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Ministerial Foreword


This Document is Archived


Regulation of Access to Vertically-Integrated Natural Monopolies

[ Last Updated 16 November 2005 ]


New Zealand has sought improved performance, efficiency gains and user and consumer benefits in a range of key service industries, including telecommunications, electricity and natural gas.

To this end, the Government has removed the statutory barriers to entry and has adopted light handed regulatory policies for these important service industries. Regulatory policies have been founded on the assumption that competition in many areas is possible, with suitable interconnection or access arrangements. Direct regulation is confined to the provisions of the Commerce Act, supplemented by industry specific regulations such as information disclosure requirements.

These policies have lead to large improvements in productivity and services provided to users in telecommunications and electricity where the policies were first introduced. Further significant benefits are possible.

The Government's first preference has always been to see the parties resolve interconnection or access matters between themselves. However, recent progress in telecommunications interconnection has been difficult, especially in local access negotiations between Clear and Telecom delaying the introduction of competition and user and consumer benefits. Developments in telecommunications, including these delays, have raised public policy concerns which the attached discussion paper addresses.

The discussion paper, prepared by Treasury and the Ministry of Commerce, seeks public views on questions which are important for the future development of major vertically integrated industries involving natural monopoly components, if New Zealand is to gain the most that these industries are capable of delivering.

The Government is considering whether it should introduce new measures. The Government will only put in place alternatives if they will better deliver overall efficiency and user benefits. Further, we are not interested in simply assisting one party to a dispute at the expense of another.

Existing measures such as price control of interconnection or retail prices under the Commerce Act, while having costs, offer options for progressing the matters in dispute between Clear and Telecom more quickly. We reiterate the possibility of interim price control as a way of making early progress. Another option to be considered is the possibility of submitting the dispute to compulsory final offer arbitration.

We invite submissions on the attached paper by 15 September. The Government will evaluate these submissions carefully in considering its options.

Philip Burdon
Minister of Commerce

Maurice Williamson
Minister of Communications

SUBMISSIONS

Please send all comments and submissions in writing by 15 September 1995 to:
Natural Monopoly Access Issues Submission
Communications Division
Ministry of Commerce
PO Box 1473
Wellington
New Zealand

Fax (04) 499 0797

Official Information Act 1982

Note that the contents of submissions provided to the Ministry in response to this discussion paper will be among the information we hold which is subject to public release under the Official Information Act 1982. If the Ministry receives a request for information contained in a submission, we would be required to consider release of the submission, in whole or in part, in terms of the criteria set out in the Act. The Act would require us to make the information available unless we consider that there is good reason, pursuant to the Act, to withhold the information, and that good reason outweighs the desirability, in the public interest, of making the information available.

The criteria (contained in section 9 of the Official Information Act) most likely to be relevant to a decision to withhold requested information in the present case are:

  1. The protection of the privacy of natural persons, including that of deceased natural persons.
  2. The protection of information where the making available of the information:
    1. would disclose a trade secret; or
    2. would be likely unreasonably to prejudice the commercial position of the person who supplied or who is the subject of the information.
  3. The protection of information which is subject to an obligation of confidence or which any person has been or could be compelled to provide under the authority of any enactment, where the making available of the information:
    1. would be likely to prejudice the supply of similar information, or information from the same source, and it is in the public interest that such information should continue to be supplied; or
    2. would be likely otherwise to damage the public interest.

Furthermore, it is the Ministry's normal practice to prepare a summary of submissions received, together with the Ministry's responses. This summary is intended for circulation amongst parties who make submissions, but it may be circulated more widely.

In providing your submission, please advise us if you have any objections to the release of any information contained in your submission, and, if you do object, the parts of your submission that you would wish withheld, and the grounds for withholding. The Ministry will carefully review any representations that you make in this regard, in preparing and releasing any summary, and in considering any formal Official Information Act requests that might be received in the future.

Privacy Act 1993

The Privacy Act 1993 establishes certain principles with respect to the collection, use and disclosure, by various agencies including the Ministry, of information relating to individuals, and access by individuals to information relating to them held by such agencies. Such personal information means information about an identifiable natural person, other than a deceased natural person.

Any personal information that you supply to the Ministry in the course of making a submission will be used by the Ministry in conjunction with consideration of matters covered by this discussion paper only.

It is the Ministry's normal practice to set out the names of parties making submissions when preparing any summary, for public circulation, of submissions on Ministry discussion papers. Your name will be included in any such summary unless you inform the Ministry that you do not wish your name to be included. In order to indicate your wishes, or to view the personal information held about you in respect of the matters covered by this discussion paper, or to request correction of that information, please contact the Ministry of Commerce, Ph (04) 472 0030.

SUMMARY

This paper discusses the issues arising from the New Zealand experience with telecommunications interconnection negotiations and the implications of the decision of the Privy Council in the case of Telecom Corporation v Clear Communications[1] for the economic regulation of access[2] issues in the telecommunications industry and other vertically-integrated natural monopolies[3] in New Zealand.

The Government's overarching objectives for the economy and for markets dominated by natural monopolies, in particular, can be found in the statement of the Government's Strategic Result Areas:

"[The] establishment, implementation and monitoring of legislative frameworks for the fair and efficient conduct of business and the operation of markets, which rewards innovation, promotes efficiency and enhances investor confidence."[4]

In particular, the Government seeks to maximise the contribution of these sectors to the overall growth of the economy through the promotion of economic efficiency.

The telecommunications and energy sectors of the New Zealand economy[5] are, at present, subject to a 'light-handed' regulatory regime which relies primarily upon competition to discipline the incumbent's use of its dominant position. Statutory barriers to entry were removed and reliance placed upon the ability of competitors to negotiate private access agreements with the natural monopoly. These private negotiations were facilitated by three components: (a) the prohibitions in the Commerce Act that prevent a firm in a dominant position from acting in an anticompetitive manner, (b) information disclosure requirements to assist negotiations and aid in the enforcement of the Commerce Act provisions, and (c) the threat of further regulation should the need arise.

Since the introduction of this regime, competition has emerged in particular segments of the telecommunications market. Partly as a result, the telecommunications sector has seen significant improvements in productivity, improvements in service quality and reductions in prices. Competition is also beginning to emerge in the energy sector.

However, concerns have arisen surrounding interconnection negotiations, particularly in the wake of the Privy Council decision in the case of Telecom v Clear.

The dispute between Telecom and Clear centred on the terms under which Clear was to interconnect to Telecom's local telephone network in order for Clear to offer a competing local telephone service. The Privy Council held that Telecom was entitled to charge a price derived from a pricing rule known (after its proponents) as the 'Baumol-Willig' ('BW') rule.

The Telecom v Clear dispute has raised three particular concerns.

The first concern surrounds the BW rule. The BW rule originated in a regulatory context in which the final prices of the monopolist are controlled. In this context (putting aside for the moment any dynamic benefits of competition) economically efficient interconnection pricing can be achieved solely by ensuring that inefficient firms do not enter the market. The BW rule achieves this goal. However, if the downstream market can support more than a few firms, the normal forces of competition can be relied upon to drive inefficient firms out of the market. Moreover, in a context in which final prices are not regulated, the BW rule will not restrain the ability of the monopolist to charge monopoly rents on the natural monopoly portion of the business. This has raised concerns about the appropriateness of the BW rule in the New Zealand context.

A second, related, concern is the handling of the costs imposed upon Telecom as a result of the Kiwi Share. Under the BW rule the Kiwi Share costs do not need to be separately estimated and verified, as the rule permits the monopolist to recover from the competitor any mark-ups it earns from selling the product itself. If, due to the concerns expressed above, the appropriateness of the BW rule for the New Zealand context is reviewed, this re-opens the question of the appropriate handling of the Kiwi Share costs.

The third concern surrounds the appropriateness of reliance upon the courts and the Commerce Act to resolve interconnection disputes. At the time when the light-handed regulatory regime was established it was anticipated that the parties would negotiate their own access agreements, with recourse to the courts and the Commerce Act only as a last resort. However, two parties are unlikely to reach agreement as long as their underlying legal 'rights'[6] are ill-defined, particularly in a context such as this, where the monopoly firm has a strong incentive to test the upper limits of legal behaviour.

At the time when Telecom and Clear commenced negotiation there was a significant amount of uncertainty over the interconnection terms and conditions that the courts would hold to be unlawful. The Privy Council decision has clarified that the BW rule is lawful under the Commerce Act. There remain a number of other terms and conditions (relating to both price and non-price issues) for which the legal limits on Telecom's behavior are still ill-defined. Telecom could seek to test the legal limits over each of these other terms and conditions in turn.

As experience overseas confirms, there is, therefore, a significant risk of further disputes and litigation. If the cost and delay experienced in this case is typical, it might take many years before a sufficient body of precedents is developed for the parties to reach agreement.[7] This raises concerns about the appropriateness of the current policy of reliance upon the courts and the Commerce Act.

To summarise, there are three main issues that arise from the New Zealand experience with telecommunications negotiations and the Privy Council decision in particular:

  1. concerns over the appropriateness of the BW rule for pricing interconnection in vertically-integrated natural monopolies in New Zealand;
  2. if the BW rule is not retained, the issue of the appropriate handling of the costs of a social obligation, such as the Kiwi Share; and
  3. concerns over the appropriateness of reliance upon the courts and part II of the Commerce Act for defining and enforcing the regulatory regime.

This document re-evaluates the current regulatory regime in the light of these concerns. However, the Government has not yet reached the view that there is any need for change. To come to such a view requires a careful consideration of various alternatives to the present regime in the light of the Government's objectives.

The Vertically-Integrated Natural Monopoly Problem

Interconnection issues (such as the dispute between Telecom and Clear) arise in contexts where:

  1. access to a natural monopoly good or service is necessary for another firm to compete in an upstream or downstream market; and
  2. the firm providing the natural monopoly service[8] also competes in that up or downstream market.

For example, in order for Clear to compete with Telecom in the local telephone service business, Clear local-service customers must be able to make calls to Telecom customers. However, portions of Telecom's local network are a natural monopoly. These portions cannot be economically duplicated by Clear or other entrants. Therefore, some form of interconnection with Telecom's network is essential. However, if Clear were to interconnect, Clear would compete head-to-head with Telecom in offering local telephone service in the other parts of the local network which are not a natural monopoly.

This industry structure is referred to as a 'vertically-integrated natural monopoly'. Vertically-integrated natural monopolies arise in other industries, particularly in the energy sector.[9]

Economic theory suggests that natural monopolies with significant market dominance may give rise to public policy concerns as they may have higher production costs, may charge higher prices and may innovate more slowly than firms subject to competitive pressures.[10] In addition, in the absence of regulation, the owner of a natural monopoly facility may seek to vertically-integrate into an upstream or downstream market in order to restrict or eliminate competition in that market. This is achieved by charging high prices or, in other ways, hindering access to the natural monopoly service. In certain circumstances, this restriction of competition in the downstream market may permit the monopolist to raise its prices and, as a result, reduce national welfare.

Broad Policy Approaches

As stated above[11] the Government's policy objective for markets with vertically-integrated natural monopolies is to establish a legislative framework that provides a clear and consistent operating environment, promotes economic efficiency, rewards innovation and seeks to maximise the contribution of this sector to the overall growth of the economy.

At the broadest policy level, there are a number of types of policies that could be considered for controlling these undesirable consequences of vertically-integrated natural monopolies. These include, for example, state ownership; breaking up of the monopolist; or control of the prices the monopolist can charge.[12]

Each of these approaches carries significant risks. For example, state-owned firms sometimes tend to be relatively weak at controlling costs and tend to influence and be influenced by non-commercial pressures. Breaking up the monopolist may raise production and transactions costs. Experience with price control suggests that it tends to distort incentives to invest and reduces incentives to control costs and to innovate. Inevitably, the selection of a preferred option will involve trading-off the risks of market failure against the risks of regulatory failure.

The undesirable effects of regulation may be kept to a minimum by limiting regulation to the natural monopoly facility and allowing competitive pressures to discipline the monopolist in the up- or downstream market. Competition promotes productive efficiency by enhancing the opportunities for inter-firm comparisons, increasing the variety of innovative activity, and forcing inefficient firms to exit the market. Competition may also, depending on the terms under which the competitor receives access to the monopoly facility, cause prices to be driven down towards the underlying costs.

This document identifies five broad policy approaches that permit competition and constrain in some way the ability of the monopolist to charge in excess of costs (including a normal profit). Of these, just two broad policy approaches are considered in detail in this paper:

  1. price restraints on access or interconnection to the natural monopoly facility; and
  2. price restraints on both access or interconnection and the retail product.

In this document, the term 'price restraints' does not refer to price regulation of the type appearing in Part IV of the Commerce Act. The term 'price restraints' refers to the variety of regulatory mechanisms which restrict, in some way, the terms and conditions that the monopolist can charge for access.

The current policy of the Government fits within approach (a). The effect of s.36 of the Commerce Act is to restrict the range of prices that a vertically-integrated natural monopoly can charge for the essential input. This approach has the advantage of not requiring state ownership (with the associated inefficiencies[13]), enforced break-up of the monopolist (with consequence losses of economies of scale and scope), or more extensive price regulation than is absolutely necessary. However, the Government has stated that it will consider more extensive price regulation (such as in approach (b) above) should the need arise.

This document focuses upon approach (a). Within this broad approach, there are a number of possible ways of restricting the terms and conditions that the monopolist can demand in interconnection negotiations. These different policy options for defining and enforcing the access regime are considered next.

The Access Regulation Regime

One of the key concerns identified above related to the appropriateness of reliance upon the courts and part II of the Commerce Act for constraining the terms and conditions that the monopolist can demand in interconnection negotiations.

A regulatory framework should, as far as possible, define and enforce the regulatory regime in a manner that:

  1. promotes economic efficiency in the industry;
  2. is timely; and
  3. yields results with a high degree of certainty and predictability.

There are a large number of possible options for the regulatory framework. These possible policy options can be described by two dimensions:

  • the degree of prescriptiveness of the principles that are specified in legislation or in statutory regulations in advance (which will be referred to as the 'principles') and
  • the nature of the institution that interprets and applies those principles (which will be referred to as the 'regulatory institution').

This document focuses upon four 'regulatory institutions': the courts, arbitrators, a statutory regulator, and the Government acting under statutory powers. Statutory regulators typically have the greatest scope for imposing sophisticated regulatory solutions that require continual oversight. However, statutory regulators tend to be relatively vulnerable to influence and lobbying and may have a tendency to act in the interests of themselves and/or the regulated firms rather than the wider public interest. In addition, the decisions of a regulator do not create a binding precedent. On the other hand, the Courts tend to be least subject to lobbying activities and the decisions of higher courts are binding on lower courts. Arbitration lies closer to the courts in the types of remedies that can be imposed, but closer to a statutory regulator in terms of vulnerability to influence and precedent value.

The more detailed and prescriptive are the principles or rules that are specified in advance, the greater the need for flexibility to modify the principles as they become obsolete or out-of-date.

This need for flexibility can be met by introducing broad, high-level, principles in legislation supplemented by a requirement that the regulatory institution have regard to statements of government economic policy issued under a mechanism similar to that which currently exists under s.26 of the Commerce Act. The broad legislative principles should seek to promote economic efficiency, possibly along the lines of the principles that already exist in sections 53 and 73 of the Commerce Act.

This document focuses upon the following combinations of principles and regulatory institution. Together, each combination represents one possible option for defining and enforcing the access regulation regime:

  1. no principles (apart from the Commerce Act) with resolution and enforcement by the courts (i.e., the status quo);
  2. no principles (apart from the Commerce Act) with resolution and enforcement by a new compulsory arbitration mechanism[14];
  3. broad legislative principles with the courts;
  4. broad legislative principles with compulsory arbitration;
  5. broad legislative principles with a statutory regulatory agency (such as the Commerce Commission);
  6. detailed industry-specific principles with the courts; and
  7. detailed industry-specific principles with compulsory arbitration.

In the text these options are evaluated against the objectives set out in paragraph 29 (i.e., promoting economic efficiency, timeliness and certainty).

Option (a) is the status quo option. At present the regulatory regime for interconnection negotiations is defined by the Commerce Act and the decisions of the courts. Officials have developed a particular formulation of option (d) in more detail. This formulation is set out in Appendix A.

Comments are invited on the choice of principles plus regulatory institution ((a)-(g) above, with a particular focus on option (d)) that best meets the objectives set out above.

Access Price Restraints

A second concern identified above related to the appropriateness of the BW rule for pricing access to vertically-integrated natural monopolies in New Zealand.

An interconnection pricing rule should, as far as possible, seek to achieve economic efficiency. Economic efficiency can, in turn, be broken down into productive, allocative and dynamic efficiency.

In the case of telecommunications, it may not be possible to choose the interconnection pricing rule in such a way as to achieve both the goal of economic efficiency and the goal of efficient handling of the cost of a social obligation (such as the Kiwi Share). Therefore, these two goals are separated. The question of the economically efficient access pricing rule in the absence of the social obligation is considered first, followed by the question of the efficient method of handling the social obligation itself.[15]

There are a large number of possible rules for pricing access to a monopolist that have been suggested by economists. These include:

  1. pricing at short-run or long-run marginal cost;
  2. pricing at long-run average incremental cost;
  3. Ramsey pricing (pricing in inverse relationship to the elasticity of demand);
  4. two-part pricing (such as a high 'fixed' charge with a low 'usage' charge);
  5. peak-load or other forms of capacity pricing;
  6. BW or Efficient Component Pricing Rule;
  7. revenue capping rules;
  8. in the case of two-way networks, 'reciprocity' and related rules such as 'bill and keep'; and
  9. more sophisticated rules that recognise that regulators do not have access to all the information they need to set prices in accordance with economic efficiency objectives and seek to provide incentives for the regulated firms to reveal this information.

Certain of these pricing rules, such as the 'cost-based rules' in options (a) and (b) above may do better than the BW rule at achieving both of the goals of productive and allocative efficiency. However, the lower the regulated price, the greater the opportunity for inadvertently distorting the incentives of the monopolist to innovate and to invest and the greater the divergence between the Government's objectives and the interests of the monopolist.

The appropriate access price in any given circumstance will depend upon a large number of factors including the information available to the regulator, the cost structure of the monopoly firm and whether or not the monopoly facility is likely to be capacity constrained. The most appropriate rule in any given context will depend upon the factors specific to the industry and the nature of the access problem involved.

The comments of consultees are invited on the rule that best meets the objectives set out in paragraph 39 above for pricing interconnection in the telecommunications sector and in other sectors. In the context of telecommunications interconnection, comments are particularly sought on options (b), (f) and (h).

Social Obligations and the Kiwi Share

A third issue raised in the light of experience with telecommunications negotiations is the issue of the appropriate handling of the costs imposed by the Kiwi Share.

A method of handling social obligations should, primarily, seek to promote economic efficiency. In this context economic efficiency is promoted by estimating and allocating the costs of the obligation amongst the parties in such a way as to minimise the overall economic distortions created by the obligation. In particular, this will involve allocating the costs of the obligation in such a way that no firm is given a competitive advantage or disadvantage.

If the costs of a Government imposed social obligation (such as the Kiwi Share) are carried entirely by one firm in an industry, that firm is competitively disadvantaged. This can create two distortions. First, other, less efficient, firms may be induced to enter the markets where the subsidy is funded. Second, other, more efficient, firms may be discouraged from entering the markets where the social obligations are required. If these distortions are to be removed, the cost of the social obligation must be shared in some manner among the industry participants.

There are two broad approaches to the handling of social obligations:

  1. those options which recover a contribution towards the social obligation costs through the interconnection pricing rule and which do not require separate estimation, verification and allocation of the social obligation costs (e.g., recovering a contribution towards the social obligation costs through the BW rule); and
  2. those options which require separate estimation, verification and allocation of the social obligation costs.

The question of how social obligations costs should be estimated, verified and allocated amongst the industry participants is difficult both in theory and in practice.

In the light of the objectives above, comments are invited on the appropriate approach to the handling of the Kiwi Share and, if approach (b) is chosen, principles and methodologies for estimating, verifying and allocating the Kiwi Share costs.

Application Of The Regime To Other Sectors

If, after careful consideration of the options, it is determined that the net benefits of invoking an access regime in the telecommunications industry exceeds the cost, it is envisaged that such a regime would be invoked immediately for interconnection disputes arising in that sector. However, the same access issues as have arisen in the Telecom v Clear case could arise in other vertically-integrated natural monopoly industries. If a modification to the existing regulatory framework is made to improve the regime for interconnection negotiations in telecommunications, should this new regime be available for access disputes arising in other sectors with the vertically-integrated natural monopoly structure? If so, who or what should decide when this new regime should be invoked?

The question of who should invoke the new access pricing regime is a question as to the appropriate regulatory arrangements, similar to the earlier decision over who should define and enforce the regime once it is invoked. As before, this decision could be made by the courts, arbitrators, a statutory regulator or the Government, subject to broad or specific principles.

Although the Government is only interested in regulating to increase wealth, not redistributing it, given the likely efficiency and distributional consequences of invoking an access pricing regime, the regulatory institution that makes the decision will inevitably be subject to intensive lobbying and influence activities. Experience with overseas access regimes suggests that competitors in many sectors claim that their industry is a natural monopoly in order to obtain more favourable regulated access terms. On the other hand, facility owners lobby strongly to prevent such a regime being put in place.

This would tend to suggest that the decision should be made by an institution which is relatively immune to lobbying. However, given the substantial amount of discretion and specialist expertise necessary to make the judgment, it may be appropriate for a statutory regulator (such as the Commerce Commission) or for a Minister to invoke the regime.

In any case, as the access pricing regime may involve more extensive regulation than exists under the current 'light-handed' regulatory regime, it would be desirable to establish broad legislative principles that establish a high 'threshold' in order to restrict the access regime to only those sectors and situations for which significant problems in the existing light-handed regime have been identified. Possible principles for defining such a threshold are set out in paragraphs 243-244.[16]

It will be difficult to adequately define such a threshold. If it is not possible to define such a threshold, the remaining options are to limit any new access regime to the telecommunications sector alone or to not implement a new access regime at all.

Key Questions

The key questions for consultees are summarised here. Given the Government's objective of providing a legislative framework that provides a clear and consistent operating environment, promotes economic efficiency, rewards innovation and seeks to maximise the contribution of this sector to the overall growth of the economy:

  1. Is the existing regulatory framework (the courts and the Commerce Act) satisfactory for defining the regime for interconnection negotiations? If not, what regulatory framework could improve upon this regime and why?
  2. Is the BW rule the appropriate rule for pricing interconnection to the facilities of a vertically-integrated natural monopoly in New Zealand? If not, are there alternatives that could better meet the objective of economic efficiency? How should the costs of Government-imposed social obligations (such as the Kiwi Share) be handled?
  3. Should any new access regime be available in other sectors with the vertically-integrated natural monopoly structure (such as electricity, gas and water)? If so, who or what should act as the 'gatekeeper' for deciding when the regime will apply? Is it possible to adequately define a 'threshold' to determine which access disputes will qualify? What principles might define that threshold?

The Paper

The remainder of this paper is divided into three sections. The first section presents the 'problem', i.e., a history of the dispute and the issues that it raises. The second section discusses in more detail the 'options' for regulation of integrated natural monopolies and sets out the questions for which a response is sought. The remainder of the paper comprises a number of appendices containing material for further reference.

For convenience, the complete set of questions for consultees are set out immediately following this summary.

Please send all comments and submissions in writing by 15 September 1995.

Ministry of Commerce
The Treasury

Wellington, New Zealand
August 1995


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