Initial Examination on Reforming the California Lottery, K Klowden, A Chatterjee

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Content: Regional Economics Milken Institute October 2007 Initial Examination on Reforming the California Lottery By Kevin Klowden and Anusuya Chatterjee, with Anita Charuworn and Benjamin Yeo
Initial Examination on Reforming the California Lottery By Kevin Klowden and Anusuya Chatterjee, with Anita Charuworn and Benjamin Yeo Regional Economics Milken Institute October 2007
The authors wish to thank Kathleen Brown of Goldman Sachs, Craig Cornett of the California state assembly Speaker's Office, Linh Nguyen of the California Lottery, and Peter Taylor and Bradley Tusk of Lehman Brothers.
Initial Examination on Reforming the California Lottery Introduction The purpose of this examination of the California Lottery is to determine which means of improving lottery performance and revenue generation are available to the California state government and what actions must be taken in order to make these solutions possible. To this end, this report provides a general overview of the lottery's cost structure and performance over the past several years. The report also directly compares California's performance against those states that lead the nation in per capita lottery sales and net revenues. Currently, the California Lottery is restricted by mandates that secure the percentage of funding for education each year but which also severely restrict any investments in games or equipment that would boost the actual growth of lottery sales. The lottery is also restricted in terms of the kinds of games that can be offered, as well in being able to utilize up-to-date technology. These restrictions prevent the California Lottery from effectively emulating either enacted or proposed changes in other states and countries. Several other states (and countries) have enacted or are considering changes to their lotteries that should be considered in California as means for improving lottery performance. The most notable example of these include the establishment of an autonomous quasi-public lottery corporation in Connecticut; increasing lottery sales by raising the percentage of sales money returned to ticket buyers, as in Massachusetts and Texas; and the leasing of lottery operations to a private company or consortium, as has been done in the United Kingdom. This paper reviews a number of options for reforming the lottery operations and boosting performance, and discusses the benefits and drawbacks of each. They include: maintaining the current lottery system with minor legislative changes establishing a quasi-public corporation to operate the lottery establishing a five- to ten-year lottery concession establishing a thirty-year (or longer) lottery concession outright sale to a private entity establishing a public corporation and holding an initial public offering. MILKEN INSTITUTE 1250 FOURTH STREET SANTA MONICA, CA 90401-1353 310.570.4600 [email protected] www.milkeninstitute.org 1
Overview The California Lottery was created to supplement education funding in 1984 through passage of Proposition 37 and enactment of the California State Lottery Act. The act authorizes the state to operate a cash prize lottery and establishes provisions for the disbursement of revenues. It empowers the governor to appoint commissioners who oversee lottery operations, and empowers the legislature to amend the act to further "the purposes of the act." The Lottery Act outlines a specific division of funds: At least 34 percent of total revenues go to public education. At least 50 percent of total revenues must be returned to lottery participants as winnings. No more than 16 percent of the total revenue is to be set aside for lottery operational costs, including staff, printing, marketing, and distribution costs. The act stipulates that any funding not spent during the course of the year on prize payouts or administrative costs be automatically allocated to the state education fund at the end of the fiscal year. This prevents the lottery from building up reserves of capital that can be used to fund more extensive marketing campaigns and instant win games with higher prize payouts. These guarantees helped ensure the passage of Proposition 37, but they have placed limitations on the lottery's overall operations. Since 1984 the lottery has operated numerous games, including Scratchers, Super Lotto (now SuperLotto Plus), Fantasy 5, Daily 3, Hot Spot, and the Daily Derby. In 2004, the state considered participation in such popular multi-state lottery games as Powerball and Mega Millions. In 2005, the California State Lottery Commission approved the state's entry into a Mega Millions partnership.1 The following figure shows the percentage of state sales by game type in 2006.2
Types of Games in California Lottery Percent of Sales, 2006
Fantasy 5 4.1% Hot Spot 4.6%
Daily 3 4.0%
Daily Derby 0.3%
MegaMillions 12.7%
Scratchers 53.8%
SuperLotto Plus 20.5% Source: La Fleur's World Lottery Almanac, 2007
In 2006, Scratchers contributed the highest percentage of sales (53.8 percent), followed by Super LottoPlus (20.5 percent) and Mega Millions (12.7 percent). Since 1999, in fact, Scratchers has 1. Lottery News, "Mega Millions Is Coming to California" (2005). See: http://www.calottery.com /NR/ rdonlyres/39B29651-8042-4D7A-BC65-4A8D3184D33E/0/PressKitforMSLGameRecommendation.pdf. 2. California Lottery, "Reports to the Public." (2006).
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driven total sales in the state lottery. The game has also shown the largest overall growth in sales. SuperLotto tickets enjoyed early popularity but suffered declining sales in 2002­2003, despite the introduction of the SuperLotto Plus variant with its bonus number feature in 2003, and have maintained constant sales levels since then.
The following table illustrates state lottery sales by game for the period 2001­2006. Sales from Mega Millions are aggregated for 2005 and 2006 because California began to offer the multi-state Mega Millions jackpot, in addition to the SuperLotto Plus jackpot, in 2005. Although combined Lotto sales did spike initially, the profiles of individuals playing the two games is similar enough that the aggregate sales of both games is only marginally higher than for the SuperLotto Plus game on its own in 2004.
California Lottery Sales By Type of Game, US$ Millions
Game
2001
Scratchers
1,188.93
SuperLotto
1,272.36
Fantasy 5
154.18
Daily 3
85.09
Hot Spot
184.90
Daily Derby
9.38
Total
2,894.84
* Changed to SuperLotto Plus ** Includes MegaMillions
Source: California State Lottery
2002 1,184.12 1,275.71 148.05 93.87 184.43 10.19 2,896.37
2003* 1,211.72 1,110.68 153.94 112.84 180.16 12.23 2,781.57
2004* 1,338.98 1,166.95 166.50 124.92 167.99 8.64 2,973.98
2005** 1,736.79 1,109.93 160.76 136.16 174.30 15.68 3,333.62
2006** 1,929.63 1,187.73 148.35 143.99 163.53 11.77 3,585.00
The next pie chart depicts 2006 administrative expenses. Retailer compensation, defined as "a minimum of 5% of the retail price of tickets or shares" plus incentive bonuses, has seen a rising trend in past few years. If administrative expenses are viewed as a total percentage of lottery sales, they amount to about 11 percent, of which retailer compensation constitutes 7 percent.
Administrative Expenses California Lottery, 2006
Direct Cost 14.0%
Retailer Compensation 61.0%
Operating Expenses 25.0%
Source: La Fleur's World Lottery Almanac, 2007
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Now, if we consider how the total revenue is allocated for administrative expenses, in 2006, retailer compensations were the major source of administrative expenses. Sales Comparison with Other States In order to examine why the California Lottery has historically underperformed relative to the national average, it is important to look both at states that have performed well and those that have implemented or are considering privatization options. States with high per capita sales include Massachusetts, New York, and Georgia. Connecticut is profiled because it has established a quasi-public autonomous corporation to run its lottery. South Dakota, West Virginia, Delaware, and Rhode Island have significantly expanded their lottery operations through the use of the controversial video lottery terminals (VLTs), which are often compared to centrally controlled, electronic slot machines. Differences in per capita sales among states depend on the games offered, as well as regulations, marketing and advertisement strategies, administrative costs, external competition, demographics, and regional attributes. California ranks low among the selected states that operate lotteries, as shown in the next two tables. We divide the states into two groupings: sales rankings that include revenues from VLTs and those that do not. VLTs are game terminals, similar to slot machines, whose winning numbers are generated by a central computer linked to the terminals. Although winning wagers are random, programmers determine the quantity and size of payouts within the system of connected terminals. Massachusetts ranks No. 1 in sales per capita without VLTs. Rank of Selected States By per Capita Sales, 2006, US$
Without VLT*
With VLT*
Per Capita
Per Capita
States
Rank Sales States
Rank Sales
Massachusetts
1
Georgia
2
707 Delaware
1
903
342 South Dakota
2
890
New York Connecticut
2
342 West Virginia
3
865
4
274 Massachusetts 4
707
Maryland
4
New Jersey
6
Rhode Island
9
Delaware
22
West Virginia
24
Colorado
27
274 Rhode Island
5
621
267 New York
6
364
241 Georgia
7
342
145 Connecticut
9
274
118 Maryland
9
274
96 New Jersey
11
267
California Arizona
28
94 Colorado
27
96
36
75 California
28
94
South Dakota
39
52 Arizona
36
75
* Video Lottery Terminal
Sources: La Fleur's World Lottery Almanac, 2007, North American Association of State and Provincial Lotteries
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VLTs were first legalized by South Dakota in 1989 and are now operational in Delaware, Rhode Island, Oregon, Louisiana, New York, West Virginia, and Louisiana. In all states but Louisiana-- where the state Gaming Control Board regulates and administers the machines--the VLTs are privately owned, but the states own and monitor the computer networks. VLTs cause a considerable boost in per capita ticket sales, as shown in the preceding table. But VLTs are controversial. A number of studies allege that they contribute to significant rates of gambling addiction.3 Because they are considered similar to slot machines in terms of operation, most states that have allowed them have placed restrictions on their hours of use or locations. The California Constitution does not permit the use of slot machines although the governor is authorized to negotiate with Indian tribes, which can operate casino-style venues (and slot machines) in exchange for remitting a portion of the profits to the state. In 2004, some tribes made the move to install VLTs rather than slot machines,4 arguing that because VLTs were not slot machines, they did not fall under the terms of agreement with the state and revenues were not subject to taxation. The tribes argued that VLTs were similar to California Lottery games and therefore legal. More aggressive marketing might enhance sales of the popular game Scratchers, and California could increase the size of prize payouts, though this rule change might necessitate legislative action. The lottery-playing public has been shown to react strongly to even moderate changes in payout rates for Scratchers. In 1997, the Texas legislature reduced the prize payout for Scratchers, and sales fell so sharply that the state raised the payout within two years. The result was a climb in sales back toward prior levels. Texas now has a prize payout of more than 61 percent of all lottery sales. The most successful non-VLT lottery in the country is in Massachusetts. It is not coincidental that Massachusetts also leads the nation in returning more than 70 percent of lottery Sales Revenues in prize money. Although Massachusetts offers the highest payout rate in the nation, all the leading states in lottery performance also offer payout rates that significantly exceed the California rate, which is just under 54 percent. The following table ranks prize payouts among the selected states. 3. Nancy Yu Brian J Cox, Robert Ladouceur, "A National Survey of Gambling Problems in Canada," Canadian Journal of Psychiatry 50, no. 4 (2005). 4. "Indian Tribes Have VLTs," http://sfgate.com/cgi-bin/article.cgi?f=/c/a/2004/10/03/ BAG8N933A01.DTL (accessed October 31, 2007). 5
Percentage of Prize Payout Selected States, 2006
Prize Per Capita
Payout
Sales
State
(%)
($)
Massachusetts
71.9
707
Georgia Texas
61.4
342
61.2
159
Colorado Florida New York Ohio
60.1
96
59.6
230
59.4
342
59.0
198
Illinois Pennsylvania New Jersey
59.0
153
58.8
247
57.4
267
Michigan Arizona California
57.3
219
55.3
75
53.9
94
* No sales from VLT are included
Source: La Fleur's World Lottery Almanac, 2007
The California Lottery works through 19,000 retailers, with average sales per retailer $188,684. This figure is significantly lower than that in other states, such as New York ($405,472). California retailers receive a 6 percent sales commission, comparable to other states. As shown in the following table, in terms of advertisement dollars per capita, California lags behind all other benchmarked states. Retailer and Advertising Allocation for Lottery Sales Selected States, 2006
Retailer
Number Residents
of
per
State
Retailers Retailer
California
19,000
1,919
Florida
12,399
1,459
Georgia
7,742
1,209
Illinois
7,884
1,628
Michigan
10,854
930
New Jersey
6,100
1,430
New York
15,999
1,207
Ohio
8,543
1,344
Pennsylvania
8,413
1,479
Texas
16,279
1,444
Source:La Fleur's World Lottery Almanac, 2007
Sales per Retailer ($) 188,684 316,883 381,733 249,146 203,830 394,316 405,472 259,970 364,943 231,875
Budget ($ Millions) 36.29 24.66 19.39 18.62 16.06 81.47 20.29 30.00 32.00
Advertising Advertising Per Capita ($) 1.00 1.36 2.07 1.84 1.84 4.22 1.77 2.41 1.36
Percentage of Sales (%) 1.01 0.63 0.66 0.84 0.67 1.26 0.91 0.98 0.85
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Administrative Restrictions on Spending and Prizes The 1984 California State Lottery Act set restrictions on prize levels and marketing. As previously noted, at least 50 percent of revenues must be returned as winnings; 34 percent is guaranteed for education; and the remainder is reserved for retailer commissions and payouts, ticket printing, and administrative costs, such as marketing. The California prize payout level is unusually low, with leading states offering between 57 percent and 71 percent to winners. A clear linkage exists between prize payout rates (including odds of winning) and public perception of state lotteries, and the lower payout rate present in California can be seen as a significant impediment to sales. When the state's 6-49 Lotto was changed in the early 1990s to a 6-53 version, for example, public backlash to the reduced odds of winning resulted in a drop in sales that was only reversed when a 6-51 version was hastily introduced. The California Lottery has successfully managed to boost sales in recent years by reducing overall administrative costs--from 16 percent to approximately 12 percent--and using the savings to boost the prize payout rate in Scratcher games. The lottery is restricted because fixed payouts for grand prizes are not permitted in any instant games. In its 1996 ruling in Western Telcon vs. California State Lottery Inc., the California Supreme Court determined that the state may not offer draw lottery games that establish fixed grand prizes instead of prizes dependent on sales and winning tickets. To do so would create an incentive for the state to see players lose. In other words, if prize amounts were fixed, the state would know its payout and would have reasons to ensure that players of these games did consistently lose. (An exception is made for the Hot Spot game due to the low prize levels.) Unless the state legislature revises Section 319 of the California Penal Code, the section of the state penal code relating to the operation of lotteries in the state, California will remain the only state that does not offer fixed prizes, either for runners-up in the SuperLotto Plus or Mega Millions games, or for the winners of daily games. By not being able to inform the public of guaranteed prize levels, word-of-mouth marketing and overall sales are restricted. Due to the constraints of the Lottery Act and subsequent legislation, the California Lottery offers a limited range of games and payouts, and is unable to introduce significant new technologies. In 1993, Section 8880.286 of the Lottery Act was added, limiting the lottery to technology available at its inception in 1985. This precludes the introduction of VLTs, as well as new electronic games, online lottery subscriptions, and other innovations. The restrictions also limit the ability of the lottery to cut costs, even when utilizing a third-party contractor. It is important to distinguish between per capita sales and per capita net revenues when measuring lottery performance. Although a highly efficient lottery model with lowered costs is important, an unwillingness to reinvest those savings in infrastructure and new games will limit long-term increases in sales. Note in the next table that Delaware, West Virginia, and New York revenues do not include gross VLT sales figures, only net VLT sales figures. In the case of Delaware and West Virginia, the inclusion of those figures would significantly increase per capital sales totals and give them a ratio of per capita sales to per capita net revenues much closer to those of Rhode Island and South Dakota. 7
Lottery Revenues of Selected States US$, 2006
Per Capita
Per Capita Net
States
Rank Sales States
Rank Revenues
Delaware**
1
903 West Virginia*
1
335
South Dakota* 2
890 Rhode Island**
2
303
West Virginia* 3
865 Delaware*
3
292
Massachusetts 4
707 South Dakota**
4
152
Rhode Island* 5
621 Massachusetts
5
148
New York*
6
364 New York*
8
114
Georgia
7
342 New Jersey
9
97
Connecticut
9
274 Maryland
10
89
Maryland
9
274 Georgia
11
88
New Jersey
11
267 Connecticut
12
81
Colorado
27
96 California
28
34
California Arizona
28
94 Colorado
36
75 Arizona
33
26
36
23
* Includes Net Video Lottery Terminal sales
** Includes Gross Video Lottery Terminal sales
Sources: La Fleur's World Lottery Almanac, 2007, North American Association of State and Provincial Lotteries
Gaming Competition California's gaming industry is composed mainly of the state lottery, Indian casinos, card clubs, and racetracks. A number of cruises operating from Los Angeles and San Diego offer casinos in international waters.5 Extensive legalized gambling in Nevada is a source of major competition. The activity in Las Vegas dwarfs that of East Coast venues, such as Atlantic City or the immense tribal casino Foxwoods in Connecticut. The 1984 California Gaming Registration Act was enacted to regulate the state's gambling industry. In March 2000, voters passed Proposition 1A, amending the constitution to permit Class III (casino-style) gaming on Native American land. The proposition also mandated that such activities conform with gaming compacts established between each tribe and the state. California currently does not permit non-tribal commercial casinos in which customers are pitted against the house. The state has signed and ratified tribal­state gaming compacts with sixty-six tribes, of which fifty-seven currently operate fifty-eight casinos. This includes a small seasonal casino, the La Jolla Slot Arcade, which has been closed since August 2004. The next table depicts tribal revenues divided into the administrative regions of the National Indian Gaming Commission. As shown, the California­Northern Nevada region has the highest overall revenues for Native American gaming of any part of the country.
5. Charlene Wear Simmons, "Gambling in the Golden State: 1998 Forward," ed. California Research Bureau (California State Library). 2006. 8
Tribal Gaming Revenues by Region Fiscal Year 2005
States Alaska, Idaho, Oregon and Washington California and Northern Nevada Arizona, Colorado, New Mexico and Southern Nevada Iowa, Michigan, Minnesota, Montana, North Dakota, Nebaska South Dakota, Wisconsin and Wyoming Kansas, Oklahoma and Texas Alabama, Connecticut, Florida, Louisiana, Mississippi North Carolina and New York Total Source: National Indian Gaming Commission
Number of Operations 47 57 48
Revenues (US$ Millions) 1,829.2 7,042.7 2,529.1
118
3,984.5
93
1,730.0
28
5,514.1
391
22,629.6
Commercial (Non-Indian) Casinos gross revenues, Selected States, 2004
Number
Gross
of
Revenue
State
Casinos (US$ Millions)
Colorado
46
726
Nevada
9
1,718
Illinois
9
1,718
Indiana
10
2,369
Mississippi
29
2,781
Nevada
258
10, 652
New Jersey
12
4,807
Sources: California State Library, American Gaming
Association
California's horse-racing industry is responsible for $4 billion of economic activity annually and employs nearly 14,000 individuals.6 With the growth of card rooms, tribal casinos, the gaming industry in Nevada, and other sources of competition, the California's horse-racing industry has suffered, with overall handle (racetrack total betting) declining to $4.1 billion in 2004­2005, a drop of $138 million from 2002­2003. Hollywood Park operates the state's third-largest card club. But voters rejected a 2004 initiative to allow casino-style gambling operations at racetracks.
6. Ibid. 9
Horse Racing in California By Type of Meetings, US$ Millions, 2005
Thoroughbread Race Meetings Harness Horse Meetings Quarter Horse Meetings Fair Race Meetings Total
Attendance* 6.0 0.8 0.9 0.8 8.4
Handle * * 3,075.1 140.7 216.0 247.9 3,679.6
Retained 604.2 32.0 44.4 51.0 731.6
Returned 2,470.8 108.7 171.6 196.9 2,948.0
*The attendance column represents total patrons in attendance at on-track and off-track sites located in California. Attendance at sites located in other states is not reported. ** Includes all commingled wagering accepted by the California Racing Association on live and imported races. It does not include any advance deposit wagering handle. Source: California Horse Racing Board
Before the introduction of the lottery and legalization of Native American casinos, the card clubs (also called card rooms) were the chief form of gambling in the state. California issues state licenses to card clubs that allow them to hold legal card games, such as poker. The card room receives a fixed fee from each of the players per game rather than participating in the game itself. Although card club revenues are significantly lower than revenues from other forms of gambling, they do present a clear competition to the lottery. Card rooms continue to thrive, particularly in Southern California, despite the lottery and growth in casinos. In 2004, gross revenues at card rooms totaled $656 million, an increase from $600 million in 2003.7
Number of Licensed Cardrooms Top Ten Counties, 2006
Number
of
County
Cardrooms
Los Angeles
88
Orange
34
San Bernardino
25
Riverside
24
San Mateo
20
Contra Costa
19
San Diego
18
Fresno
15
Santa Clara
15
Alameda
14
Source: California Gambling Control Commission
7. Office of the Attorney General, California Department of Justice, "Attorney General Lockyer Announces Release of Report Providing Detailed of California Gambling's Scope and Impact," 2006. 10
Privatization Efforts With a view to increasing sales, a number of states have considered privatizing their lotteries. Some of these efforts are reviewed in this section. In addition, we look at some privately run overseas lotteries. An important consideration when attempting to increase per capita lottery sales is the "substitution effect." An increase in ticket sales can lower sales of other commodities, such as clothing and electronics, and lead to lowered state and county sales tax revenue. This effect should be noted in an analysis of privatization. Political resistance--in the form of claims that the lottery is a form of regressive taxation because the middle class and poor buy a disproportionate share of lottery tickets--is another potential obstacle to privatization. Connecticut In 1996, Connecticut created the quasi-public Connecticut Lottery Corporation (CLC). Like the U.S. Post Office, the CLC is controlled by the government (the state in this case) but is selfsupporting and runs as a corporation, with its own employees. The CLC has been able to take advantage of this flexibility in bidding for services, responding to market demand, and reacting to increased competition from tribal casinos like Foxwoods. The corporation decided to operate as a nonprofit in order to avoid corporate taxes and enjoy more flexibility on splitting moneys between payouts, administration, and returns to the state. Despite increased competition from local casinos, lottery ticket sales increased by nearly 18 percent from 1996 to 2000. Connecticut was also able to cut telecommunications costs by $750,000 and instant-ticket printing costs by $500,000 almost immediately by negotiating with subcontractors as an independent corporation and free from the standard regulatory restrictions of state agencies. 8 The autonomous structure of Connecticut's lottery corporation has allowed it greater flexibility in adjusting to changing market conditions within the state. Although Connecticut's ratio of advertising to sales is lower than California's, flexibility in its budget has allowed it to more effectively target its marketing efforts. Connecticut pays a higher fee to ad agencies than does California--$350,000 to $290,000, for fiscal year 2006, despite a dramatically smaller market and budget. Connecticut has also been able to offer $10 instant games (scratchers) since 1997, $20 instant games since 1999, and $30 instant games since 2002 to help keep revenues rising. In contrast, California is unable to effectively offer instant games above $5 due to the restrictions placed on its winnings ratios by the Lottery Act.9 Wisconsin The state's governor vetoed initial efforts in 1995­1996 to introduce partial privatization. Renewed efforts in 2003 also stalled. In 2005, the state decided to streamline operations by shifting significant operations--including retailing, information technology, ticket delivery, ticket 8. Eugene Martin Christiansen and Sebastian Sinclair, "Global Lottery Privatization: The Equity Potential of Government Lotteries." in CCA Research Report (Christiansen Capital Advisors LLC). 2001. 9. La Fleur, Theresa E. and Bruce A. Lafleur, eds. "La Fleur's 2007 World Lottery Almanac." TLF Publications Incorporated, Boyds, Maryland, 2007. p.48. 11
printing, and advertising--to private vendors.10 This was done on a more thorough scale than has occurred in California. Wisconsin's goals have been to cut operational costs and reduce the number of state employees rather than develop new revenue streams. Michigan The Michigan legislature has resisted efforts to privatize the lottery, including a proposal to sell the lottery outright, a transaction that could net up to $2 billion for the state.11 Concerns have also been raised about any potential buyer being restricted by a 2004 referendum that requires the passage of a public initiative to expand the games. Indiana In February 2007, the Indiana State Senate authorized enactment of the governor's proposal to privatize the Hoosier Lottery. According to the terms of the legislation, the state may contract with a private operator for thirty years as long as the operator meets the minimum terms of a $1 billion upfront payment and a minimum of $200 million in annual revenue, intended to close shortfalls in the state budget.12 In April, however, the governor decided to hold off on the process for a year in order to study further the potential costs and benefits of lottery privatization.13 Illinois Like the California Lottery, the Illinois Lottery has long been considered to be an underperformer, with per capita sales trailing those in Ohio, Michigan, and eastern states. Illinois established a plan to place its lottery operations up for bid, to be operated under a long-term lease similar to that being considered in California and some other states. The Illinois legislature authorized the state to place the lottery concession up for competitive bidding, for lease terms of up to 75 years, and for a minimum price of a $10 billion upfront concession payment. The deadline for receiving these bids was on February 20, 2007.14 The Illinois Lottery is considerably smaller than California's, and its expected level of funding is much lower. A decision was made in the process to emphasize immediate payments, even at the risk of guaranteeing long-term revenue for the state budget, even to the extent of authorizing the sale of the lottery instead of a long-term lease.15 After negotiations were completed on the terms of a seventy-five-year lease for $10 billion, the bill to lease the lottery for 75 years was strongly rejected in the state assembly because it did not offer any long-term revenue guarantees and was 10. Wisconsin Joint Committee on Finance, "Privatization of Lottery Operations (Dor­Lottery Administration)," (Legislative Fiscal Bureau, Wisconsin). 2003. 11. Michael D. LaFaive, "Place a Bet on Lottery Privatization," 2003. See: http://mackinac.org/ article.aspx?ID=5021. 12. Lottery Post, "Indiana Lottery Privatization Takes Big Step Forward." 2007. See: http://www.lotterypost.com/news/151473.htm. 13. Lottery Post, "Indiana Lottery Privatization on Hold." 2007. See: http://www.lotterypost.com /news/154915.htm. 14. Charles Duhigg and Jenny Anderson, "Illinois Is Putting Lottery on Block for Quick Payoff. " The New York Times. 2007. 15. Illinois General Assembly, "Full text of HB 1352." 2007. See: http://www.ilga.gov/legislation/ fulltext.asp?DocName=&SessionId=51&GA=95&DocTypeId=HB&DocNum=1352&GAID=9&LegID=30 122&SpecSess=&Session=. 12
instead planned to plug a more immediate hole in the state pension plan.16 A plan that would include guarantees of current revenue flows or some other profit sharing may yet be considered. Texas Although Texas has not privatized its lottery system, it has successfully outsourced a number of operations and partnered with private firms to offer technologies and game varieties unavailable in California. In late 2001, the state lottery commission entered a nine-year "facilities management contract" with GTECH Holdings Corporation.17 The partnership facilitated the implementation of faster ticket machines and reduced administrative costs per ticket. In 2002, more than 16,500 lottery retailers changed over to new terminals with programmable LED (light emitting diode) displays, to better advertise new games, and customer display screens that provide verification of winning tickets at lottery retail outlets. Such technology is currently prohibited in California under the Lottery Act. Texas has also demonstrated clear examples of the importance of prize payout rates in the success of different lottery games. In 1997, the payout rate for Scratcher games was significantly reduced down to around 50 percent, which resulted in a dramatic fall in sales. In 1999, the state responded by boosting its prize-payout level to over 61 percent, resulting in Scratcher sales rising to a new high. In the past year, however, Texas was confronted by a significant market failure in its "Texas Two Step" game, which involves the customer picking two numbers and being assigned a random third. Because of the lack of control over the third number, as well as a perception that the odds of winning were far too low, the public reacted negatively and the game is actually costing the state more money than it is generating.18 Overseas Lotteries United Kingdom National Lottery The UK National Lottery is the clearest example of a successfully privatized lottery that can be found worldwide at or above the size of California's. Because the National Lottery was privatized for the purpose of improving performance and cost efficiencies, rather than emphasizing large upfront payments, it contains a number of provisions that differ from other lottery privatization plans, such as those in Illinois and Indiana. The National Lottery currently operates under a shorter-term concession agreement that emphasizes short- to medium-term operational performance rather than establishing a fixed minimum level of returns to the government. Under the terms of the lottery concession, the National Lottery Commission licenses the games and monitors operator performance. 19 For the first two concession periods under which the lottery has operated, the contract has been with the British-based gaming company Camelot. Camelot itself is owned by several British and 16. Kurt Erickson, "House Rejects Plan to Lease Lottery," Illinois House Republican Organization, accessed October 31, 2007. See: http://www.ilhro.com/press/view/article/house-rejects-plan-to-leaselottery/. 17. GTECH Holdings Corporation. Annual Report. Form 10-K. February 23, 2002. See: http://www.secinfo.com/dsvr4.33sj.htm. 18. Ibid. 19. Rob van der Gaast, "The Bidding on UK's National Lottery. " Gambling Privatization. 2006. See: http://gambling-privatisation.com/index.php?cat=ong_pri&sayfa=bidding. 13
foreign companies, including Cadbury-Schweppes, Fujitsu, and Thales Electronics. Reflecting its operating purpose, the National Lottery funds are divided in the following manner: 50 percent is paid in prize winnings 28 percent targets "good causes," determined by Parliament 12 percent returns to the government in lottery duty 5 percent of all sold tickets returns to National Lottery retailers 4.5 percent is paid to Camelot for its operational expenses 0.5 percent is profit for Camelot The National Lottery funds are utilized primarily for "good causes," which can include charitable and arts funding. National Lottery monies have been used to help support and expand the production of independent film theaters in Britain,20 as well as support other significant art endeavors. The lottery has raised more than Ј17 billion ($34 billion) since privatization for good causes. Because the National Lottery has been able to operate with only limited restrictions on innovation, it has introduced a number of lottery models that could be tried in California. Lottery sales are now allowed by recurring weekly subscription, which may be authorized either by mail or on the lottery's secure Web site. Sales are also possible through a satellite television interactive service and by mobile phone. The next National Lottery license concession is being offered for ten years rather than seven. The purpose of the longer concession is to encourage more competitive bidding and allow time for the operator to make greater investments in lottery operations and infrastructure. While only two bidders were interested in the concession in 2000 (Camelot and Virgin Group), numerous bidders expressed interest in the contract awarded in August 2007. These included Camelot (which was again awarded the concession); Virgin Group, which announced it would donate operating profits to charity in addition to the current "good causes" fund; a consortium led by Lehman Brothers, Hilton/Intralot; William Hill, a betting firm; Sportstech PLC; and Tattersalls, which operates the Victoria State Lottery in Australia. It is conceivable that any of these firms would be interested in a California lottery concession, either on their own or with additional partners. Tattersalls and the Victoria and Tasmania Lotteries Tattersalls is an Australian gaming concern that has been in existence since 1881 and is based in Melbourne, Australia.21 Tattersalls is unique among lottery operators in that it has been the sole operator of the Tasmania State lottery since its inception in 1897, giving it the experience of starting and operating a state-sanctioned lottery without undergoing any privatization process. In 1954, Tattersalls took over operation of the Victoria State lottery and has since added the lotteries of the Northern and Australian Capital territories. It operates each lottery independently under the respective governing bodies of each state and territory. Tattersalls submitted an unsuccessful bid for the UK National Lottery and has expressed interest in running other overseas lotteries. 20. Dale Kasler, "Move Toward Privatization of Lottery Has Investors Licking Chops," Sacramento Bee. 2007. 21. Christiansen and Sinclair, "Global Lottery Privatization: The Equity Potential of Government Lotteries." 14
Greece The Greek National Lottery is the one example of a government-run gaming concern that has offered a stake to the general public. 22 As a means of raising funds for the 2004 Olympic Games, the Greek Government offered a 10 percent stake in OPAP S.A. (Greek Soccer Pools and Lotteries) in a 2001 stock offering on the Athens Stock Exchange. Potential Scenarios for Changing the Lottery: Scenario 1: Maintain the Current Lottery System with Minor Legislative Changes Due to constraints of the California State Lottery Act and subsequent legislation, the California Lottery offers a limited range of games and payouts, and is unable to enact significant new technologies. But because the legislature has amended the Lottery Act on multiple occasions, a precedent exists for enacting changes, so long as they are consistent with the original intent of the act. Making changes to the act would allow for the potential growth of the lottery but would lack the revenue guarantees and upfront payments that can be found in many of the privatization models. Potential reforms could include the introduction of administrative and gaming technologies that would reduce costs and increase potential sales. New ticket-vending machines could be introduced, as well as new Scratchers, which could be advertised with interactive displays on the machines themselves. The legislature could establish a provision to direct all year-end leftover lottery revenues toward capital improvements, new games, and marketing, rather than to the education fund. The main problem with this approach is that there is a limit to how much growth can be achieved without significantly changing the guaranteed 34 percent of lottery revenue due each year to education to a guaranteed, fixed, minimum dollar amount. Even if the courts should allow such a change in the law without a referendum, political pressure to put the issue to a vote seems likely. Also, the lottery will remain restricted with respect to administrative and hiring practices as long as it remains a state agency and bound by Article 7 of the constitution. Scenario 2: Establish a Quasi-Public Corporation to Operate the Lottery Although the state constitution and penal code impose strong barriers to overall improved lottery performance, California could follow the Connecticut model and retain control over the lottery, particularly in terms of revenues and oversight, while gaining flexibility in spending practices, hiring, and subcontracting. As a publicly owned corporation, the California Lottery would be no longer be part of the state employment pool but free to delegate services, such as information technology and distribution, to key subcontractors on a larger scale than is currently possible. The lottery could also offer more competitive salaries in order to attract key administrators and could move some operations to other locations, such as Silicon Valley, where larger potential employee pools exist. With a more flexible cost and revenue structure, the lottery could also potentially develop models for 22. Eugene Martin Christiansen and Sebastian Sinclair, "Case Study in Privatization: The Greek National Lottery, Opap SA," ed. CCA Research Report (Christiansen Capital Advisors LLC). 2005. 15
more wide-scale changes in games like Scratchers, and develop more effective and longer-term marketing campaigns. The key concerns with establishing a quasi-public corporation are that it would be difficult to guarantee growth in education funding in the new corporation, even if it would be likely. A quasipublic corporation would also face some bureaucratic and recruiting issues similar to those faced by other such companies, as there would be a limit to any salary or incentive structure. There would also be no ability to raise immediate capital, as with a long-term lottery concession or public stock offering. In addition, any such changes to the lottery would require either significant legislative action or a new state initiative, or perhaps both. Scenario 3: Establish a Five- to Ten-Year Lottery Concession This scenario would allow for the California Lottery to be leased out as a concession for moderate length of time, at the end of which the contract could come under review by both parties and then renewed if everyone is satisfied. This model is currently being followed in the UK, which has issued two seven-year leases and introduced a ten-year lease term, effective in 2008. In this model, the focus is on year-to-year performance, with minimums established for contributions to the state education fund of at least $1.3 billion, to be adjusted for inflation each year. As the performance of the state lottery improves, a significant percentage of the additional revenues would then be guaranteed for the state education fund. The key advantages of this approach is that it would be one of the strongest models for ensuring growth in overall lottery sales and performance, as well as contributions to the state education fund. The state would retain oversight through a public lottery commission, while the private operator would be free to allocate additional funds to marketing and new games as long as the minimum education contributions are met. Because of the relatively short term of the lease, the state would have the ability to offer the concession to a new bidder if performance has been sub-par, or to negotiate for improved revenue-sharing terms if performance is excellent, as has been the case in Britain. The 650 or so public employees who currently work for the California Lottery could be given a choice of private employment with the new company or a guarantee of an equivalently salaried job in another state department. The main problems with the shorter lease term are that any potential upfront payments would be significantly reduced, and the overall shorter term of the lottery would limit incentives for the operator to make large investments in new technologies and lottery infrastructure. In Britain's case, the term of the lease has been expanded to ten years in order to encourage operators to make greater capital investments in the lottery's operations.23 As with the other scenarios, significant changes to the state penal code and the Lottery Act would be required in order to allow for private operation and would have to be implemented in advance of soliciting bids for the concession. Scenario 4: Establish a Thirty-Year (or Longer) Lottery Concession A longer-term lottery concession provides most of the administrative benefits of a shorter-term concession, while also allowing the state to secure a significant upfront payment as part of the lease terms. With a longer lease, a potential concession operator is able to secure an upfront 23. National Lottery Commission , accessed October 31 2007. "Ensuring a Fair Lottery for the Nation." See: http://www.natlotcomm.gov.uk/client/news_item.ASP?NewsId=16. 16
payment to the state with the guarantees of long-term revenues over the course of the lease. This allows the state to set terms that guarantee a significant upfront payment. As reported in the Sacramento Bee, Lehman Brothers has publicly stated a valuation of a long-term lease at around $37 billion in today's dollars, 24 and a significant percentage of that valuation could be required as part of any successful bid for the lottery concession. A longer-term lease provides an increased incentive for any lottery operator to reinvest lottery revenues into developing new games, improving technologies, and expanding lottery retail operations. Because the concession operator is more concerned with continuing to expand the lottery over the long term rather than facing a shorter-term review of its operations, it can overcome many of the constraints facing the California Lottery under its current restrictions. The concession operator would also be able to hire employees more easily since they will not be concerned with job security each time the lottery lease comes up for review. The primary concern with any long-term lease is how to address the situation if the lottery operator fails to meet performance requirements or in other ways proves unable to operate the lottery in a satisfactory manner. Because the lottery operations would not be not up for frequent review, the committee that oversees the lottery's operations must be able to sanction the lottery operator effectively without having so much power that potential bidders are scared away before the lottery concession is even awarded. Scenario 5: Outright Sale to a Private Entity This action has the potential to raise the largest amount of money over the short term. However, because the lottery would necessarily retain a statewide monopoly in order to ensure the highest possible asking price, the potential for public backlash against a sale would be high, especially among education advocates who would see the guarantee of funding for schools disappear. Concerns from Native American casinos and private card rooms would also be significant, as they would be facing competition from a privately held, state-sanctioned monopoly. Perhaps the most important issue of concern is that once the lottery is sold, reversing the process will prove exceedingly difficult. Any efforts to enforce strict compliance by the state to counteract such concerns could result in a reduced sale price that may actually be below the initial payment from a long-term lease concession. Another possibility is to consider retaining a stake and investing significant proceeds in an annuity, as well as help to close funding gaps at the state budget over the short term. If sale is possible at $35 billion while retaining a stake, the money could be divided into an annuity to keep funding education and retire bond obligations. A $20 billion annuity could net the state $1.3 billion per year at 6.5 percent interest, which would provide ongoing funding for the state's education fund. However, unless a portion of this interest was added to the capital in the fund, the overall rate of funding would stay constant, despite inflation. The result is that the fund would actually see a decline in received contributions in real terms. 24. Dale Kasler, "Move Toward Privatization of Lottery Has Investors Licking Chops," Sacramento Bee. 2007. 17
Scenario 6: Establish a Public Corporation and Hold an Initial Public Offering This scenario combines the terms of establishing a quasi-publiC Company with the additional step of selling a portion of the new corporation's shares to the public through a stock market public offering. This would allow the legislature to retain a controlling ownership stake in the publicly traded corporation, while gaining the benefits of raising a significant amount of capital through the public sale of stock. This approach has significant positives and negatives. The largest positive is that it allows the legislature to raise funds in the short term through the stock offering while still earning significant ongoing dividends through its ownership stake in the lottery. Because the lottery would operate largely independent of the state bureaucracy, it would be able to recruit and pay employees outside the state hiring system. In addition, since the state retains ownership of the lottery, it could enact reforms and administrative changes without being in danger of abrogating a lease contract. The chief drawback to an initial public offering comes from its chief advantage. By selling stock, flexibility in revenue utilization is reduced because the lottery corporation must provide a share of revenues to stockholders in addition to that going back to the state. If the lottery corporation fails to provide these dividends, the overall valuation of the stake will drop. There is also no guarantee that the state can raise more money through a stock sale than can be raised through a competitive bid for a long-term lease. Another potential concern is conflict of interest through stock purchases by institutional investors. Since such investors are often involved in pushing for good corporate governance, outside pressures could be placed on the running of the lottery corporation. Potential conflicts of interest could also occur if various state and local pension plans became involved in purchasing lottery corporation stock. Conclusion In determining which path to take in improving the performance of the California Lottery, there are three significant factors to consider. These include (1) the regulatory framework of the lottery itself; (2) the potential financial impact of any significant changes, such as privatization; and (3) the length of time available to actually execute any significant changes to the lottery before additional hurdles are created. If the legislature agrees to proceed with significant regulatory changes to the lottery, including partial privatization, the issue of placing a proposition on the ballot becomes significant. Although it may be possible to amend the 1984 Lottery Act through the legislature, as has been done in the past, political resistance and potential court challenges are likely and would be more daunting than placing the issue before the public. As has been noted previously, the current restrictions on spending, technology, and gaming parameters serve to severely curtail any potential growth of the lottery, regardless of who actually runs it. In order to maximize the potential return on any changes to the lottery, it is essential to focus on the financial aims of the state government in both the short and long term. With the interest payments of the Economic Recovery Bonds, combined with those of the recent Infrastructure Bonds, there is strong incentive toward considering a privatization option, which secures a significant upfront payment. For political considerations, it is also essential that education funding be preserved at least at the current range of $1.2 billion to $1.3 billion. 18
Projected net sales assumptions should be realistic. It would be imprudent and potentially fiscally irresponsible to assume that net sales could double and triple within five to seven years under any operating scenario, even under the best of circumstances. And while it is not possible to provide specific projections and recommendations on the ideal combination of debt relief and increased lottery income without further study, certain key items are evident. In terms of an upfront payment, the best single option is the outright sale of the majority of the lottery, which is most likely to secure the largest amount in the short term. However, as noted previously, this also severely limits growth in long-term income. Even if a large portion of the payment is placed into an annuity, the amount of income generated is unlikely to exceed the current net revenues and will also not grow to keep pace with inflation. The next strongest option for an upfront payment would be a long-term lease concession. In the short term, annual funding could be maximized by placing the majority of the upfront payment in an annuity and using that funding to bolster a guaranteed level of net revenue from the concession that would be required to match current funding levels. This could secure annual funding that is closer to the $2 billion range, but due to an incentive structure for any private operator, growth for this number would be limited in the short term. Maintaining majority ownership, while establishing a public-private corporation that operates autonomously, offers the potential for the highest annual payments if the lottery grows rapidly. However, if the rapid growth does not occur, payments are likely to be below those from the other options. Timing is a significant factor because California faces a limited window of opportunity for pursuing a stock offering or auction of a lottery concession if it hopes to get the largest valuation from any potential bidder. The market's appetite for privatization could be satisfied by other states going through privatization. The issue of supply and demand could come into play. Also, a number of potential suitors could wind up committed to other lotteries, reducing the pool of bidders. Because any lottery reform will require either significant legislation or a ballot initiative, and possibly both, the state government will have to act in a timely manner to place the issue on the ballot by November 2008 or resolve the issue in the legislature, or see the potential gains from privatization be significantly reduced. 19
References: California Lottery. www.calottery.com "California Lottery Reports to the Public." 2006 Nancy Yu Brian J Cox, Robert Ladouceur. "A National Survey of Gambling Problems in Canada." Canadian Journal of Psychiatry 50, no. 4 (2005): 213-17. Eugene Martin Christiansen, and Sebastian Sinclair. "Case Study in Privatization: The Greek National Lottery­Opap SA" Edited by CCA Research Report: Christiansen Capital Advisors LLC. 2005. ------. "Global Lottery Privatization: The Equity Potential of Government Lotteries." In CCA Research Report, Christiansen Capital Advisors LLC, 2001. Charles Duhigg, and Jenny Anderson. "Illinois Is Putting Lottery on Block for Quick Payoff." The New York Times, 2007. "Ensuring a Fair Lottery for the Nation." National Lottery Commission. See: http://www.natlotcomm.gov.uk/client/news_item.ASP?NewsId=16. (accessed Oct 31 2007) Kurt Erickson. "House Rejects Plan to Lease Lottery." Illinois House Republican Organization, See: http://www.ilhro.com/press/view/article/house-rejects-plan-to-lease-lottery/ (accessed Oct 31 2007) Rob van der Gaast. "The Bidding on UK's National Lottery " Gambling Privatization, 2006, See: http://gambling-privatisation.com/index.php?cat=ong_pri&sayfa=bidding "Indian Tribes Have VLTs." http://sfgate.com/cgi-bin/article.cgi?f=/c/a/2004/10/03/BAG8N933A01.DTL (accessed October 31, 2007) Wisconsin Joint Committee on Finance. "Privatization of Lottery Operations (Dor­Lottery Administration)." Legislative Fiscal Bureau, Wisconsin, 2003. California Department of Justice. "Attorney General Lockyer Announces Release of Report Providing Detailed of California Gambling's Scope and Impact." Office of the Attorney General. 2006. Dale Kasler. "Move Toward Privatization of Lottery Has Investors Licking Chops." Sacramento Bee. 2007. Michael D. LaFaive. "Place a Bet on Lottery Privatization." 2003. http://mackinac.org/article.aspx?ID=5021 California Lottery. "Reports to the Public." 2006 Lottery News. "Mega Millions Is Coming to California." 2005 Lottery Post. "Indiana Lottery Privatization on Hold" http://www.lotterypost.com/news/154915.htm (2007) ------. "Indiana Lottery Privatization Takes Big Step Forward." (2007), http://www.lotterypost.com/news/151473.htm ------. "Indiana Senate Approves Lottery Sell-Off." (2007), http://www.lotterypost.com/news/151913.htm Charlene Wear Simmons. "Gambling in the Golden State: 1998 Forward." edited by California Research Bureau: California State Library, 2006. Brad Watson. "Lottery Game Flop Stirs School Fund Concerns." KVUE.com. 20

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