In order to ensure that the Commerce Act will have comprehensive application to the Crown Health Enterprises following their establishment, the following matters - require further consideration: (i) Whether the Crown Health Enterprises should, for Commerce Act purposes, be deemed to be separate legal entities. Without such deeming provisions, the restrictive trade practices provisions of the Commerce Act will not apply where the only parties to the relevant arrangements are Crown Health Enterprises. In addition, it is unlikely that any merger of Crown Health Enterprises could successfully be challenged under the Commerce Act without such deeming provisions, because there would merely be a transfer between interconnected bodies corporate; (ii) Whether the exemption provisions in the Commerce Act relating to contracts of and for services should be deleted and/or amended so far as they apply to the health care industry; and (iii) Whether there are any practices which should be specifically authorised by legislation so as to exempt the application of the Commerce Act to them. We shall be pleased to discuss our report further at your convenience.

Yours faithfully BELL GULLY BUDDLE WEIR

MNBeny Partner

MNB :252 1 II MEMORANDUM

To: Mr S A Jennings CS First Boston NZ Limited Wellington I From: M N Beriy/J H Shirtcliffe Date: 23 December 1991

COMPFJIJ JON LAW AND HEALTH CARE IN NEW ZEALAND Ti 1. INTRODUCTION

You have, on behalf of the National Interim Provider Board, instructed us to undertake a preliminary review of New Zealands competition laws in the context of the proposed restructuring of the health care industry. Our review will be in three main parts: I (a) The impact of competition laws on the health care industry in the US; (b) An outline of New Zealands competition laws; and 1 - (c) An assessment of the adequacy and likely application of New Zealands competition laws to the proposed new health care regime. I 2. COMPicImON LAW AND HEALTH CARE IN TEE US I 2.1 From our review of foreign jurisdictions, only the US provides an informative case study of how competition laws may impact on the health care industry in New Zealand. The following brief review of the US system is informative to the extent I that it identifies areas that are likely to be subject to scrutiny under competition laws. We do not intend to elevate the US expeiience beyond such status because of differences in statute law and the diverse nature of the markets under review in the US. I 2.2 Industry Trends in the US We understand that the US health care system has historically been characterised by private mechanisms of health care finance and delivery. Providers deliver medical care to consumers in return for payment from third party payors. Payors in turn market health care insurance plans to consumers. I

-2- 2.3 Historically, physicians operated as sole practitioners in accordance with a fee-for-service structure whereby they were reimbursed on an indemnity (actual charge) basis by local independent insurers. While this system encouraged high quality care, there was little or no incentive to contain rising costs. Third party payment through health insurance schemes virtually eliminated price competition among providers and over-stimulated demand for health services.

2.4 The inefficiencies of this traditional Structure of service delivery has now been challenged by the emergence of a variety of economising innovations in the organisation and administration of private health care plans. Cost containment strategies are generally presented in the form of provider networks (ie. groups of hospitals, physicians, laboratories and others) which integrate and co-ordinate services and share fees in a variety of ways.

2.5 The following varieties of provider collectives have emerged in the US:

(a) Affiliations: Loose co-operative arrangements among providers for patient referrals or joint marketing, with minimal integration of functions.

(b) Joint Ventures: Joint efforts for a limited common purpose that does not extend to the full integration of productive resources across the whole range of provider services.

(c) Preferred Provider Organisations: (PPOs), which involve little co-ordination of productive resources or functions, but an overall co-ordination of service delivery, subject to cost and utilisation control. They may be sponsored by entrepreneurs, insurance companies, hospitals, or doctors acting individually or in joint ventures.

(d) Multi-Facility Systems: Consolidation of marketing, financial and managerial structures, although some degree of autonomy in facility provision may persist, for example, Health Maintenance Organisations (HMOs) provide a wide range of comprehensive health care services for a specified group at a fixed periodic payment, and may be sponsored by the government, medical schools, hospitals, employers, labour unions, consumer groups, insurance companies, and hospital medical plans.

(e) Mergers or Acquisitions: True consolidation of almost all functions and virtual elimination of competition between the entities so combined.

2.6 The most common form of integration to emerge is the provider-sponsored PPO and our review of the US experience will focus upon this entity. PPOs are arrangements whereby fee-for-service providers agree to offer their services, subject to the utilisation and cost containment controls, at a discount, to a defined

-3- pool of patients, who have free choice of providers but who have economic incentive to utilise the networks providers. If a patient uses a panel of designated "preferred" providers, the patient receives the full level of benefits provided under the insurers health care plan.

2.7 PPOs are not entities but are contractual arrangements. They do not involve the complete integration of provider services and functions, and are therefore more than affiliations but somewhat less than mergers. They are often viewed as joint ventures as they offer partial economic integration to achieve increased efficiency, lower premiums, and thus greater market share.

2.8 Relevant Legislation

The US antitrust laws which impact on the health care industry are Sections 1 and 2 of the Sherman Act. Section 1 of the Sherman Act declares to be illegal every contract, combination or conspiracy between independent entities that is in restraint of trade or commerce. Section 1 has generally been interpreted to prohibit only those restraints that are unreasonably restrictive of competition. Section 2 prohibits monopolisation, attempts to monopolise and conspiracies to monopolise.

2.9 A brief comment on the methodology used to interpret these laws is appropriate. In reviewing whether an arrangement is likely to be unreasonably restrictive of competition, the so-called "rule of reason" approach is adopted. This means that a detailed inquiry is undertaken to identify the relative competitive benefits and threats of a particular arrangement. In order to reduce this burden, the US Supreme Court has developed so-called "per se" rules. These rules assume that certain -forms of practice are inherently anti-competitive and should be held to be unlawful without detailed examination. There have been fluctuating views over the years on practices which should be per se unlawful. Practices that have been considered to I be per se unlawful include price fixing, market division, tying arrangements and certain boycotts.

2.10 Legality of the PPOs Activities

Within the US context, it may readily be apparent that joint venture and other co-operative arrangements may enhance both efficiency and competition given the Ihistory of the emergence of such forms of organisation. Naturally, it is also relevant to examine whether there is any anti-competitive motivation underlying such industry structures. Recurring themes in analysing the legality of provider Inetwork structures are:

(a) Whether a bona fide joint venture has been established;

(b) Whether any restraint imposed is necessary to the operation of the joint venture; and

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2.11 The remaining parts of our discussion on the US system summarise examples where practices have received antitrust law scrutiny. The categories which we will discuss are:

(a) Price fixing; (b) Boycotts of non-participating providers; (c) Essential facilities; (d) Exclusive dealing; (e) Tying; (f) Referrals; (g) Peer review and utilisation controls; (h) Monopolisation; and (i) Exclusion of allied health providers. / - 2.12 Price Fixing

The concern that PPOs may be engaging in price fixing stems primarily from the Supreme Courts judgment in Arizona v Maxicopa County Medicare Society 457 US 332 (1982). This case concerned two provider networks which had been established in the form of medical care foundations. Within each of these networks, competing physicians had agreed not to charge above certain maximum prices. On the facts it was noted that the physician organisations in question had market power and faced limited competitive constraints. The physicians set the maximum fees unilaterally. The Court ruled that this was unlawful price fixing, because the fee ceiling was such as to stabilise prices and ensure economic reward regardless of the quality of service.

2.13 Following the judgment in Maricopa there has been much commentary on price fixing and PPOs. While the effect of the judgment is not to declare all price fixing involving PPO participants to be unlawful, PPOs now tend to avoid agreements which may be viewed as price fixing. A variety of structures have been developed to assist in achieving this goal including:

(a) Full integration of participating provider practices into a single business entity;

(b) Reduction of competitive overlays between participants (eg. selection of different geographic areas and different specialties); and

2.14 Boycotts of Non-Participating Providers

Experience has shown that the formation and operation of provider-based PPOs may involve boycott activities. Competing providers can establish these

•1 -5- organisations and use them as a device to exclude new entrants, particularly those providers who may be innovative and competitive.

2.15 As a general rule, US courts will undertake competition analysis when dealing with boycott activity. It may not in all cases be anti-competitive. However, per se illegality treatment is likely to attach where the relevant entity (or entities): I (a) Has market power; (b) May deny access to essential facilities; and

2.16 Essential Facilities

Considerable debate surrounds the essential facilities doctrine in the US. For / I present purposes it is assumed that the doctrine states that a finn (or combination of firms) that controls some productive or distributive facility which is, as a practical matter, essential for the viability of competing entities , may have a duty to make the facility available to competitors on commercially reasonable terms. 1 The doctrine only applies where the entity controlling the facility has monopoly power, the competitor cannot reasonably duplicate the facility, and the use of the I facility could reasonably be made available without destroying its value to the controlling enterprise.

2.17 The doctrine may arise in relation to health care. While considered unlikely in the US, a dominant provider network in a locality may be viewed as an essential facility and it may foreclose competition by denying other providers access to such facility.

2.18 Exclusive Dealing

Exclusive dealing arrangements of one or more of the following kinds are common in the operation of PPOs:

(a) That the PPO will deal exclusively with certain providers and not with others;

(b) That purchasers (usually employers) will make the nominated PPO available to the subscribers (usually employees);

(c) That the PPOs participating providers will join only one PPO and will not deal with other PPOs or alternative delivery systems; and

(d) That subscribers will deal exclusively with providers participating in the nominated PPO. S

2.19 The legality of such exclusive dealing arrangements depends upon their overall effect on competition. Such arrangements may be considered to be pro-competitive (eg. if they enhance physician loyalty, the advancement of new techniques, the competitive functioning of the organisation) or anti-competitive (eg. if they raise entry barriers).

2.20 The most frequently challenged exclusivity arrangement to date has involved agreements by providers preventing participation in another PPO or competing J alternative delivery system. Such exclusivity would endanger competition where it involved tying up a large percentage of providers with long term exclusive contracts, thus preventing alternative delivery systems from entering or effectively competing in the market.

2.21 Tying

By definition, a PPO involves only preferred providers, not exclusive providers. Subscribers are thus permitted to go to other non-participating hospitals or physicians. However, the typical PPO is designed to encourage subscribers to use only the preferred providers, such as the requirement that subscribers pay part of such providers fees and/or a requirement that subscribers initially pay the entire costs of the medical services and later seek partial reimbursement from the PPO. The PPO therefore restricts the subscribers freedom of choice among competing providers and may thus restrain competition in the providers market.

- 2.22 The -leading case in the US on tying is Jefferson Patish Hospitalv Hyde 466 US 2 - (1984). In that case the defendant hospital had allegedly tied the providing of L - anaesthesiological services to the providing of hospital services. Every patient undergoing surgery at the hospital was required to obtain anaesthesia from a small .1 group of providers with whom the hospital had an exclusive contract. It was held 1 that a tying claim must establish:

(a) That there are two separate and distinct products involved. Where, as was t held to be the case here, the economic advantage of jointly packaging the services is so substantial, the package cannot be viewed as two distinct I products; and

(b) That the seller has sufficient market power in the tying product to force the I purchaser to buy the tied product which the buyer does not want or would otherwise purchase from another seller; and

1 -7- 2.23 Referrals

Primary care physicians often recommend fellow PPO participants in referring patients to specialists. Such referrals may be voluntary, or mandated by the PPO. This practice is economically advantageous to the patient, ensures that the specialist will meet the PPO criteria of quality service and cost efficiency, and protects the primary physicians economic interest to keep the patient within the PPO network.

2.24 This practice is only likely to be unlawful in the US where it involves collusion between competitors and where it is engaged in for the purpose of boycotting other competitors either directly, or by persuading or coercing others (suppliers or customers) from dealing with them.

2.25 Peer Review and Utilisation Controls

A PPO relies on quality service and cost containment to gain a competitive advantage over other health plans and insurers. In particular, a PPO may require a - second opinion for certain medical procedures, and pre-admission screening to determine whether admission is strictly necessary and reasonable. Participating providers may therefore be disaffiliated for failure to meet review standards.

2.26 While such circumstances may be reviewed under antitrust laws, it is likely that most PPOs will be able to defend those procedures which benefit consumers. They will therefore, be viewed as a pro-competitive measure unless there is some additional evidence which demonstrates that they are designed to facilitate price fixing, boycotts and the like. -

2.27 Monopolisation

We do not think it necessary to discuss this matter in any detail, except to note that PPO networks that achieve a position of market power will be potentially subject to claims under Section 2 of the Sherman Act which prohibits monopolisation, attempts to monopolise and conspiracies to monopolise.

2.28 Exclusion of Allied Health Providers LI

• Allied health providers are practitioners such as podiatrists, nurse-anaesthetists, nurse midwives, clinical psychologists, chiropractors, and physical therapists who are not physicians but who are licensed to perform certain limited types of procedures and thus operate, where the law allows, in direct competition with physicians for patients and referrals.

2.29 The most common antitrust case arising in this context occurs where allied health professionals are denied access to hospitals. Where a provider seeks staff 1 privileges at a hospital or has his or her privileges terminated, the central antitrust issue revolves around whether the practitioner can show the action was a result of concerted action within Section 1 of the Sherman Act, and if so, whether the exclusion had an adverse effect on competition.

2.30 Thus, where a hospital excludes a particular alleged health provider, no violation will be found if the hospital acts unilaterally for its own legitimate reasons. Concerted action is most clear when the hospital allows members of the medical staff to control decisions about staff privileges for allied health providers. For example, in Weiss v Yo± Hospital 470 US 1060 (1985) it was determined that the medical staff exercised such control over the credentiailing process that they were able to prevent osteopaths from obtaining privileges. However, the hospital was not liable for conspiring with its medical staff as its members were acting as the hospitals agents in making decisions on privileges.

2.31 An illegal conspiracy between hospital and staff may however exist where a hospital has excluded allied health professionals from obtaining privileges as a result not of unilaterally adopted policy, but of pressure from physicians on its staff. However, it would remain to be shown that the exclusion was an unreasonable restraint of competition. In most cases, even when an entire class of practitioners have been excluded courts have failed to find an adverse effect of competition. There are usually numerous alternatives to which patients can turn to obtain the necessary services. Anti-competitive effects have only been found where hospitals have occupied a virtual monopoly position and excluded practitioners had no other alternatives in the area.

- 2.32 Reference Materials -

Our study of the impact of competition laws on the health care industry in the US has involved a review of a wide range of materials. For ease of reference, we list • below those materials which we consider to be the leading contributions on this issue:

(a) Phillip A Proger, "Antitrust Developments Affecting the Heath Care Sector", 57 Antitrust Law Journal 315 (August 1988);

(b) H E Frech ifi and Paul B Ginsburg, "Competition Among Health Insurers, Revisited" 13 Journal of Health Politics, Policy and Law 279 (Summer 1988);

(c) Clark C Havighurst, "Professional Restraints on Innovation in Health Care Financing", 303 Duke Law Journal 303 (1978);

(d) American Bar Association, "Developments in Antitrust Health Care Law", 1990;

(e) American Bar Association, "Managed Care and Antitrust : The PPO Experience", 1990; and

(f) Jonathan B Baker, "The Antitrust Analysis of Hospital Mergers and the Transformation of the Hospital Industry", 51 Law and Contemporary Problems 93 (Spring 1988).

3. NEW ZEALANDS COMPJIIHON LAWS

3.1 New Zealands competition laws are essentially contained in the Commerce Act 1986. It should also be noted that the common law economic torts can also apply to competition law matters. However, we do not consider that a discussion of these is necessary at this time given that our primary focus is on the adequacy of the Commerce Act.

3.2 Commerce Act 1986

The restrictive trade practices, monopolisation and business acquisitions provisions contained in the Commerce Act have the potential to apply to the health care industry in New Zealand. We briefly outline these provisions.

3.3 Restrictive Trade Practices

The restrictive trade practices provisions are contained in Part II of the Commerce Act. There are two classes of practice. There are those practices which are per se unlawful. This means that the mere existence of such practices is sufficient to establish that they are in breach of the Act. The other class of practice is that which is only in breach of the Act if it lessens competition substantially. Consideration of this latter class of practices often involves detailed competition analysis.

3.4 The practices which are per se unlawful are:

(a) Pricefizing

Any contract, arrangement or understanding between competitors which has the purpose, effect or likely effect of fixing, controlling or maintaining the price for goods or services is absolutely prohibited under Section 30 of the Commerce Act. Price fixing agreements also include agreements relating to discounts, allowances, rebates or credits. This prohibition also extends to attempts at price fixing.

Joint venture pricing is exempt from this prohibition against price fixing by virtue of the provisions of Section 31. The form of pricing which is exempt is that which relates to the joint supply by the parties to the joint venture of services which are supplied by that joint venture.

It should also be noted that Section 33 exempts the application of the price fixing rules to the price for goods or services which are collectively acquired.

_10- (b) Resale price maintenance

Section 37 of the Commerce Act absolutely prohibits minimum resale price maintenance, that is, where a supplier makes known to a reseller that the supplier will not supply the goods unless the other person agrees not to sell them at a price less than the price specified by the supplier. The resale price maintenance prohibition also extends to withholding the supply of goods and inducing or attempting to induce a reseller not to sell at a price below the suppliers specified price. The resale price maintenance prohibition does not extend to maximum resale prices (i.e. where a supplier tries to prevent a reseller selling above a certain price), but such a provision may be prohibited if it substantially lessens competition contrary to Section 27 or if it constitutes the use of a dominant position in breach of Section 36. There are exemptions under the Act for prices which are recommended prices, provided that there is no obligation to comply with the recommendation.

This practice may be of limited concern to the health care industry because it relates only to circumstances involving the supply of goods and does not extend to matters involving the provision of services.

Agreements between two or more competitors which have the purpose of preventing, restricting, or limiting the supply of goods or services to or the acquisition of goods or services from a person who is in competition with any of the parties to the contract is a collective boycott and is absolutely prohibited by Section 29.

3.5 Practices which are not per se prohibited are subject to competition analysis under Section 27 which provision is cast in very broad terms. It provides that:

"No person shall enter into [or give effect to] a contract or arrangement, or arrive at an understanding, containing a provision that has the purpose, or has or is likely to have the effect, of substantially lessening competition in a market."

This provision has potentially unlimited application-to the review of all contracts, arrangements or understandings which may be entered into by market participants. It should also be noted that a similar provision in the Act, Section 28, prohibits covenants relating to land which may have the purpose, effect or likely effect of substantially lessening competition.

3.6 Monopolisation

Section 36 of the Commerce Act prohibits any person with a dominant position in a market using that position for certain prohibited purposes. The purposes which

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are prohibited under Section 36 are:

(a) Restricting the entry of a person into a market;

(b) Preventing or deterring a person engaging in competitive conduct in a market; or

3.7 In order to show that a breach of Section 36 has occurred, it is necessary to define the relevant market, to show that the person in question has a dominant position in that market and finally to show that the person had used or threatened to use that dominant position for one of the prohibited purposes. A causal connection needs to be established.

3.8 Exceptions

There are certain exceptions under Sections 43 and 44 to the application of the restrictive trade practices and monopolization provisions. The most significant of these are:

(a) Any practice specifically authorized by another enactment;

(b) Certain arrangements between interconnected bodies corporate and partners;

(d) Labour arrangements so far as they relate to remuneration, conditions of employment, hours of work, or working conditions of employees.

3.9 Business Acquisitions

The provisions of Section 47 apply to all acquisitions of assets of a business and shares. The Act prohibits such acquisitions if they result in the acquisition or strengthening of a dominant position in any market in New Zealand. At present, there is a voluntary pre-merger regime in operation. This regime is described in more detail in paragraphs 4.9 - 4.11 below.

At the present time the provisions of Section 27, outlined in paragraph 3.5 above, also have the potential to apply to business acquisitions which are not implemented in accordance with a clearance or authorisation of the Commerce Commission. However, we understand that there are likely to be amendments to the Commerce Act next year which will remove the potential for Section 27 to apply to business acquisitions, and accordingly, we do not discuss this point further. -12-

4. COMPIITIION ISSUES UNDER THE PROPOSED REGIME

4.1 Background

In order to assess the adequacy of New Zealands competition laws in relation to the new health care regime, it is necessary first to outline the likely framework of that regime. The key features which we note are that:

(a) Funding

New Zealanders will have an entitlement to a level of Government funding for their health care. They will be in a position to elect whether this should be paid to one of the four Regional Health Authorities (RHAs) or to a private health care plan of their choice. Additional user charges and private health care premiums will become a feature of the new regime. For the purposes of our present review you indicated that we should assume that the Government will be the core provider of funds.

(b) Purchasers

The RHAs and the health care plans will buy the health services. Again, for present purposes you have instructed us to assume that the RHAs will be the core purchasers of health care services.

The larger public hospitals and related services will become Crown Health Enterprises (CHEs) while smaller community hospitals and other local health services are likely to become community trusts. The precise mechanics of the transfer of assets and liabilities to these organizations and their proposed structure has yet to be fmalised. However, for present purposes you have instructed us to assume that an Establishment Board will be responsible for preparing the existing public hospitals for colporatisation. This may involve various reorganisational phases. Ultimately the assets and liabilities of these organisations will be transferred to the CHEs. The proposed corporate structure of these CHEs is that they will be wholly owned by a common holding company, which company will in turn be owned by the Minister of CHEs.

4.2 The Transfer Process

It is convenient briefly to comment on the transfer process to the CHEs. We assume that this will be achieved by way of specific legislation which will be based upon provisions similar to those contained in the State-Owned Enterprises -13-

Act 1986. If this is the case, it will be appropriate to include an equivalent provision to Section 23 of that Act so as to exclude the potential application of the business acquisitions provisions of the Commerce Act to the transfer of assets and liabilities to the CHEs.

4.3 Concerns Regarding Application of the Commerce Act

We understand that the National Interim Provider Board is concerned to ensure that the Commerce Act will have unfettered application to the new health care regime following the transfer process. In particular, the Board wishes to ensure that the Commerce Act has the potential to apply to each CHE as an independant head in the market. In order to achieve this goal we think that the following matters will require attention:

(a) We first refer to the business acquisitions provisions of the Commerce Act and the possibility that CHEs may at some future time attempt to merge. This raises the issue, based on current assumptions, that there will be a merger of two companies both being subsidiaries of the same parent. Prior to 1 January 1991, there was an express exemption under the Commerce Act for mergers between interconnected bodies corporate. This exemption has, however, been repealed following the introduction of the new voluntary pre-merger notification regime. The implications of the repeal of this legislation have yet to be tested in the courts. Commentary to date • suggests that as a general rule such mergers are unlikely to be in breach of the relevant Commerce Act provisions relating to business acquisitions: see Berry and Riley, "Beware the New Business Acquisitions Provisions in the Commerce Amendment Act 1990" (1991) 21 VUWLR 91, 101-102. Accordingly, the CHEs would be at liberty to merge without reference to the Commerce Commission and without being in breach of the Commerce Act.

In order to address this question we suggest that legislation should be introduced to deem each of the CHEs to be a separate legal entity for Commerce Act purposes. This deeming provision should be without limitation as to time. The appropriate place for such provisions will be in the legislation governing the establishment of the CHEs.

(b) Section 44(1 )(b) of the Commerce Act provides that nothing in Part II of the Act, which contains all the restrictive trade practices provisions, shall apply to any contracts, arrangements or understandings where the only parties to such arrangements are interconnected bodies corporate. If this issue is not addressed, it will xan that the CHEs will be able to collude and to otherwise exercise such market power as they may have, jointly and individually, with immunity from challenge under the Commerce Act. This problem can likewise be overcome with amending legislation of the kind referred to in (a) above. -14-

(c) Section 44(1)(c) of the Commerce Act provides that nothing in Part II of the Act shall apply to any contract of service or contract for services insofar as it contains a provision by which a person agrees to restrictions as to the work in which that person may engage. This exception has the potential to remove certain restrictive trade practices, which may involve significant competition concerns, from the purview of the Act. For example, if a CHE enters into exclusive dealing or tying arrangements with surgeons or others on a long term basis, these arrangements will be exempt scrutiny under the Commerce Act by virtue of Section 44(1)(c).

Another exemption provision which will require careful consideration is Section 44(i)(f). This provides that none of the restrictive trade practices provisions of the Act shall apply to any contract, arrangement or understanding insofar as it relates to the remuneration, conditions of employment, hours of work, or working conditions of employees. Section 44(1)(f) is likely only to apply to contracts of service (ie. employer/ employee relationship) rather than contracts for services (ie. principal/ independent contractor). The distinction between these concepts is well illustrated in the case Collins v Hertfordshire County Council [1947] KB 598. Resident house surgeons were held to be employees under a contract of service with the hospital in which they worked whereas operating surgeons, over which the hospital had little day-to-day contact, were held to operate under contracts for service.

The issues surrounding Section 44(1)(f) are more complex than those applicable to Section 44(1)(c). On a first reading, Section 44(1)(f) may convey the impression that it relates only to legitimate labour practices. However, terms such as "conditions of employment" are potentially subject to wider construction. For example, a CHE may attempt to impose an employment condition on an employee surgeon that he or she will not provide services on behalf of another health care provider. Alternatively, if such employee may provide services on behalf of a competitor, the CHE may attempt to stipulate that these services be provided at certain prices. Until there are test cases on issues such as these, it is clearly arguable that such practices may be exempt from Part II of the Act because of the provisions of Section 44(1)(f).

Whereas we consider that the legislation establishing the CHEs may readily negate the application of Section 44(1)(c) to these institutions, the treatment to be given Section 44(l)(f) requires more detailed consideration. It should be noted that a Discussion Document was released on 13 December 1991 by the Ministry of Commerce and this in part addressed the continued application of Section 44(1)(f) of the Act. The Ministrys discussion illustrates the complexity of the issues which _15-

require attention. For example, collective bargaining, which the Government has legitimised under the Employment Contracts Act 1991, may be subject to attack under the price fixing provisions of the Commerce Act should Section 44(1)(f) be repealed. Unfortunately, the Ministrys review of the issue is brief and a number of the conclusions which they advance are clearly debatable.

Further examination is required of the issues concerning the potential impact of Section 44(1)(f) on the CHES. Are there likely to be provisions contained in contracts of service which will be anti-competitive? If particular concerns can be identified, then it may be appropriate to exclude the application of Section 44(1)(f) to those practices in the legislation establishing the CHEs. This approach will be the easiest option to follow. If more fundamental amendments are proposed, such as repeal of the application of Section 44(l)(f) to the CHEs, then detailed market analysis should first be undertaken to ascertain whether there may be any labour market practices (such as collective bargaining) which should still remain exempt from challenge under the Commerce Act.

(d) A final point we note is that Section 43 of the Commerce Act provides that none of the restrictive trade practices provisions of the Act apply to matters which are specifically authorised by other enactments. There is a need for a high degree of specificity in such legislation before this exemption will apply: see the judgment of the Privy Council in Apple Fields v New Zealand Apple and Pear Marketing Board [1991] 1 NZLR 257. Once the new health care legislation is drafted, it should be carefully scrutinised to ascertain whether it may specifically authorise any practices which should be open to scrutiny under the Commerce Act. Conversely, it may be thought desirable to specifically authorise certain practices which may be viewed as not appropriately being subject to Commerce Act review.

4.4 General Application of the Commerce Act

Assuming that the matters in paragraph 4.3 are addressed, we next comment to the extent possible on the potential application of the Commerce Act to health care in New Zealand.

4.5 The first point we note is that, on the assumptions you have asked us to make, the Government as funder and the RHAs as purchasers may have market power. It is not immediately apparent that the Governments role as funder raises competition concerns. RHAs are likely to have monopsony power. However, we gather that you do not wish us to address this issue further at the present moment.

4.6 Accordingly, our following comments focus upon the providers. In reviewing such level of the market it is convenient to address the conventional issues of market

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structure and conduct. Before discussing these matters, however, we comment on the question of market definition. As will be apparent from our earlier discussion of the provisions of the Commerce Act, the concept of "market" is central to many of these provisions.

4.7 Defining the relevant market is the conventional starting point to competition analysis. Undue attention is often attached to this exercise and in consequence the outcome of many cases will depend upon how markets may be defined. We do not intend to set out the relevant principles of market definition. We think that it is sufficiently informative briefly to review how this issue of market definition has been addressed in US case law.

4.8 US experience indicates that there is likely to be considerable debate on relevant markets in the health care industry in New Zealand:

(a) In the case of product markets the problem is to ascertain whether a wide or narrow definition of the market is appropriate. In the hospital merger cases in the US, the product market has generally been defined widely to include a cluster of services. However, specialist hospitals have provided an exception to this where they do not compete for the same patients served by the general acute care hospitals. In reviewing this issue the US courts appear to have attached significant weight to supply substitution considerations. For example, in Hospital Corporation of America Inc 106 FTC 395, a childrens hospital affiliated with an acute care hospital was included in a hospital market because there was no major impediment to converting beds for adult use. However, psychiatric hospitals have been excluded from the wider market because they would require major renovations to offer the same services. Thus, specialist service institutions have been subject to narrow product definitions.

(b) There is limited US authority on the question of the relevant product market for individual physicians. These cases depend largely on their facts. The most likely approach to defining such markets is to identify groupings of physicians in competition with each other (including other health care providers who may also compete in the same market).

(c) Turning to geographic market considerations, the US authorities are divided on whether this should take account of geopolitical designations or reflect the area of competition between hospitals. It is submitted that the latter approach is more likely to be adopted in New Zealand, and accordingly, narrow geographic markets are likely to be identified. -17- 4.9 Market Structure

The Commerce Act at present contains a voluntary pre-merger notification regime. Procedurally, this means that merger parties can implement a transaction without prior reference to the Commerce Commission. They can also elect to seek clearance or authorisation from the Commission prior to implementation if they wish to proceed in the certainty that the merger cannot subsequently be challenged by the Commission or third parties.

4.10 The relevant test for ascertaining whether a merger is or will be in breach of the Act depends upon whether a dominant position in a market will be acquired or strengthened in contravention of Section 47. As previously noted, we do not address the potential dual application of Section 27 (the prohibition against arrangements which substantially lessen competition) in this context as we understand that there are likely to be statutory amendments which will remove the potential for this provision to apply to business acquisitions.

4.11 Assuming that the CHEs are deemed to be independent entities, as described above in paragraph 4.3, all mergers and takeovers between such bodies and private health care providers will be subject to scrutiny under the Commerce Act on the same basis as their competitors and all other industry participants. It would be possible to impose a requirement on the CHEs (again in their empowering legislation) that they must first obtain clearance or authorisation from the Commerce Commission before they could implement merger or takeover proposals. However, this • additional requirement would impose an obligation on them which does not, so far as we are aware, apply to any other entity in the marketplace.

4.12 Conduct

Proper analysis of conduct issues can only be undertaken once it becomes apparent how the new health care sector will function. If there is an apparent absence of competition, then it may be appropriate to enquire whether this is in consequence of market power and/or collusion. Alternatively, the market may respond in an efficiency enhancing and pro-competitive way in which case an appropriate framework to consider possible competition issues is to review the US experience outlined above.

4.13 We provide our preliminary views on the potential application of the restrictive trade practices provisions contained in the Commerce Act to a range of issues which may arise. Our list of examples is essentially based on the US experience:

(a) Professional bodies

The affairs of various Associations representing the interests of sectors of the health care industry (eg. NZMA) will be subject to Commerce Act scrutiny. Indeed, trade association conduct has the potential to be ii _18-

particularly sensitive because Section 2(8) of the Act deems all members of an Association to be party to any understanding or arrangement of that Association. Furthermore, Association recommendations are deemed to be agreements between all members. Thus, Associations may be the vehicle for arrangements which may substantially lessen competition (eg. market sharing and exclusive dealing arrangements) (Section 27), or which may Ti result in collective boycotts (Section 29), price fixing (Section 30) and monopolisation (Section 36).

(b) Joint venture structures and co-operative arrangements generally

The formation and operation of joint ventures and co-operative arrangements will also potentially be subject to wide-ranging scrutiny. Again, by virtue of Section 2(8) of the Act, all members of such an association of persons will be deemed to be party to any understanding or arrangements by that body and any recommendations made by such an association will also be deemed to be an agreement between all parties. This obviously enhances the potential for the application of Sections 27 and 29 where the joint venture or co-operative arrangements substantially lessen competition or result in collective boycotts. Further points to note concerning these structures, which will be discussed below, include price-fixing and monopolisation.

Price-fixing is per se prohibited in New Zealand under Section 30 of the Commerce Act. Thus, price collusion is prohibited between competitor health providers whether they be individuals or joint venture structures. However, brief comment is required in relation to the joint venture pricing exemption provisions contained in Section 31. The price-fixing prohibition contained in Section 30 does not apply to cases involving the joint supply of services by the parties to a joint venture. The situation may arise, as is the case with PPOs, that there are competitor providers within such organisations who may endeavour to Set or recommend minimum, maximum or other price levels. If the view was taken that each member provided the service, rather than joint venture, then this exemption would not be available. It would be relevant to know whether for example an individual physician was performing the service in his or her name rather than in the name of the joint venture organisation. The potential for some doubt on this issue does accordingly exist.

(d) Boycotts

Collective boycotts of health care providers have the potential to be prohibited under the exclusionary provisions contained in Section 29. -19-

It should, however, be appreciated that a recent amendment to Section 29 may significantly limit its application. For Section 29 to apply it must be established that:

(i) The boycott is entered into between two or more persons in competition with each other;

(II) The boycott has the purpose of preventing, restricting, or limiting the supply of services to or from any person; and

(ill) The party subject to the boycott is in competition with those parties referred to in (i) above.

In one way, this boycott provision is potentially wider in its application than is the case under US law in that liability can attach even in cases where those orchestrating the boycott do not have market power. However, condition (iii) above, which was introduced last year, has the potential to frustrate a case involving a potential new entrant.

Essential facilities

The High Court rejected the express application of the US essential facilities doctrine in Port Nelson [1990] 2 NZLR 662. However, the Court did observe that in many cases the application of Section 36 of the Commerce Act would achieve a result similar to that achievable by the essential facilities doctrine. Thus, our discussion on monopolisation will be relevant to this issue.

(f) Exclusive dealing

Following the decision of the High Court in Fisher & Paykel [1990] NZAR 241, we think it is appropriate to assume that exclusive dealing issues in the health care industry will be determined under Section 27 in a manner consistent with the discussion of this issue under US law: see paragraphs 2.19 and 2.20 above.

(g) Tying

There is no leading authority on the practice of tying in New Zealand. Again, we suggest that the US law discussion on this issue is likely to provide an appropriate framework for the application of Section 27 of the Commerce Act to such situations: see paragraphs 221 and 2.22 above.

(h) Referrals/Peer review and utilisation controls

If referral, peer review or similar procedures are likely to result in collusion between competitor providers with the purpose of achieving a boycott of

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other providers, this will be reviewable under the collective boycott provisions contained in Section 29. Other provisions of the Commerce Act which may apply to referral, peer review and related activities are Sections 27 and 36.

(i) Monopolisation

The issue of monopolisation may well asume significance, particularly given that, if markets are narrowly defined in New Zealand, there will be high levels of market concentration. In this regard there are some material distinctions between US and New Zealand law. In New Zealand it is not an offence to be in a dominant posiiton (provided this has not been achieved by merger conduct in breach of the Act). However, once in a dominant position, no person may use that position for the purpose of:

(i) Restricting new entrants; (ii) Preventing or deterring competitive conduct; or 1 (iii) Eliminating competitiors.

Thus, the monopolisation provisions contained in Section 36 of the Commerce Act will have the potential to impact significantly on health care services in New Zealand in certain situations. Section 36 clearly has the potential to apply to any single entity which is dominant. Although there is no case law on point in New Zealand, it is also likely that Section 36 will apply to circumstances of joint dominance.

(j) Exclusion of allied health providers

If allied health providers are denied access to institutions such as the CHEs, such conduct will have the potential to be subject to scrutiny under Sections 27, 29 and 36 of the Commerce Act. In the absence of any factual example, it is difficult for us to comment further on the likely outcome of any review of such a practice.

5. SUMMARY

5.1 The experience in the US clearly demonstrates the potential for antitrust laws to apply to the health care industry.

5.2 By way of general comment, New Zealands competition laws, as contained in the Commerce Act 1986, may be viewed as adequate for the purposes of regulating restrictive trade practices and business acquisitions. Indeed, there are some strong parallels between New Zealand and US law because the Commerce Act I-S- largely based upon the Australian Trade Practices Act, which in turn is modelled on US federal antitrust law. -21-

5.3 However, we have identified a range of particular issues which require further consideration. They are:

(a) Whether the legislation to establish the CHEs should exempt the application of the Commerce Act to the transfer of assets and liabilities to such bodies: see paragraph 4.2;

(b) Whether the CHEs should, for Commerce Act purposes, be deemed to be separate legal entities. Without such deeming provisions we consider that restrictive trade practices which involve only the CHEs as parties will be exempt from the Commerce Act. In addition, it is unlikely that any merger activity between the CHEs could successfully be challenged without such deeming provisions, because there would merely be a transfer between interconnected bodies corporate: see paragraph 4.3(a) and (b);

(c) Whether the exemption provisions relating to contracts of and for services should be deleted and/or amended so far as they apply to the health care industry: see paragraph 4.3(c); and

(d) Whether there are any practices which should be specifically authorised so as to be exempt from the application of the Commerce Act: see paragraph 4.3(d).

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APPENDIX G: UK REFORM EXPERIENCE

G.1 Introduction

In this section we review the changes to the health system in the UK and the lessons that can be derived for New Zealands health care reform process. Our discussion is based on material produced by the National Health Service and discussions with commentators in the UK, as well as New Zealanders that have visited the UK in the past year.

Ci General Description

The reform of the health sector in the UK is based on the principle of separating the provision of health services from purchasing. Contractual arrangements have been introduced between the various units that are responsible for organising the delivery of health care services in the UK and the new purchasing units.

Government funding is now passed to 14 Regional Health Authorities ("RHAs") in England which are responsible for allocating budgets to the approximately 190 District Health Authorities ("DHAs") for hospital and community services, to the Family Health Service Authorities for expenditure on drugs and other primary care services, and to CF practices that choose to handle their own budgets for patients.

Under the reforms, the DHAs together with budget-holding CF practices purchase health services on behalf of consumers from public hospitals in their districts, hospitals in other districts, community services, the new hospital trusts and (at least in theory) the private sector.

The reform allows provider units to establish themselves as "self-governing" units (NHS Trusts) which have power over pricing, costing and the ability to raise private loan capital subject to certain Treasury parameters. Units include hospitals and other providers such as ambulance services.

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Those units that do not convert to self-governing bodies remain as directly managed units under the authority.and management of the DHAs.

G3 Self-Governing Hospitals and Other Units1

G..3.1 Background

The objective of establishing "self-governing" hospitals and other units in the UK is to devolve decision-making to the local operational level to make units more responsive to the needs of their patients, to secure local commitment and to achieve better value for money. Self-governing hospitals and other units have greater freedom to make decisions without detailed supervision from above.

Self-governing hospitals and other units remain within the National Health Service (NHS).

G3.2 NHS Hospital Trusts

Self-governing hospitals are established under statute as separate legal entities within the NHS and are known as NHS Hospital Trusts. Each is constituted as a corporate body. All hospitals are potentially eligible for self government. To become self-governing, management must be able to demonstrate the skills and capacity to run the hospital and senior professional staff including consultants must be involved in management. The Secretary of State decides which hospitals will be given self-governing status.

Fifty-seven Trusts were established in the first round of reform in April 1991. A further round was announced by government in October 1991 involving 99 further Trusts to be created in April 1992. Together these account for approximately one third of hospital and community health services. A further 150 hospitals and other units have expressed interest in participating in the third round of Trust creation.

Each Trust is run by a board of directors which has a substantial degree of freedom and responsibility. The non-executive chairman is appointed by the Secretary of State. Two non- executive members are drawn from the community and appointed by the RHA. Executive

1 The Health Service (1989), Self-Governing Hospitals, Working Paper 1, HMSO Publications.

-G2- (;S FIRS] losro.\ directors include the general manager of the hospital, a medical director, the senior nurse manager, and finance director. The general manager is appointed by the board.

The board is responsible for determining the overall policies of the Trust, monitoring their implementation, and maintaining financial ,viability. The general manager is responsible for giving affect to the boards policies and for the day-to-day management of the Trust.

Each Trust must hold an annual meeting which is open to the public. However, beyond that, it can make its own decision on whether or not to hold other meetings in public.

Neither the NHS Management Executive nor health authorities are involved in a Trusts detailed operations. The Secretary for State has reserve rights to issue directions and to institute enquiries where there is a prima fade case for concern. Each Trust is accountable to the Secretary of State via the NHS Management Executive. The Trusts are required to provide an annual business plan, annual report on the previous years performance, and annual accounts. They are also required to provide financial monitoring information, statistical data, submissions for major capital schemes and annual reports under the AIDS (Control) Act. They must inform the Management Executive if, at any time, their financial viability is at risk.

All self-governing hospitals have the power to:

provide services under contracts with their own or other districts;

negotiate the price of services;

generate income within statutory limitations;

to acquire, own and dispose of assets;

to borrow subject to an annual financing limit;

to retain operating surpluses and build up reserves;

to establish management structures without control from districts, regions or the NHS Management Executive;

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LJ to employ the staff they consider necessary; and

D to determine pay and conditions of staff.

G.3.3 Funding, Contractual and Asset Management Arrangements

A self-governing hospital earns its revenue principally from the contract services it provides II for health authorities. Other contracts and revenue may come from general practitioner practices with their own NHS budgets, private patients or their insurers, private hospitals and employers or other self-governing hospitals.

Prices are regulated to the extent that NHS Trusts are required to make no more, and no less than a six percent return on their assets (after recovering costs including depreciation of their assets) when contracting with NHS purchasers. They can earn more from private purchasers.2 (This constraint is comparable to the pricing regime applying to directly managed units.)

The Trusts are able to raise finance from government and the private sector, and from leasing and other financial transactions subject to an annual financing limit for each Trust set by the Secretary of State. The Treasury sets a national limit for all external financing and the Secretary of State establishes the individual limit for each Trust. Trusts must borrow on the most favourable terms and official documents point out that it is unlikely that more favourable finance could be obtained from the private sector.

The assets of self-governing hospitals are vested in the Trusts which are free to dispose of them subject only to the power of the Secretary of State to intervene if he believes the disposal would be against the public interest. The valuation of assets and the establishment of capital charges are discussed in more detail in Appendix G.6.

G.3.4 Impact of Establishing Trusts

The reform of hospitals into Trusts has resulted in some labour shedding and rebalancing of skill mixes within hospitals. For example, Guys Hospital, a teaching hospital in central London, has reduced staff by around 600 people or around eight to ten percent of total staff. The more overt and transparent constraints imposed by contracting have been a major spur to cost savings although to date, information on costing is still very poor.

2 Bartlett, W. (1991), Quasi-Markets and Contracts: A Markets and Hierarchies Perspective on NHS Reform, SAUS Publications, University of Bristol, p 13.

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G.4 Practice Budgets for General Medical Practitioners3

G.4.1 Introduction

Larger C? practices have the opportunity to manage a budget from which they are responsible for purchasing a defined range of hospital and primary care services on behalf of their patients. Budgets are based on the relative needs of patients within a practice, higher rates are set for the elderly and, in exceptional cases, adjustments are made for individual high risk patients to reduce risk selection. There is an upper limit of £5,000 to the cost the GP budget must bear for hospital treatment for any particular patient in a year.

The practices themselves decide whether or not to join or leave the scheme. Initial criteria for establishing practice budgets were a registered list of at least 10,000 patients, and the ability to manage budgets as demonstrated through adequate administrative support, and information systems.

Budget-holding has attracted some 306 practices involving 1,700 GPs (out of a total of 33,000) covering 4 million patients. It has attracted the more entrepreneurial type of C?, many of whom feel that the GPs role has been too severely curtailed and who particularly resent the GPs exclusion from hospital care.4

G.4.2 Services Covered by Budgets

The budgets must meet the costs of the following services (among others):

a defined group of surgical inpatient and day case treatment covering most elective procedures;

outpatient services;

• diagnostic investigations;

The Health Service (1989), Practice Budgets for General Medical Practitioners, Working Paper 3, HMSO Publications. ' Dr David Green, pers. comm., December 22 1991.

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• some GP practice team staff costs and accommodation costs; and

• drugs prescribed and dispensed.

Contracting arrangements are discussed below.

GP budget holders are able to keep profits from efficiency improvements for re-investment in services, equipment and staff.

G.43 Impact of GP Practices

In the early stages of the reform it was envisaged that GP budget holders would try to negotiate more favourable contracts for their patients and thus give a lead to the rest of the service. But during May 1991, a dispute arose about "preferential terms" which had been negotiated by GPs in Watford. On average, patients at the local hospital were admitted as inpatients within 20 weeks. GPs negotiated a contract under which their patients had to be treated within 13 weeks. After only weak resistance, the Secretary of State decided that all patients had to be treated in the same way (which in practice meant that they had to all experience a 20 week wait). The result has been to stifle the potential benefits that could have been achieved through negotiation and to average service to the lowest level.5

G.5 Funding and Contracts for Hospital Services6

G.5.1 Introduction

DHAs and GP budget holders are responsible for contracting with providers for the provision of services to individuals. In the case of the directly managed units, contracts take the form of management budgets which are structured as contracts, but are enforced through normal management processes. Contracts between DHAs and Trusts are based on an anns-length contracting approach.7 It is envisaged that by April 1994 all provider units will be operating under such contracts.

D Dr David Green, pers. comm., December 22 1991. 6 The Health Service (1989), Funding and Contracts for Hospital Services, Working Paper 2, HMSO Publications. Bartlett, op. cit., p 9.

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APPENDIX F: ECONOMIES OF SCALE, SCOPE AND "CHAIN"

F.1 Introduction

Appendix B reviewed the empirical evidence regarding the impact of competition on health care providers and health sector efficiency in the US. This appendix examines empirical evidence, principally from the US, concerning the most efficient operating size of providers and the efficient allOcation of responsibility for outputs across health entities.1

These issues are interdependent in practice. For example (setting aside the heterogeneous and qualitative nature of hospital output), halving the size of each existing hospital and simultaneously doubling the number of providers to retain the existing market capacity would affect (increase) the amount of direct provider competition. The net effect on the efficient provision of health care of such a step is unclear, however; the change in efficiency will depend on at least:

the implications that increased competition have for efficiency (US evidence suggests that this outcome is contingent on the regulatory environment and the nature of the system of reimbursement between funders and providers);

the efficient scale of operation for each health entity;

the impact on patient convenience; merging hospitals, whilst possibly realising production efficiencies, may reduce welfare as some patients will have further to travel to reach a hospital.

There will sometimes be a tension between these considerations; for example, in a market of fixed size, reducing the size of each hospital may increase competition but require that ead hospital produces below its productively-efficient level. As discussed in Section 4.0, recognising the

1 As in Appendix B, the notion of efficiency used here is that of productive efficiency.

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potential for this tension is important in establishing the most efficient initial structure for the health sector.

In evaluating the initial structure and scale of government-owned health care enterprises, it is necessary to take into account:

the most efficient scale of operation for a particular output. When the production of an output is characterised by economies of scale, for example, it may be more efficient for all production to be undertaken in a single hospital rather than in a number of hospitals. Production in a single hospital may enable cost savings inherent in decreasing average costs across increasing production levels to be realised; and

possible complementari ties in the production of different outputs which mean that those outputs are more efficiently undertaken within the same organisation than in a number of independent specialist organisations.

However, as stressed throughout this report, wherever possible, judgements regarding the preferred structure of New Zealands health care industry should be made by competing health care businesses in response to the preferences of RHAs and other purchasers. While the NIPB is required to recommend a preferred initial configuration of government-owned health care entities, the NIPBs principal concern should be to initiate a process that provides for flexibility and diversity, rather than to prejudge the future share of the health care industry.

In this appendix we review a selection of empirical studies of economies of scale and scope in short-term, acute2 hospitals in the US and UK. The proclivity of hospitals to operate in chains is also examined. A summary together with a brief discussion of the relevance of thi literature for the New Zealand health sector is provided in Appendix F.3.

2 In the US, "acute" is used to distinguish the hospital from long-term and other specialised care hospitals.

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F.2 Econometric Evidence

F.2.1 Features of the Econometric Analysis

Economies of scale and scope are typically calculated by estimating a hospitals cost function and examining the relationship between hospital output and output cost. It is difficult to distil a consensus of opinion about cost economies from the empirical literature. This is due in part to the gradual evolution of suitable methodological approaches to estimating appropriate hospital cost functions, and the sensitivity of results to the econometric methodology employed.

To identify the economies of scale and scope specific to the representative or "benchmark" hospital, a number of cost factors not directly related to the level of output must be controlled for. Differences in hospital case mix are probably the most important reason for inter-hospital cost

variation.3 As a hospital undertakes more complex and difficult cases, costs will be expected to increase, all other things being equal. Case mix has been found to alter (often increase) in severity

as hospital size increases.4 It is necessary, therefore, to control for case mix variation in order to undertake meaningful comparisons of the relative efficiency of hospitals of different sizes. 5 In the absence of careful analysis, the cost effect of increased case mix severity would tend to overstate the diseconomies of scale or understate the economies of scale in large hospitals. Some studies have found that controlling for the severe case mix in large hospitals substantially reduces the apparent cost disadvantage of large hospitals.6

The importance of accurately proxying the diverse case-mix possibilities is underlined econometrically; empirical studies have found that case mix variation can explain a sizeable

3 Relatively simple discussions of the issues are presented in Cowing, T.G., Holtman, A.C. and Powers, S. (1983), "Hospital Cost Analysis: A Survey and Evaluation of Recent Studies", Advances in Health Competition in the Economics and Health Services Research, 4, pp 257-303; Zwanziger, J . (1987), California Hospital Industry 1980-1935, Working Paper, The Rand Corporation. 4 See, for example Becker, E.R. and Sloan, F.A. (1985), "Hospital Ownership and Performance", Economic Inquiry, 23, pp 21-36. A possible rationale for this case mix effect is that larger hospitals are able to offer a wider range of services in a relatively cost-efficient fashion. With a wide variety of services on offer, such hospitals tend to have disproportionately more complex and expensive cases. 5 For example see: Becker and Sloan, op. cit.. 6 Robinson, J . and Luft, H. (1985), "The Impact of Hospital Market Structure on Patient Volume, Average Length of Stay and the Cost of Care", Journal of Health Economics, 4 , pp 333-356; Jenkins, A. (1980), "Multiproduct Cost Analysis: Service and Case-type Cost Equations for Ontario Hospitals, Applied Economics, 12, pp 103 113; Robinson, J.C. (1985), "The Impact of Hospital Market Structure on Patient Volume, Average Length of Stay, and the Cost of Care", Journal of Health Economics, 4, pp333-366.

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proportion of hospital cost variation. 7 In the interests of econometric tractability, however, general hospital models require high levels of aggregation of the multiplicity of services on offer. This compromises the ability of such models to represent the full range of services offered by hospitals. In defining the broad output groups, some structure is imposed upon the results; in particular, economies of scale and scope can only be estimated for the aggregates defined.

One of the factors, for example, that has been responsible for inter-hospital cost variation is geographic location - a number of studies have reported higher hospital costs in metropolitan areas.8 An obvious reason for geographic cost variation is that the prices of factor inputs vary. geographically.

Problems also arise in ensuring that like is compared with like. Not-for-profits are generally the only hospitalsto provide teaching and to operate in relatively poor urban areas. Studies which compare averages will miss the cost implications of these factors.

In attempting to measure the importance of scale and scope to hospital efficiency, it is also important, as far as possible, to control for competition-related cost effects underlying a particular organisational choice. The number of competitors faced by a hospital may influence its expenditures, as illustrated by the experience of hospitals faced with retrospective reimbursement in competitive markets. As the cost influence of the competitive environment is expected to be largely independent of the level of individual hospital output, it should be controlled for to facilitate insight into the nature of the hospitals cost function.

In the absence of an econometric consensus as to the appropriate methodology for estimating economies of scale and scope, a cautionary note is often included in survey papers to qualify any general conclusion. There is also a paucity of work based on post-1983 data; in light of the substantial revisions in hospital incentives in the US about this time, this is a significant qualification to the relevance of this empirical work to current circumstances in the US.

7 Cowing et al., op. cit.; Zwanziger op. cit.. 8 A recent study attributed an 11 percent cost premium to metropolitan hospitals (Grannemann, T.W., Brown, R.S. and Pauly, M.V. (1986), "Estimating Hospital Costs: A Multiple-Output Analysis", journal Of Heal!): Economics, 5, pp 107-1.27).

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F.2.2 Economies of Scale

Early studies of the hospital cost function reported a U-shaped average cost schedule, 9 often with economies of scale up to 500 beds, 1011 implying that productive efficiency would be enhanced by the integration of hospitals smaller than 500 beds. Recent work has taken issue with the methodology employed in these early studies and the results drawn therein. The identification of methodological shortcomings discounts the early work heavily.12

A diversity of conclusions have been obtained in subsequent work,13 generally finding more limited evidence of economies of scale. Evidence of both economies and diseconomies of scale have been reported for general hospital services. Despite these mixed results, a number of survey papers have concluded that economies of scale are often limited to small hospitals (those with fewer than 100 beds), while claiming larger outputs tend to be characterised by constant returns to scale.14 Brief details of some representative and more notable studies follow.

9 That is, average costs fall over lower output ranges, before rising steadily over larger output ranges. Economies of scale exist over output levels where average costs are falling. 10 For example Cart, W.J. and Feldstein, P.J. (1967), The Relationship of Cost to Hospital Size", Inquiry, 4, pp 45 - 65; Feldstein, P.J. (1967), Economic Analysis and Health Service Efficiency: Econometric Studies of the British National Health Service, Amsterdam: North Holland; and Cohen, H.A. (1967), "Variations in Cost Among Hospitals of Different Sizes", Southern Economic Journal, 45, pp 355 - 366. A summary of these early studies is reported in Cowing et al., op. cit. 11 The number of beds in a hospital is frequently used as a proxy for hospital size. A number of other size proxies have been employed in the literature; the choice of size proxy does not appear to be crucial however (Vitaliano, D.F. (1987), "On the Estimation of Hospital Cost Functions", Journal of Health Economics, 6, pp 305-318). 12 The modelling of hospital cost functions continues to attract empirical work. A number of reviews of the issues exist, including Cowing et al., op.cit., and Breyer, F. (1987), "Specification of a Hospital Cost Function", Journal of Health Economics, 6, pp 129-146. One of the trends in recent literature is a preference for flexible functional forms that make only weak assumptions about the nature of the underlying production function. Some of the flexible function work only provides a reasonable approximation to scale economies in the vicinity of the output - level of the average sample hospital. Evidence obtained from such studies of local economies of scale cannot be used prescriptively in recommending restructuring of existing hospitals, which requires an accurate view of cost economies some distance from the point of approximation. See: Vita, M.G. (1990), "Exploring Hospital Production Relationships with Flexible Functional Forms", Journal of Health Economics, 9, pp 1 - 21. 13 Detailed coverage of these results is provided in surveys by Cowing et al., op. cit. and Wagstaff, A. (1989), "Econometric Studies in Health Economics: A Survey of the British Literature", Journal of Health Economics, 8, pp 1-51. 14 Cowling ci al., op.cit.; Eastaugh, S.R. (1987), Financing Health Care: Economic Efficiency and Equity, Auburn Publishing: Massachusetts; Frech III , H.E. (1988), "Au Economic Analysis of the Proposed Merger of Sacred Heart Hospital and the Eugene Hospital", The Economics Group, Inc., Santa Barbara.

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A survey of 138 short-term general care hospitals examining 1975 data, considered five service categories, those of emergency care, medical-surgical, maternity, paediatric and other inpatient care.15 Holding physician numbers and capital inputs constant, a proportionate increase in the output of all 5 categories was accompanied by a smaller proportionate increase in cost. When emergency care, medical-surgical and maternity care outputs were increased individually, evidence was found that costs increased by a smaller proportion also. It was estimated, however, that diseconomies of scale eventually occurred. The overall economies of scale measured in this study correspond to movement along a short-run cost schedule; however, recalculation of the results in a subsequent study employing a long-run cost schedule found slight scale diseconomies.16

Recent US work has confirmed that there may be economies of scale on a departmental basis, rather than at an aggregate hospital level. Evidence of economies of scale was found in emergency departments in a study of over 800 non-federal, short-term hospitals, but not in other organised outpatient programmes, where constant returns to scale were observed;17 Case mix break down was made across a number of major inpatient and outpatient categories.

Professor Robert Evans, on his recent visit to New Zealand, commented that a critical aspect of a hospitals efficiency was the employment of specialists with high throughput. In his view, this aspect is of greater importance than the size of the hospital per Se. The importance of throughput to hospital efficiency has been evaluated empirically in the US; these results are reported in F.2.2.2.

Economies of scale within US home and health agencies have also been investigated. At the time of the study, entry into this sector was regulated by government. In failing to find any evidence of economies of scale and scope, the study concluded that regulated entry into the indutry was unnecessary.18

15 Cowing, T.G. and Holtman, A.G. (1983), "Multiproduct Short-Run Cost Functions: Empirical Evidence and Policy Implications from Cross-Section Data", Southern Economic Journal, 49, pp 637 - 653. 16 Vita, op. cit.. This study of 296 short-term Californian general care hospitals employing 1983 data failed to provide strong evidence of scale economics. 17 Crannemann, et al., op. cit. Similar work finding evidence of scale effects at a departmental level include Hu, T. (1971), "Hospital Costs and Pricing Behaviour: The Maternity Ward", Inquiry, 8, pp 19 - 26; Baron, D.I. (1978), The Economics of Obstetric Care", Journal of Economics and Business, 30, pp 98-107. 18 Kass, D.J. (1987), "Economies of Scale and Scope in the Provision of Home Health Services", Journal of health Economics, 6, Pp 129-146.

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Studies inevitably remain particularly sensitive to the econometric methodology employed.19 For example, work bn Californian hospitals has reported constant or slightly decreasing average costs when physician costs are excluded from the model. When physician costs were included, however, hospital average costs were found to increase with size-20

A number of papers attempt to survey the literature on economies of scale. A recent paper commented that "Ei]ndustry experts and managers generally believe that there are important scale economies up to at least a scale of about 100 beds. This is manifested in the refusal of bond rating companies to rate the bonds of hospitals with fewer than 100 beds".21

Given the problems associated with conventional econometric studies of economies of scale in hospitals, survivorship studies really provide the only passably reliable indicator of efficient scale. The conclusion in the paper above appears to be supported by recent survivorship statistics from California, and the US as a whole, which indicate that a disproportionately large number of failing short-term general hospitals have fewer than 100 beds.22 As shown in Table F.1, over the period of analysis (1983-1989), the only Californian hospitals to increase market share had more than 400 beds. Hospitals of this size account for less than one-third of the general hospitals in the US however.

19 Specification tests have been found to be an important check to econometric models of hospital costs. A study employing 1981 data which surveyed 166 medical-surgical or acute care hospitals in New York State, found that two distinct cost functions fitted the data set particularly well. One described a U-shaped average cost schedule (consistent with many of the earlier studies), with the other describing significant increasing returns to scale. The latter was found to be the better specified model (Vitaliano, op. cit.). 20 Bays, C. (1980), Specification Error in the Estimation of Hospital Cost Functions", Review of Economics and Statistics, 42, pp 302-305. By way of contrast, another study found that the cost function exhibited increasing returns to scale after correcting for medical staff characteristics. This survey included only 50 hospitals however (Pauly, M.V. (1978), "Medical Staff Characteristics and Hospital Costs", Journal of Human Resources, 13, pp 77 . fli). 21 Frech 111, op. cit.. This may reflect perceived economies in hospitals by the rating firms, or the relative expense of rating small hospitals. 22 Frech Ill, H.E. and Mobley, L.R. (1991), "Deregulation of Health Insurance and Hospital Efficiency: A Multivariate Survivorship Analysis", Working Paper.

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Table F.1 Market Share of Short-Term General Hospital Bed-Days By Hospital Size California 1983-1989

Size 1983 1989 6-24 .002 .001 25-49 .014 .009 50-99 .082 .065 100-199 .191 .167 200-299 .207 .200 300-399 .180 .173 400-499 .118 .147 500+ .206 .239

Some of the early survivorship studies are relatively simple, and in neglecting to control for the confounding effects of market environment and institutional factors, do not isolate the relevance of hospital size for survivorship. A recent paper finds that after attempting to control for these factors, economies of scale were found in hospitals of up to 370 beds. 23 Estimates of the extent of scale economies were sensitive to the econometric method used.24

P.2.2.1 Charactcrisation of Some Systematic Operational Differences

The regression-based estimates of economies of scale presented in the literature usually relate to the average or benchmark hospital. In presenting conclusions for the benchmark hospital, the analysis abstracts from a number of systematic cost and operational distinctions existing between hospitals. A brief discussion of some of these distinctions is worthwhile to characterise the diversity of hospitals in the sample populations analysed.

Systematic operational and cost differences have been observed between profit and not-for-profit hospitals. Proprietary hospitals have been observed to operate on a smaller scale and offer a smaller range of less complex services than their non-profit counterparts. 25 Differences across these ownership forms are discussed in some detail in Section 3.2. A study of non-teaching

23 Frech Ill and Mobley, op.cit.. 24 As an indicator of the productive efficiency of a hospital, survivorship studies need to be interpreted carefully. Essentially they are more a reflection of hospital profitability, and, to this degree, the results of survivorship studies will be contingent on the nature of the regulatory environment and funding approach in vogue. 25 A survey is presented in Cowing et al., op. cit..

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hospitals with fewer than 400 beds could not identify any notable differences between investor- owned and not-for-profits.26 However, other studies have identified differences across features such as case mix,27 and quality of care.28 There is mixed evidence regarding the relative productive efficiency of th respective ownership forms.

Teaching hospitals,29 the majority of whom operate as not-for-profit concerns, also appear to be larger than the "benchmark hospital ,30 and have systematically higher costs than non- teaching hospitals.31 The systematic size differences are hinted at in a study conducted in 1985 of New York State short-term general hospitals. Some of the detail of this study is reproduced in Table Fl below.32

Table F.2 Comparison of New York State Teaching and Non-Teaching Hospitals

Teaching Non-Teaching Bed Size Proportion Proportion

6-99 0.0 27.5 100-199 2.0 29.9 200-299 12.0 . 27.6 300-499 36.0 15.0 500+ 50.0 0.0

26 Sloan, F.A. and Vraciu, R.A. (1983), "Investor Owned and Not-For-Profit Hospitals: Addressing Some Issues", Health Affairs, 2, pp 25-37. Inquiry, 14, 27 Bays, C.W. (1977), "Case Mix Differences between Nonprofit and For-Profit Hospitals", pp 17-21. 28 Cowing and Holtman, op. cit.. 29 In the US, a hospital with a residency programme is described as a "teaching" hospital; it need not have a medical school affiliation. 30 The size of teaching hospitals may be argued to reflect the optimal size for jointly delivering a wide range of services, providing teaching facilities and undertaking research. Some of the largest teaching hospitals are affiliated to the Council of Teaching Hospitals ("COTH");members of COTH tend to have a medical school affiliation and research facilities. (1985), "Case-Mix 31 Cowling et al., op. cit.; Vitaliano, op. cit.; Frick, A.P., Martin, S.C. and Schwartz, M. and Cost Differences Between Teaching and Nonteaching Hospitals, Medical Care, 23, pp 283-295; Butler, J.R.C. and Dossell, D.P. (1987), "Economic Analysis of Public Hospitals in Queensland", in Economics and Health: 1987. Proceedings of the 9th Australia,, Conference of Health Economists, Australian Studies in Health Service Administration. 32 Source: Frick et al., op. cit.. A more detailed breakdown confirming the trend for teaching hospitals - especially those with a medical school affiliation - to operate on a relatively large scale is available in Health Services Research, 15, pp 203-230. Sloan, F., (1980), "The Internal Organisation of Hospitals", (:o,itidcnii

It is a matter of some interest whether systematically larger costs among teaching hospitals can be explained by case mix or qualitative differences in teaching hospital outputs. In the absence of such an explanation, additional costs in teaching hospitals may arise from indirect teaching costs associated with the learning process, or the relative inefficiency inherent in teaching hospitals.33

Hospital size and case mix severity have often been observed to be positively correlated.34 Because teaching hospitals tend to be larger than the benchmark, the cost premium found in teaching hospitals may reflect a (size-induced) case-mix effect. After controlling for case mix variation, the majority of US studies found that teaching status helps to explain inter-hospital

costs differences,35 although some studies reported that the impact of teaching status on hospital

costs was not uniform across departments. 36 In contrast, a study of Australian hospitals found that teaching status added limited explanatory power to the regression analysis undertaken, after controlling for case mix, scale and utilisation. Prior to controlling for these factors, systematic differences in Australian hospital costs were reported which were consistent with the US evidence.37

The nature of the teaching facility appears to influence hospital costs, 38 with the costs of teaching hospitals appearing to be associated positively with the level of teaching irttensity.39 One study found the medical school affiliation dummy to be insignificant, although members of the Council of Teaching Hospitals were found to have costs 15 percent higher than those of other hospitals.40

33 Frick ci al., op. cit.. 34 See, for example, Becker and Sloan, op. cit.. 35 Watts, C.A. and Kiastorin, T.D. (1980), The Impact of Case Mix on Hospital Costs: A Comparative Analysis", Inquiry, 17, Pp 357-367; Pettengill, J. and Vertrees, J . (1982), "Reliability and Validity in Hospital Case-Mix Measurement", Health Care Management Review, 4, pp 101-128; Vitaliano, op. cit.. 36 Culyer, A.J., Wiseman, J ., Drummond, M.F. and West, P. A. (1978), "What Accounts for the Higher Costs of Teaching Hospitals?", Social and Economic Administration, 12, pp 20-30; Sloan, F.A, Feldman, R.D. and Steinwald, A.B. (1983), "Effects of Teaching on Hospital Costs", Journal of Health Economics, 2, pp 1-28. 37 Teaching Status was found to be a more significant explanator of hospital costs when a less sophisticated case mix proxy was employed, suggesting that teaching status has a close association with hospital case mix. 38 Butler, op. cit., for example, examined doctor education programmes via medical school affiliation, and two nursing training programmes. After controlling for case mix effects, the nature of the training programme continued to have some differential effect upon hospital costs, 39 For a general review of these issues, see Butler, op. cit.. Pettengill and Vertrees, op. cit. provide a specific example of this. 40 Grannemann, et al., op. cit..

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Cost differences which remain after controlling for case mix variation might be ascribed to qualitative differences in teaching hospital output. Operating size/teaching status has been positively associated with output quality in a number of studies.41

A systematic relationship between the size of the hospital, quality of care and cost is difficult to capture in the inherently quantitative econometric analysis. Hospital costs would be anticipated to increase monotonically with output quality; if there is variation in quality across output levels, an analysis of the relative cost-efficiency of alternative production levels should be conducted on a quality-adjusted basis. Failing to adjust for the enhanced level of quality provided by larger hospitals would overstate their relative inefficiency. It remains unclear whether the quality of teaching hospital output is different from from that of a comparably. large non-teaching hospital.

F.2.2.2 Service Quality - Indicators

The empirical literature has identified a mix of relationships between hospital size and service

quality.42 -

A number of studies have found that the range and quality of care is positively related to

hospital size; on this basis, both physicians and patients will prefer large hospitals. 43 Consumer

preference for a wide range of services has been well documented in the literature. 44 This point has also been emphasised to us by the Dean of Medicine at School of Medicine at the University of Auckland. In his view there are benefits for seriously ill patients in going to larger hospitals because of the range of specialist services available and because of the limited tertiary services

41 The size-quality effect has been discussed by Frech III and Mobley, op. cit., while others attest to a teaching status-quality effect. For example see Palmer, R.H. and Reilly, M.C. (1979),"Individual and Institutional Variables Which May Serve as Indicators of Quality of Medical Care ", Medical Care, 27, pp 693-717. It is difficult to assess the relative importance of the two effects, as teaching hospitals tend also to be large. Palmer and Reilly suggest that it is the correlation of size with teaching status that explains the positive correlation between size and quality. A more general discussion of the qualitative nature of hospital output appears in F.2.2.2. This has some implications for the evaluation of the relative efficiency of teaching hospitals. 42 For a relatively informal discussion of the attributes of different sized hospitals, see Higgins, J., The Burden of Medicine: Private Health Care in Britain, MacMillan: London, pp 198-203. 43 Note however that a causal link is not drawn. 44 A discussion of this literature and other size related quality issues may be found in Frech Ill and Mobley, op. cit..

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available at small hospitals.45 The juxtaposition of case mix and quality effects suggests that large hospitals will tend to have a more complicated and expensive mix of cases than their smaller counterparts, and larger per case costs. Failing to recognise this case mix/qualitative difference in service may mean that the relative inefficiency of large (possibly teaching) hospitals is overstated.

A study of US non-federal acute care hospitals found that the quality of the patient outcome was positively related to hospital throughput, especially for surgical patients. After controlling for this effect, hospital size was found to be significantly negatively related to patient outcome, however.46 Patients in teaching hospitals were found to experience relatively poorer outcomes reflecting the fact that teaching hospitals tend to be larger than average. A similar point was made to us by a number of practitioners we , spoke to in the course of undertaking this study; these individuals argued that the speed and quality of a surgeons work was strongly and positively correlated with the frequency with which a surgeon undertook a particular procedure.

F.2.2.3 Anecdotal Evidence of Scale Economies

The Managing Director of a major Australian private sector hospital chain suggested to us that a hospital size of approximately 150 beds is optimal; he believes that beyond this size, diseconomies of scale are experienced. A New Zealand private hospital operator remarked to us that economies of scale appear to exist up to about 100 beds. Neither of these statements are inconsistent with the US literature. According to First Bostons health institution specialists in New York, hospitals with fewer than 100 beds are tending to close, 47 and hospitals with over 500 to 600 beds to incur repeated financial losses. (As noted in Appendix B, this may in part reflect the fact that larger hospitals tend to be in urban areas where there are often more problems with undercornpensated Medicaid care and uncompensated care for uninsured patients.)

Professor J . D. K. North, pers. comm., 13 December 1991. 46 Flood, A.B., Scott, W.R. and Ewy, W. (1984), "Does Practice Make Perfect? Part II: The Relation Between Volume and Outcomes and Other Hospital Characteristics, Medical Care, 22, ppi 115 - 124. As discussed in Appendix B, cottage hospitals may function efficiently with less than 100 beds.

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F.2.3 Economies of Scope

Important complemen ta ri ties between the production of different hospital services may mean that it is sensible for the hospital to offer a number of services, rather than specialise in one. This is the intuition inherent in economies of scope.

Many of the studies of economies of scale discussed above also evaluated economies of scope. However, there are significant methodological problems in such analysis; for exampi?, it is usually necessary to limit the analysis to approximately 6 care categories to ensure the study is econometrically tractable - a rather crude approximation. Economies of scope were found to be significant in the provision of paediatric care in conjunction with all other services in the study of 138 hospitals based on 1975 data. Diseconomies of scope occurred in the provision of emergency care services, in conjunction with the remainder of all other services. This particular study finds more substantive evidence of economies of scale than scope implying that larger, more specialised hospitals provide cost advantages.

In a study of over 800 hospitals, diseconomies of scope were found between the emergency department and inpatient care. 48 This study also found diseconomies between inpatient and outpatient care in general. A study of economies of scale and scope across five service categories in 296 Californian short-term general care hospitals, found only weak evidence of economies of scope-49

The empirical literature as yet suggests no consistent pattern to economies of scope. The absence of a clear conclusion can be attributed in part to the sensitivity of econometric results to the specification of treatment groups.

48 Crannemann et al., op. cit.. 49 The five service categories considered were medical/surgical, obstetric/ gynaecological, paediatric, outpatient and other services.

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F.2.4 "Chain" Economies

A recent structural trend among health providers in the US is the increasing prevalence with which short-term, acute care hospitals choose to operate as part of a chain.50

A common rationale for the multi-hospital chain is that it might offer "better access to capital, economies of scale, system diversification, more productive personnel and management distribution, and system planning and organisation". 51 However, some empirical evidence appears to be to the contrary, reporting that under the retrospective reimbursement system, chain hospitals had costs (in some cases significantly) higher than those of independent proprietary hospitals.52 As the trend toward chain operation does not appear to be motivated by cost economies inherited from operating as a chain, commentators attribute the trend to the chains ability to extract rentals under the funding approach that existed at the time of data collection (i.e. prior the introduction of PPS).

A study undertaken in 1983 using a national sample of 1979 hospital data reviewed the relationship between the form of hospital ownership and hospital costs.53 The relative performance of proprietary, government and private non-profit hospitals was considered. Hospitals were further classified into another three categories: independent hospitals; hospitals with a short-term chain affiliation; and hospitals with a long-standing chain affiliation. The study attempted to control for a number of other factors that might account for inter-hospital cost variations, such as case mix, the extent of third-party funding and the quality of service.

Proprietary hospitals were found to be slightly less costly than independent, private non-profit hospitals on a cost per admission basis.54 On average, chain-owned proprietary hospitals were more costly on a per admission basis than independent, private non-profit hospitals, the standard

50 Arnould, R.J. and DeBrock, L.M. (1986), "Competition and Market Failure in the Hospital Industry: A Review of the Evidence", Journal of Health Politics, Policy and Law, 43, pp 253 - 292); Eastaugh, op. cit.. Between 1970 and 1980 there was a 204 percent increase in the number of hospitals involved in multi-hospital systems (Sloan and Vraciu, op. cit.). 51 Arnould & DeBrock, op. cit., p 259. 52 A study of 280 Californian hospitals based on 1980 data found that costs in for-profit chains were five percent higher than costs for independent proprietary hospitals (Pattison, R. and Katz, H. (1983), New England Journal of Medicine, "investor-Owned and Not-For-Profit Hospitals", 309, pp 347-353. Eastaugh, op. cit., surveys a number of papers which provide similar results. 53 Becker and Sloan, op. cit.. 54 On a cost-per-day basis, proprietary hospitals were found to be more costly, but reported a shorter average length of stay than non-profit hospitals.

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for comparison utilised in this study. Among proprietary companies, mature chains were found to be less costly than "new" chains.

The study notes, however, that certain cost differences between these types of ownership chain may follow from non-ownership related aspects of hospital operation.

One of the principal cost differences expected between proprietary and non-profit hospitals which is unrelated to hospital ownership arises from the tax-exempt nature of not-for-profits, and the ready access of these hospitals to tax-exempt bond financing. On average, the study estimates these factors account for a 4.5 percent cost premium on a cost-per-admission basis for proprietary hospitals, relative to their independent not-for-profit counterparts. After controlling for these factors, the costs of mature proprietary chains were found to be only two percent higher than independent private non-profits.

Cost differences may also be traced to the practice among chain hospitals of incurring promotional expenses. Patients may be prepared to bear these costs if advertising reduces uncertainty about the health services. The factoring of these issues into the analysis does not alter the studs broad conclusion that "no meaningful ownership differences in efficiency could be found" 55 - the differences reported were not statistically significant.

Other studies have been unable to detect a systematic cost difference between hospitals within chains and independent hospitals. In a survivorship study of the Californian health sector from 1983-1989, the impact of system affiliation (i.e. belonging to a chain) on the survivorship of a hospital could not be measured precisely enough to ascertain its economic substance. 56 Similarly, a recent study of 293 Californian hospitals was unable to discern a relationship between system affiliation and hospital cost.57 In summary, the trend toward chain operated hospitals is difficult to explain on the basis of the econometric evidence.

55 Becker and Sloan, op. cit., p 33. 56 Frech Ill and Mobley, "p. cit.. 57 Vita, op. cit..

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F.3 Conclusions

A consensus as to the methodology appropriate for the evaluation of hospital cost relationships is yet to emerge from the literature. The range of conclusions from the literature is attributable in part to the diverse nature of methodologies employed and the problems associated with analysis of this kind. The econometric problems justify considerable scepticism about the results. The discussion in this appendix may be summarised as follows:

0 economies of scale are often limited to small hospitals (those with fewer than 100 beds), while larger hospitals tend to be characterised by constant returns to scale up to about 500 beds. Scale economies may also exist at a departmental level;

systematic differences exist across the hospitals surveyed. For instance, non-profits (of which teaching hospitals are a significant component) tend to operate on a larger scale, and offer a wider range of services than the for-profits;

teaching hospitals have higher costs than non-teaching hospitals. The cost differential has generally been attributed largely to case mix differences, with the existence of specific teaching costs, and differences in quality and efficiency being possible explanations of any residual cost differential;

the interaction of qualitative aspects of output and output size have proved difficult to control for. Some evidence suggests that hospital quality is positively related to the number of services on offer, which in turn is positively correlated with hospital size. Failure to recognise this interaction between hospital size and quality overstates the relative inefficiency of large hospitals;

measurement of economies of scope is sensitive to the specification of treatment groups; tractable econometric models have to abstract from the significant heterogeneity that exists in general hospital output. No reliable patterns regarding economies of scope are apparent; and

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although individual hospitals are increasingly being operated within chains, econometric studies have been unable to demonstrate the economic advantages mooted to exist in this form of operation.

The above conclusions need to be qualified. During the 1980s, the health sector in the US has undergone significant change. Because most of the studies discussed above use data sets which are several years old, they generally do not account for these recent changes.

More fundamentally, the work described above is not directly applicable to the New Zealand environment; the results need to be adapted for the funding, regulatory and market conditions applying in New Zealand.

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Contracts generally specify the following:

nature, level and quality of service;

price;

information and access needed to monitor performance;

remedies if the hospital fails to meet the contract; and

mechanics for changing or renewing the contract.

Contracts can specify methods of assessing quality, and some DHAs have introduced quality assurance measures, but to date such provision is rudimentary and far from being the norm.

Contracts with hospitals for the delivery of health care services are based on prices that include both capital and revenue costs.

Three different types of contract are used:

Block contracts: The DHA or C? practice pays the hospital an annual fee for access to a defined range and level of services, particularly for the treatment of urgent cases. The contract could be viewed as funding a given level of capacity, particularly with respect to the treatment of urgent cases. The contracts do not specify a price for every eventuality. The contracts can set performance targets such as waiting times; the proportion of day cases or length of stay. The contracts also in some cases specify ways of judging quality and efficiency and the relative roles of the hospital and purchasers in monitoring performance.

C Cost per case: The payment is on a case-by-case basis, set at the marginal or average cost per case. The arrangement does not involve any prior commitment by either party to the volume of cases which might be dealt with. Cost and volume: Hospitals receive a fixed sum for a baseline level of activity, defined in terms of a given number of treatments or cases. Beyond that level, cases are funded on the basis of either marginal or average cost per case. For the h3spital, a guaranteed baseline of activity assists planning. From the perspective of the

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purchaser, contracts have to specify a maximum volume of cases or treatments in order to maintain expenditure control.

A proportion of treatments will inevitably be carried out in hospitals with which the DHA has no contract - particularly for emergency treatment. A key principle is that the lack of a contract should not inhibit treatment For this reason there is a "contingency reserve" held by the DHA to pay for non-contracted treatment. However, extra contractual referrals have been under provided. For example, patients that hoped to get referred to other districts with shorter waiting lists have been told that this is impossible if their own district will not pay in advance.

The likely mix of contract types that might emerge in New Zealand can be obtained by reviewing the contracts which were proposed in the first wave of NHS Trust applications. In these, the block contract was the most common contract with 25 percent of Trusts expecting to operate entirely on block contracts. A further 61 percent expected to operate mainly on block contracts and only 14 percent intended to rely primarily on cost-per-case contracts-8

The lack of developed information systems has created problems in establishing robust contracting arrangements. Some hospitals have been unable to price particular surgical procedures quoting instead an average cost for each specialty. In practice this means tlat a DHA or budget holding CF would be expected to pay the same for a bunion operation as for a hip or knee replacement. Where hospitals have established operation-specific prices, there have been wide variations. For example the price for an operation on a child with a squint varied from £150 in one hospital to £450 in another.9

Competition between provider units appears to have had little impact in shaping contractual arrangements and there is scepticism as to whether hospitals will compete for patients. Use of private sector providers has been limited to the "waiting list initiative which targets additional funding on waiting list problems. Some DHAs have made use of yardstick competition to put pressure on provider units. G.5.2 Impact on Patients and GPs

Except in the case of an emergency, a patients contact with a hospital follows reference by a CF. The GP needs to ensure that the patients referral is covered by a contract. Non-budget holding GPs have been refused consent to refer patients to non-contract hospitals despite long

8 ibid,p15. College of Health (1991), Guide to Hospital Waiting Lists, p 40.

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standing referral patterns and in a few cases this has occurred in the middle of a patients - course of treatment.lD

GPs with their own budgets contract with hospitals for the placement of their own patients. For other individuals, the DHAs inform GPs of the hospitals covered by contracts.

G5.3 Funding of Training and Research

In the past, most of the costs of training NHS staff and support for research have been part of the general costs of hospitals. To remove these costs from pricing decisions, direct funding from the RHAs or for special health authorities, from the Department of Health, is provided. Salary costs for post-graduate trainees are borne by the RHAs. The RHA is responsible for ensuring that hospitals do not cut back on post-graduate training to achieve immediate cost savings where this would result in poorer standards of service. The RHA is required to fund post-graduate training directly if necessary. The RHA can contract with individual hospitals or groups of hospitals to provide appropriate training programmes.

The new arrangements require RHAs to allocate some of their funds to support locally organised research. Some regions and individual teaching hospitals have substantial research funds available from their endowment resources. At a national level, the Medical Research Council ("MRC") is responsible for promoting clinical research. Health authorities are responsible for providing the clinical facilities enabling research sponsored by the MRC to be undertaken.

G.6 Capital Charging"

The Government has introduced a new system for capital charging for all government-owned health care assets. The objective is to increase awareness of the cost of capital and strengthen incentives to use capital efficiently. The capital charging and funding is designed so that there is no net increase in public expenditure in the health system and no reduction in funds available for patient services.

Capital charges comprise:

10 ibid, PP 38-40. 11 The Health Service (1989), Capital Charges, Working Paper 5, HMSO Publications.

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depreciation based on the current value of assets calculated using ordinary accounting principles;

0 interest calculated on the current value of the capital assets.

Assets have generally been valued on the basis of depreciated original value or the current replacement value. Land and buildings are valued at their current value, on an asset rather than cash flow basis. Plant, services and equipment are valued at current cost defined as the lower of depreciated replacement cost and recoverable amount (which is the higher of net realisable value and economic value). In most cases indices applied to historic cost are used to arrive at replacement cost. The more complex calculations required to calculate recoverable amount are assumed to be worthwhile only for valuable assets (over £100,000). In the case of Trusts, the valuation of assets, and the actual assets vested in the Trusts, was negotiated with the DHAs.

The interest element of the capital charge for non-Trust hospitals is calculated by applying a prescribed interest rate to the value of the capital assets used by authorities. The rate of interest is determined by government and is applied to the current value of the assets.

For the Trust hospitals, capital comprises two elements: interest bearing debt which has defined interest and repayment terms and public dividend capital on which the Trust pays dividends to government. This has no fixed return or repayment obligations. However, in the long run, the overall return is expected to be no less than on an equivalent loan.

G.7 Impact of the Reforms in the UK

G.7i Benefits of the Reform

As yet, there is little detailed analysis in the literature of the impact of the UK reforms. As a result, the conclusions presented here are based on discussions with a number of individuals. Overall, it appears to us that the UK reforms have achieved several positive outcomes.

The separation of funding and provision and the move towards contracting, although at a very crude stage, has focused attention on the outputs being produced, the cost of these, and the relative priorities for expenditure. The contracts are, in particular, creating pressures for cost control and quality improvements, both from Trusts and directly managed hospitals. As well, purchasing agencies have focused attention on improving the quality of services

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produced by providers. Commentators suggest that contracts will become increasingly specific about quality over the next few years.

The Trusts have introduced more flexible working practices, rebalancing of skill mixes and the shedding of surplus labour.

Budget-holding by GPs has been one of the success stories of the UK reforms to date, allowing more innovative GPs greater flexibility to manage care for their patients. They had been able to negotiate improved performance from providers (although this was later overturned by the Secretary of State who decided all patients should be treated in the same way). GP budget holders have proved more willing to use the private sector than DHAs, though as yet on a small scale. Some budget holders are establishing their own hospitals as for example in Epsom, Surrey. The British Medical Association was originally opposed to budget holding but in recent weeks has reversed this position.12

However, a number of problems with the UK reforms have been identified. The key ones are described below. I I I i

12 Dr David Green, pers. comm., December 22 1991.

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G.7.2 Political Resistance

One of the major problems in the UK has been the failure of policy makers to "sell" the benefits of the reforms. In many cases the benefits have been presented in a manner that has been esoteric and not understood by the public. The Government appears to have seriously underestimated public concerns about the equity aspects of the changes.

G.73 Timing of Funder and Provider Reform

The reform of the providers has proceeded more quickly than that of the funders with many of the most skilled and entrepreneurial managers from within the health system being attracted to the provider units. As a result, the funders have struggled to recruit high- quality personnel.

G.7.4 Nature of the Contracts

Because of concerns about the costs of transition, the initial contracts have tended to "freeze" the pattern of purchasing and service delivery that was used in the past rather than developing new arrangements. In effect, the initial round of contracts largely formalised the previous implicit contracts. This has been reinforced by the lack of detailed information on costing which has acted as a barrier to the development of more detailed contracting.

Because of the lack of detailed costing information, and the delay in the reform of funders, the contracts that have developed have been relatively crude. In particular, there has been greater reliance on bulk contracting than would be desirable in the long run. Because block contracts are incomplete (in particular, they do not specify a price for different eventualities), they potentially create opportunities for opportunism. For example, there are risks that providers might reduce the quality of service. On the other hand, mechanisms for enforcing contracts may undermine the autonomy and independence of the self-governing hospitals.13 Block contracts force the providers to bear the risk of unexpected cost increases - the impact of this depends on whether the providers are better able than purchasers to control such costs and the relative risk premiums each would need to charge to bear the associated risk.

13 Bartlett, op. cit., p 11.

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In addition, the use of block contracts inevitably delays the gains from greater specificity and accountability that might be achieved through moving towards a use of cost-per-case contracting. It appears that it will take a number of years before robust contracts on a cost- per-case basis will be developed.

A further result of the relatively slow development of contracts is that the providers have been forced to develop without guidance as to the services and the methods of service delivery that might be preferred by the funders. Existing providers have tended to become entrenched, rather than being shaped by the potential changes that a funder might consider desirable. This may increase the difficulties for the purchaser in encouraging changes in the future.

As yet, purchasers have a limited range of sanctions for poor contract performance. RHAs still have a role in arbitrating disputes between purchasers and providers.

G.7.5 Funding Arrangements

There appears to be some confusion as to the relative roles of the funders at the different levels of regions and districts. The multiple funding levels risk distorting accountability and increasing administrative costs.

G.7.6 Hospital Trusts

The Hospital Trusts have so far proved capable of making some of the adjustments necessary to improve services, but they still lack the freedom required to achieve the major changes required. For example, although they have greater control of the wages paid to employees, they are still bound by national pay agreements for junior hospital doctors.

However, the major problem is the lack of full control of their capital programmes, a serious problem given the years of under-investment in the NHS. Hospital Trusts have greater control of capital programmes than directly-managed units, but they remain subject to considerable central regulation. For example, each Trust still has an external financing limit determined by the NHS Management Executive.14

14 Dr David Green, pers. comm., December 22 1991.

-G13-

( oiili1ctt i;tI CS FIRST BosioN

G.7.7 GP Practices

The decision by the Secretary of State that all patients must be treated the same, whether or not they belonged to Cl practices, has reduced the incentive for Cls to negotiate favourable contracts and put pressure on providers. Such restrictions should not be imposed on the GPs. If they are allowed to negotiate whatever agreements they can on behalf of their patients, then budget-holding would have the potential to deliver worthwhile but modest improvements in the service.15

G.7.8 Capital Charges and Valuation

The cost of capital used for capital charging for non-trust assets is based on an interest rate for the total value of the assets rather than a cost of capital comprising debt and equity. Because the cost of equity is higher than the cost of debt, the capital charge will be less than the opportunity cost of capital. The capital of Trust hospitals is divided into debt and "public dividend capital", the equivalent of equity. However, the required rate of return on the latter is no less than the interest cost on the same amount rather than the rate of return a private provider would require on equivalent equity. As a result, the cost of capital may not reflect the true opportunity cost of capital and may create distortions relative to private providers.

G.7.9 Consumer Choice

When the white paper was published it was suggested that the reforms would enable greater consumer choice. However, the internal market is based on a tendering process in which sub- contractors compete for business from a central contractor. The DHAs are the consumers proxy, and whether or not the service becomes more responsive depends primarily on the DHAs. The DHAs have made some progress in functioning as the patients advocate looking at quality, waiting times and block appointments. However, in a fully competitive market, a patient who is dissatisfied can go elsewhere. Under the UK system the producers do not have to please patients but rather the DHAs. It is questionable whether this will ensure that the patients interests are put first. This weakness will also apply in New Zealand until individuals are able to use their RHA funding to purchase a health plan.

15 ibid.

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( ;otIti(I(1lli;II (;S Fi RS1 BosioN

G.8 Implications for New Zealand

A number of implications can be drawn for New Zealands reform process:

There must be strong political commitment to the reforms and the benefits of the restructuring must be "sold" to the public;

M The separation of funding and provision and contracting can yield some benefits irrespective of the introduction of competition;

Funders must treat all providers neutrally and promote contestability from the outset to avoid entrenching existing providers;

The contracting arrangements are essential in determining the shape of providers and in achieving efficiency gains. A significant effort is required to develop robust and detailed contracting arrangements as soon as possible in the reform process;

Budget-holding by GPs has been one of the success stories of the UK reforms to date, allowing more innovative GPs greater flexibility to manage care for their patients. A similar scheme in New Zealand may help to generate some reforming zeal among the providers and especially GPs who feel their job is too narrowly constrained; and

The demand in the UK that everyone be treated in the same manner, suppresses the differences on which progress depends. Progress, improvement and change occur in part through emulation, i.e. the worst producers must match the best or go out of business. But if all differences in quality are suppressed, then this process of emulation is curtailed, as was the case when the British Government prevented budget holding GPs in Watford from securing a better deal for their patients.

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( .()Hhi(I(1ItiII CS FIRST BOSTON

-G16- CS Ii Rl IOSTON

APPENDIX I: LEGISLATION ADMINISTERED BY THE DEPARTMENT OF HEALTH

The Department of Health administers 37 Acts of Parliament as follows:

Alcoholic Liquor Advisory Council Act 1976 Alcoholism and Drug Addiction Act 1966 Area Health Boards Act 1983 Burial and Cremation Act 1964 Childrens Health Camps Act 1972 Chiropractors Act 1982 Clean Air Act 1972 Dental Act 1988 Dietitians Act 1950 Food Act 1981 Health Act 1956 Health Benefits (Reciprocity with Australia) Act 1986 Health Benefits (Reciprocity with UK) Act 1982 Health Research Council 1990 Hospitals Act 1956 Human Tissue Act 1964 Maternal Mortality Research Act 1968 Medical Auxiliaries Act 1966 Medical Practitioners Act 1968 Medicines Act 1981 Mental Health Act 1969 Misuse of Drugs Act 1975 New Zealand Council for Post Graduate Medical Education Act Repeal Act 1990 New Zealand Register of Osteopaths Incorporated Act 1978 Noise Control Act 1982 Nurses Act 1977 Occupational Therapy Act 1949 Optometrists and Dispensing Opticians Act ,1976 • Pharmacy Act 1970 • Physiotherapy Act 1949 Plumbers, Gasfitters and Drainlayers Act 1976 Psychologists Act 1981 Radiation Protection Act 1965 Smoke-free Environments Act 1990 Social Security Act 1964 Toxic Substances Act 1979 Tuberculosis Act 1948

I-1- ( : >2) I )( IeI)l ill ______(S 1i RSI BOSTON

The Department also administers the following Regulations and Orders in Council made pursuant to the above Acts:

Alcoholic Liquor Advisory Council Regulations 1978 Alcoholism and Drug Addiction Act Commencement Order 1968 Alcoholism and Drug Addiction Institutions Order 1969,1972, 1975, 1978, 1982, 1986, 1988 Alcoholism and Drug Addiction (Forms) Regulations 1968 Alcoholism and Drug Addiction (Medical Fees) Regulations 1987 Anthrax Prevention Regulations 1987 Artificial Aids Notice 1964 Asbestos Dust (Concentration of Fibres) Notice 1984 Asbestos Regulations 1983 Auckland Area Health District Order 1988 Auckland Area Health District (Triennial General Election and Boundaries) Order 1989 Bay of Plenty Area Health District Order 1989 Bay of Plenty Hospital District Order 1974 Burial and Cremation (Removal of Monuments and Tablets) Regulations 1967 Camping Ground Regulations 1985 Canterbury Area Health District (Triennial General Election and Boundaries) Order 1989 Chiropractors Orders 1984, 1988 Chiropractors Regulations 1990 Clean Air Act Schedules Order 1982 Clean Air Act Second Schedule Order 1987 Clean Air (Licensing Regulations) 1973 Clean Air (Smoke) Regulations 1975 Clean Air Zone (Christchurch) Order 1977 Clean Air Zone (Christchurch) Order 1977, Amendment No.4 Clean Air Zones (Canterbury Region) Order 1984 Cremation Regulations 1973 Dental Regulations 1988 Deratting of Ships Notice 1961 Dietary Supplements Regulations 1985 Dietitians Regulations 1987 Drainage and Plumbing Regulations 1978 Drug Tariff 1990 I Drug Tariff 1990, Amendment No. 3 Electroplating Regulations 1950 Exhumation Licence Fee Order 1991 Fire Extinguishers Regulations 1958 Fireguards Regulations 1958 Food Act Commencement Order 1984 Food Additives Notice 1989, 1991 Food Hygiene Regulations 1974 Food (Labelling and Additives) Notice 1991 Food (Labelling and Additives) Notice (No. 2)1988 Food Regulations 1984 Fumigation Regulations 1967 Hawkes Bay Hospital District Order 1971 Health Benefits (Reciprocity with the United Kingdom) Act Commencement Order 1984 Health (Burial) Regulations 1946 Health (Bursaries) Regulations 1965 Health Districts Notice 1988 Health (Diseases Communicated by Animals) Regulations 1965 Health (Hairdressers) Regulations 1980 Health (Infectious and Notifiable Diseases) Regulations 1966 Health (Infirm and Neglected Persons) Regulations 1958 Health Inspectors Qualifications Regulations 1975

1-2- I

( :111 i(ICfllhiI CS 1i IS BOsii)N

Health (Needles and Syringes) Regulations 1987 Health (Quarantine) Regulations 1983 Health (Registration of Premises) Regulations 1966 Hearing Aids Notice 1957 Hospitals Amendment Act (No. 2) Commencement Order 1972 Hospital Boards and Committees of Management Regulations 1959 Hospital Board Finance Regulations 1958 Hospital Districts (Borough of Kapiti) Order 1974 Hospital Districts Order 1988 Hospitals (Turangi Home) Order 1969 • Housing Improvements Regulations 1947 • Infectious Diseases Order 1983, 1986 Kakapo Stream Pollution Control Order 1976 Lead Process Regulations 1950 Medical and Dental Auxiliaries Act Commencement Orders 1967, 1968, 1982 Medical Laboratory Technologists Regulations 1989 Medical Practitioners (Fees) Regulations 1990 Medical Practitioners (Overseas Qualifications) Order 1985 Medical Practitioners Registration Regulations 1952 Medical Practitioners (Registration of General Practitioners) Regulations 1987 Medical Practitioners (Registration of Specialists) Regulations 1971 Medical Radiation Technologists Regulations 1982 Medicines Act Commencement Order 1984 • Medicines Regulations 1984 Mental Health (Fees and Forms) Regulations 1969 Mental Hospitals Road Traffic Bylaws 1960 Microwave Ovens Regulations 1982 Misuse of Drugs Act Commencement Orders 1977 Misuse of Drugs Orders 1978, 1981, 1982, 1984 Misuse of Drugs Orders (No. 2)1978, 1984 Misuse of Drugs Regulations 1977 Northland Area Health District Order 1985 Northland Area Health District (Triennial General Election and Boundaries) Order 1989 Northland Hospital District Order 1967 Noxious Substances Regulations 1954 Nurses Regulations 1986 Obstetric Regulations 1986 Occupational Therapy Regulations 1964 Old Peoples Homes Regulations 1987 Optometrists and Dispensing Opticians Regulations 1977 Pharmacy Registration Regulations 1972 Pharmacy Regulations 1975 Physiotherapy Regulations 1979 Plastic Wrappings Regulations 1979 Plumbers, Gasfitters and Drainlayers Regulations 1977 Podiatrists Regulations 1982 Porirua Hospital Traffic Bylaws 1969 Private Hospitals (Hours of Work) Regulations 1938 Private Hospitals Regulations 1964 Psychologists Act Commencement Order 1984 Psychologists Regulations 1983 Quarantine Inspection Places Notice 1981 Radiation Protection Act Commencement Order 1973 Radiation Protection (Appeals) Regulation 1974 Radiation Protection Regulations 1982 Revocation of the Burial-Ground Dedication Regulations 1984 Revocation of Health Districts Order 1988 Revocation of Hospital Boards Appointments Regulations 1985

1-3-

Gm I 1i( Icli I jal (S h -i BOSTON Revocation of Hospital Boards Representation Order 1988 Revocation of Social Security (Physiotherapy Benefits) Regulations Sanitary Plumbing (Exemption) Notice 1978 Sanitary Plumbing (Permission for Householders) Notice (No. 2) 1985, 1986 Sanitary Plumbing (Permission for Householders) Notice 1987, 1988 Smoke-free Environments Regulations 1990 Smoke-free Environments Regulations 1990 (No.2)1990 Social Security (Breast Protheses) Regulations 1989 Social Security (Breast Protheses) Regulations 1989 Amendment No. 1 Social Security (Contact Lenses) Notice 1979 Social Security (Dental Benefits) Regulations 1983 Social Security (Dental Benefits) Regulations 1983 Amendment No.8 Social Security (Diagnostic Imaging Services) Regulations 1985 Social Security (District Nursing Services) Regulations 1964 Social Security (Domestic Assistance) Regulations 1944 Social Security (Hospital Benefits - Inpatients) Regulations 1979 Social Security (Hospital Benefits - Outpatients) Regulations 1947 Social Security (Laboratory Diagnostic Services) Regulations 1981 Social Security (Maternity Benefits) Regulations 1939 Social Security (Medical Fees) Regulations 1986 Security (Pharmaceutical Benefits) Regulations 1965 Social Security (Physiotherapy Benefits) Regulations 1984 Social Security (Supplementary Maternity Benefits) Regulations 1939 Social Security (Surgical Footwear) Notice 1980 Social Security (Wigs and Hairpieces) Regulations 1981 Social Security (Wigs and Hairpieces) Regulations 1981 Amendment No. 3 Southland Area Health District Order 1988 Spray Coating Regulations 1962 Tairawhiti Area Health District Order 1988 Tairawhiti Area Health District (Triennial General Election and Boundaries) Order 1989 Taranaki Area Health District Order 1987 Taranaki Hospital District Order 1968 Taranaki Area Health District (Triennial General Election and Boundaries) Order 1989 Toxic Substances Act Commencement Order 1983 Toxic Substances Regulations 1983 Tuberculosis Regulations 1951 University of Otago School of Anatomy Order 1969, 1988 Venereal Diseases Regulations 1982 Waikato Area Health District (Triennial General Election and Boundaries) Order 1989 Water Supplies Protection Regulations 1961 Wanganui Hospital District Order 1968 Wellington Area Health District Order 1989 Wellington Area Health District (Triennial General Election and Boundaries) Order 1989 West Coast Area Health District Order 1988 West Coast Hospital District Order 1967

I 1992 HOUSE SITTINGS

Sits Rises

3 March 9 April

22 April 7May

2 June 2 July

21 June (Budget?) 20 August

15 Sept 22 Oct

10 Nov 17 Dec APPENDIX H: CHAPMAN TRIPP SHEFFIELD YOUNG LETTER REPORTING ON LEGISLATIVE ISSUES

Chapman Tripp Sheffield Young Barristers Solicitors and Notaries Public Wellington and Auckland, New Zealand

PARTNERS 0. S. Aldersiade S. L Franks F. Miller L E. S. Attin D. J. Goddard S. J. Mills U. G. Anderson N. E. Gray P. J. Murphy 1 Grey Street Telephone 64 .4-499 5999 S. L.Anderson J P Greenwood K. I. Murray R. A. Armstrong A. L Homes N. A. ORegan Wellington I T.Arnold E. C. A. Harrison P W. ORegan P.O. Box 993. Wellington Fax 64-4-472 7111 P.A. Barnett L. I. Hinton R. I. Parker R. J. Beech J. E. Hodder A. M. Paterson DX 8024 . 64-4•472 7090 P W. Bennett L U. Howes W. A. Reece a R. Boon a H. W. Hutchinson p U. Reese H. N. Bowie A. J. Keenan W. A. Smith T.J.Broadmore K. 0. .1. G. B. J. Brown R. K. Macdonald U. C. Walls Your ref: R.A.Bycrolt LMcKay E.CWiMiams R. S. Clarke A. R. McRae R.. Wilson 0. .1 Cochrane Cl E. Marriott A. W. Ibung P. N. Crotty CI 0. Martin G.W.David H. F. Melrose Mr Cochrane/Mr Franks Our ref: CONSULTANTS EXECUTIVE DIRECTOR dslf53009a T. W. Blennerhasseil E CL Deane .t T. Sheffield P Stone --

24 December 1991

By Facsimile No: 473 4618

Mr Stephen Jennings/Ms Sue Begg CS First Boston NZ Limited WELLINGTON

NIPB LEGISLATION PLANNING

1. We have considered your draft dated 22 December of the section intended to become section 6.

Areas where legislation is likely to be required

2. The establishment of CHETBs and the CHESB need legislative sanction, for three main reasons:

2.1 to establish funding authority;

2.2 to avoid constitutional challenges;

2.3 to assure risk averse prospective members of the validity of the framework for the task they are invited to perform, and to give confidence in the consistency of policy.

It is possible that the reform will be challenged including by the seeking of injunctions restraining establishment action, unless the steps are clearly authorised. This would be troublesome even if the actions are not well founded.

3. Though interim arrangements (such as declaring NZ to be a single area health district or two health districts or - running the Boards as adjuncts to Commissioners, or from the office of the Prime Minister) might be explored, in our opinion they are almost certain to be challenged if they proceed beyond planning and evaluation before legislation. - Your timetable, as discussed recognises this aspect.

Auckland: Quay bwer. 29 Customs Street West P.O. Box 2206 Telephone 649309 4470 Fax 64 9•770 851 2. Chapman Tripp Sheffield Young Page No.

4. A more precise description of avenues of challenge and the prospects of them succeeding would require considerable further research into the detail of the legislation and the extent of the initial steps the CHESB might wish to take. The opportunities for challenge will be minimised by minimising any administrative role of the bodies prior to conferral of statutory authority, but not entirely avoided.

5. Thus some of the steps in the proposed reforms which would ordinarily be taken, such as formal establishment and appointment of the CHESB and the CHETB can not be implemented within the current legislative framework. The proposals therefore, prudently suggest an interim phase during which the relevant personnel would be designated and work only on evaluation and planning. Their precise appointment status may not be entirely clear.

6. There is some scope for CHETB Chairpersons and perhaps their deputies to hold office as Commissioners and Deputy Commissioners under Area Health Board legislation. This may focus CHETB structures on geographic definition more than is • desired. To go further would be problematic, pending legislation. For example, the State Services Commission is responsible for negotiating collective employment contracts for all area health board employees. Though the responsibility can be delegated at present to General Managers, in order to confer that authority on a CHETB a legislative amendment would be needed.

7. Use of the existing legislation to appoint intended CHETB Chairpersons as Commissioners. (contemplated for May/June 1992) could also impose other constraints. For example as a matter of administrative law the Minister will have to be satisfied that a person to be appointed Commissioner has the attributes for that task as well as the attributes that commend him or her as Chairperson of a CHETB. The nominee will also, of course need to feel comfortable about accepting the administrative burden of that office.

8. Even if there is technical legal capacity to achieve authorisation, if it relies on bold interpretation of the meaning of the authorising provisions, it is possible that consequent challenges to any system devised could be as disruptive as the alternative of taking the time to pass specific legislation on the subject.

9. As stated (and without examining specific issues in detail at this stage) it will be necessary to have legislation to authorise the establishment of the CHESB. Such legislation could give the necessary powers to appoint CHETE directors/trustees and deal with establishment authorisations for CHEs. 3. Chapman Tripp Sheffield Young Page No.

10. Possibly the interim (pre-establishment) phase of the CHESB could be as part of the NIPB. Whether or not this is a practical solution depends on the financial limits, of and the base for the NIPB. If NIPB funding and authorisation is not adequate it may be that this area could be addressed by an Appropriation Bill within the next six months. 11. It is possible that some of the earlier establishment work, particularly in relation to the CHESB early stages could be funded through other existing appropriations such as through Vote:Health. There will presumably be at least one Appropriation Bill between now and the end of the current financial year.

12. However, funding of the establishment process is only part of the matter. We agree with the reported conclusions of the Crown Law Office and Health Department on the severe limitations in the existing legislation on "commercial" activity using Health assets. Legislation will be necessary if the reforms are to proceed to implementation past planning, evaluation and more certainly the designation of appointees to prospective employment positions.

Full Legislation Review or Necessary Amendments Only?

13. A comprehensive redrafting of the relevant legislation would take 3 months from the making of a comprehensive set of policy decisions. This would be because of the need to consult with affected Departments and refine the major policy decisions. Attempts to shorten such a time frame may be proposed. They would have a chance of success only if there was near unanimity in Cabinet on the policy issues and an accompanying determination to override the multiplicity of delays which can arise at departmental (and Cabinet committee) level.

14. This would cover the full rewrite of the Area Health Boards, Hospitals, and Health Acts and checking and possible amendment of some of the 34 other Acts administered by the Health Department as well as the many regulations that are relevant. The process can be speeded up but in doing so two factors must be recognised:

14.1 Sacrifice of quality. This allows greater scope for justified criticism later on. The division of regulatory and other functions will be critical, and must be got right. If criticism emerges at the Select Committee stage and shakes caucus confidence in the integrity of the preparatory work, any time gained in shortening the earlier stages will be lost. HN Chapman Tripp Sheffield Young Page No.

14.2 Loss of Minimum Consensus. The risk of not • having time to fully explain the proposals to all relevant Government parties (including affected Departments, Caucus, and even parts of Cabinet) is increased. If haste appears to compromise quality, the result could be less than wholehearted support for difficult measures during their passage irrespective of their real quality.

It is not always easy to explain or totally refine policy at the earliest stages. It can sometimes evolve as part of the dynamic of the law drafting process.

15. On the other hand point 13.2 above needs to be assessed realistically. If a Department (say Health or a segment of Health such as Hospitals Administration) is implacably opposed, then giving them more time does not necessarily add to the available information or the quality of debate, but it does give them , more time to oppose and to rally kindred spirits to their cause.

Minimal Legislation

16. If a 2-3 month drafting and consultation period is not available, the next option is to do the minimum amount of legislative reform necessary to get the programme under way, leaving the balance for further on in the process. The advantage of this is that it leaves all 3 legislative programme options open. The disadvantages . are possible confusion caused because the legislation is not presented as a cohesive package. There is probably a greater risk of oversight and error. At the end, the legislation remains fragmented as it is at present (e.g. the Area Health Boards Act following the 1990 and 1991 Amendments) though the expected reform of legislation proposed by Health could still follow.

17. The following discussion of the legislative options is on the basis that the legislation will not be a comprehensive review of all relevant legislation, but if one of the two "ordinary" (non Budget) options is adopted, then some of the wider review tasks should be able to be addressed.

Legislation options

18. The available options are:

18.1 "Ordinary" legislation;

18.2 "Ordinary" legislation, but with urgency taken to speed passage through the House if necessary; 5. Chapman Tripp Sheffield Young age No.

18.3 • Budget night legislation, which is legislation passed through all stages within a few days.

"Ordinary" legislation

19. Two timetables are set out below, both aimed at having legislation in place by end June 1992. The earlier discussion mentions matters for which legislation is necessary, so as to decide whether this is a critical date.

20. Parliament will be in recess from 2 July to 21 July. Shortly after resumption on 21 July the Budget, the Budget debate, and urgent legislation must be expected to take up most of the session until 20 August when there is another recess (to 15 Sept).

Possible Timetable

No.1 No. 2

21 Jan Cabinet meets for first time in 1992

2-6 Mar 3-7 Feb Issues to Cabinet Committees.

9(&16) Mar 10 & 17 Feb Cabinet decisions. 3 March House resumes.

2 April 5 March Bill to Cabinet Legislation Committee

7-9 April 10-12 March Bill introduced.

8 May 10 April Submissions close.

14-23 April Hear submissions. This period includes Easter and a Parliamentary recess so submissions are likely to take until 30 April.

11-30 May Hear submissions. House in recess. Committees can sit all day but typically take 1 week of school holidays off.

2-3 May 5-6 May Select Committee considers and deliberates.

9 June 2 June Bill reported back.

16-18 June 9-11 June Second reading debate.

7 6. Chapman Tripp Sheffield Young Page No.

23-25 June 16-18 June Committee stages: Supplementary Order Paper amendments.

before end June Third reading and Royal Assent.

Note A similar timetable is no doubt being planned for other legislation, and the legislative programme will be very full until the end of June at least. We are aware of several other pieces of controversial legislation with 31 J March and 30 June deadlines. There is little room for slippage, especially with No. 1 timetable above. It assumes in particular prompt passage through the Cabinet process and No. 1 could also involve urgency being taken for House proceedings during June.

21. Attached is a table showing the likely House sitting and recess times for 1992. They are tentative only. Budget Legislation

22. This option sees the legislation put through all stages as part of the Budget programme in late July or early August.

23. Points to consider:

23.1 The speed and secrecy which usually accompanies Budget legislation prevents public and interest group participation, as well as limiting Government Department involvement. This can result in defects or omissions going undetected.

23.2 This option does not see legislation in place by 1 July.

23.3 The legislation must be the bare minimum necessary to achieve the essential objective. Additional reforms that are desirable but not essential are not likely to make it into the legislation. If they do, there is the risk that the Bill may be delayed in passage or referred to a Select Committee.

Even if the changes were to comprise Budget legislation we would urge that as far as possible policy decisions are made before the Budget round of decision making intrudes and takes up much of the time of officials and Ministers. ri Chapman Tripp Sheffield Young Page No..

24. The more minimalist the approach, the more likely it is that Budget legislation could be used if time pressures so require.

RHA Complications

25. The RHA related reforms further complicate the position. The Government has to make political assessments as to whether it wants all the legislation relating to this Health reform in one package or whether it wants separate legislation with all that entails in the way of separate submission hearings, debates, and use of House time.

26. The regulatory functions of the Department and the Boards, and those with specific statutory powers and duties (such as Medical Officers of Health) will have to be addressed and reallocated where appropriate. This indicates some advantages in a more comprehensive approach. However. those aspects would appear not to necessarily impinge directly on the proposed tasks of the CHESB and CHETB personnel during the months up to October 1992 (proposed to be analysis, development of guidelines and policy statements, discussions on contractual issues, valuations and general planning). During that time the current operation of existing services would seem to be affected only in the limited sense that the development of plans unavoidably introduces some uncertainty.

27. This is not a legislative difficulty. However, we note that if the RHA reforms are split legislatively from these reforms it seems inevitable there would be two major health debates in 1992 as well as the ACC debate. This may not be seen as helpful in what will surely be a very full legislative year.

Conclusion In our opinion, some legislation will be essential by 1 July, though it need not be extensive to achieve the immediate objective of establishment of the bodies to develop the structure. That interim approach will be recognised as incomplete but speed of reform and removal of uncertainty for those involved may dictate this course. We recommend Timetable No. 1 with a fall back to Budgt legislation if that timetable can not be met.

CHAPMAN TRIPP SHEFFIELD YOUNG

S.L. Franks