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Part I: The Problem


This Document is Archived


Regulation of Access to Vertically-Integrated Natural Monopolies

[ Last Updated 16 November 2005 ]


This section is laid out as follows: First, we describe the vertically-integrated natural monopoly industry structure and discuss the theoretical public policy issues that arise. Second, we review the history of the existing regulatory arrangements and the history of the Telecom v Clear interconnection dispute. Third, we consider the public policy concerns that have arisen surrounding the regulation of vertically-integrated monopolies in the light of the experience in the telecommunications sector and the Telecom v Clear case in particular. Lastly, we consider the implications of the Telecom v Clear dispute for the energy sector.

The Vertically-Integrated Natural Monopoly

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 a firm to compete in upstream and/or downstream markets; and
  2. the firm providing the natural monopoly service[18] also provides services in those upstream or downstream markets.

For example, in order for Clear to compete with Telecom in the local-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.[19] 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.

The electricity industry provides another example. Electricity distribution line businesses are natural monopolies. These businesses are often also involved in down-stream electricity retailing. In this capacity they compete with other electricity retailers who need access to their lines in order to sell to consumers in the areas of their network.

Because the firm controlling the natural monopoly facility is vertically-integrated into the up- or downstream market, this industry structure is known as a 'vertically-integrated natural monopoly'.

This document will not deal with questions of access to the facilities of a monopolist which is not vertically-integrated. In particular, this document does not deal with access issues in electricity transmission as Trans Power (which owns and operates the electricity transmission network) is involved in neither of the associated competitive activities: electricity production and electricity retailing. Nor do we deal with issues of access to airport and port facilities.

Vertical Integration and Market Foreclosure

Natural monopolies may give rise to public policy concerns. Natural monopoly firms, by definition, do not face competitive pressures. Compared to firms in competitive industries, monopoly firms may have higher costs, may charge higher prices and may be slower to innovate or to introduce new technologies.

These concerns may be heightened if the monopolist is vertically-integrated into an upstream or downstream market. In this context the monopolist may, by restricting access to the natural monopoly facility, restrict or prevent competition in the related market.[20] If the monopolist is successful at eliminating competition, the related market is said to be foreclosed.

Is Market Foreclosure a Public Policy Concern?

The antitrust authorities in the US have, in the past, taken a fairly hostile view towards vertical integration and market foreclosure.[21] Partly in response, several economists have emphasised that vertical foreclosure may improve overall economic efficiency. For example, vertical integration may occur in order to take advantage of vertical economies of scale, to reduce transactions costs between firms with highly co-specialised assets, or to eliminate the inefficiencies that arise from 'double marginalisation'[22] when the downstream market is not perfectly competitive.

However, vertical integration does not necessarily improve welfare. For example, integration to eliminate the inefficiencies that arise from 'variable proportions' or to allow the incumbent to engage in price discrimination will result in gains to the incumbent but these may be offset by the losses to consumers. Furthermore, in some circumstances vertical integration actually reduces welfare.[23]

Furthermore, these arguments tend to focus on the allocative efficiency benefits from competition. Competition can also be expected to enhance productive efficiency. First, competition causes efficient firms to prosper at the expense of inefficient ones. Second, increasing the number of firms in the industry permits owners to identify substandard performance and reward performance on the basis of inter-firm comparisons. Third, increasing the number of firms enhances the variety of experimental innovations that firms undertake and increases the opportunities for firms to learn from one another. As a result, a reduction in competition, even without any corresponding allocative efficiency losses, will tend to lower overall welfare.[24]

To summarise, vertical integration and market foreclosure is not necessarily, in itself, a public policy concern. However, in circumstances where (a) the productive efficiency gains from vertical economies of scale and reductions in transactions costs are not too strong; and (b) the foreclosure results in a substantial lessening of competition, some form of restrictions on the ability of the monopolist to foreclose the related market may be expected to improve overall social welfare. In New Zealand these restrictions on the property rights of the monopolist are provided by the Commerce Act under the so-called 'light-handed' regulatory regime.

The 'Light-Handed' Regulatory Regime

At present, the telecommunications sector and certain parts of the energy sector (electricity and natural gas) in New Zealand are governed by a 'light-handed' regulatory regime. This section reviews the history and experience of the telecommunications and energy sectors operating under this regime.

The History of the Light-Handed Regulatory Regime

The light-handed regulatory regime originated in the telecommunications sector during a period of rapid deregulation and privatisation between 1987 and 1990.

Telecom Corporation was formed as a State-Owned Enterprise in April 1987. In preparation for deregulation, the Government commissioned a report from Touche Ross. This report concluded that, subject to satisfactory interconnection agreements, competition in network services was possible and sustainable and that any resultant losses of economies of scale and scope would be small and would be outweighed by the dynamic gains arising from greater pressures on Telecom to be efficient, to offer better service and to be more innovative. As a consequence, in late 1987 the Government determined that competition in all telecommunications markets would be permitted from early 1989.[25] On 1 April 1989 New Zealand became the first member of the OECD to introduce full competition to all sectors of the telecommunications industry.

It was recognised that simply removing statutory restrictions on entry would not, by itself, ensure that competition emerged. Telecom could, if unrestrained, restrict access to its 'local-loop' business and thereby significantly restrict or eliminate competition in other components of the telecommunications market. Although future technological developments (in cellular telephony or cable television) might erode this monopoly position "these technologies were not sufficiently advanced to allow sustainable and effective competition without the government intervening to promote competition."[26]. Some form of regulatory restrictions were necessary.

Consideration was given to alternate regulatory options, such as introducing an industry-specific regulator (as in the Australian and UK telecommunications industries) or structurally separating out the local access business (as adopted in the US).

Instead, recognising the theoretical and practical drawbacks of extensive regulatory intervention, the Government opted for a regime that was (a) generic to all natural monopoly industries, (b) yielded relatively 'light-handed' regulatory restraints on the monopolist and (c) relied, for enforcement, upon private legal actions together with a generic competition law enforcement body. In addition, the Government explicitly left open the possibility of more extensive regulation should the need arise.

This regime became known as New Zealand's 'light-handed' regulatory regime. The regime relies upon private negotiations between competitors and the integrated natural monopoly to secure interconnection agreements, subject to:

  1. the existing competition policy regime, to prevent anticompetitive behaviour; in particular, s.36 of the Commerce Act which prohibits businesses which are in a dominant position in a market from using that dominance for the purpose of restricting entry into a market or from deterring competition in a market;
  2. information disclosure regulations, to make transparent the performance of businesses with market power; this facilitates both negotiations with these businesses and recourse to the provisions of the Commerce Act; and
  3. the threat of further regulation (such as the introduction of price control under part IV of the Commerce Act) if market dominance is abused.[27]

The key features of this policy were reiterated in a statement of Government policy for the telecommunications sector, issued in December 1991:

"The Government sees competition as the best regulator of telecommunications markets. Accordingly, there will continue to be no statutory or regulatory barriers to competitive entry into telecommunications market in New Zealand . . .

To maintain the conditions of effective competition, the Government places primary reliance upon the operations of the Commerce Act 1986. In particular, it relies on the enforcement of the statutory prohibitions against anticompetitive practices.

The following supplementary measures will continue to apply: (a) the Telecommunications (Disclosure) Regulations 1990; and (b) the Telecommunications (International Services) Regulations 1989[28].

If it proves to be necessary, the Government will consider the introduction of other statutory measures or regulation. It will take particular care to ensure that it is not seen to be acting merely to enhance the commercial position of one firm or group within society at the expense of another."

The Telecommunications Sector Under the Light-Handed Regime

Since the light-handed regulatory regime was established in the telecommunications sector there have been several positive developments both for users and consumers and for New Zealand as a whole. Including:

  1. Significant productivity gains (measured in terms of lines per employee[29]);
  2. A major capital investment program which has resulted in 98% of access lines connected to digital switches (one of the highest percentages of digitalisation in the OECD);
  3. Significant increases in service quality (including, for example, reduced waiting times for telephone connection);
  4. Small overall average annual real decreases in the price of a basket of telecommunications services[30], including:
    1. Significant real reductions in toll charges (including improvements in terms and conditions such as the change from three minute minimum call charge plus one minute rounding, to a one minute minimum plus one second rounding of toll calls and the introduction of special offers and discounts);
    2. Following significant increases in residential rentals in the late 1980s, the real telephone line rental charge has been held constant since 1990, under the Kiwi Share obligations;
  5. The emergence of competition in the cellular, long-distance, value-added services and customer premises equipment markets;
  6. The early introduction of several new technologies (GSM, DAMPS, fibre to the curb, PCS and ATM trials)
  7. The successful negotiation of five interconnection arrangements (with Clear for long-distance services, BellSouth for a cellular service, BCL for connection with BCL's trunk radio Teamtalk service, Sprint for international services, and with Telecom's own subsidiary Telecom Mobile Communications Limited).

However, as might have been expected, the regime has also been characterised by virtually continuous dispute over terms and conditions relating to interconnection. For example, disputes have arisen over whether or not:[31]

  1. access to Clear's network would require a separate access dialling code;
  2. Clear's customers would have access to Telecom's seven-digit National Numbering Plan;
  3. Clear's customers would be listed in Telecom's white and yellow pages;
  4. Clear and other service providers would be allocated '0800' numbers in order to provide a toll-free service;
  5. Telecom would make available certain intelligent network features to BellSouth's network (such as international roaming);
  6. Clear would be required to make a contribution towards the costs incurred by Telecom as a result of the Kiwi Share; and
  7. Telecom could lawfully insist upon an access price given by the BW rule.

The final two points of disagreement were taken by Telecom and Clear as far as the Privy Council. The full history of this dispute and the Privy Council decision are set out below.[32]

The Energy Sector Under the Light-Handed Regime

As in the telecommunications sector, significant productivity improvements are occurring in the electricity sector under the light-handed regulatory regime.

So far, the electricity and gas industries have not experienced such intense and protracted disputes as have arisen in the telecommunications context. In the case of electricity industry, legal barriers to retail competition have only recently been removed and network negotiations are relatively recent. Officials do not, at present, have substantial concerns about the progress on electricity distribution network access agreements.

As Trans Power is not vertically-integrated, electricity transmission access does not raise serious competition issues. However, Trans Power could cause competition problems if another firm attempted to bypass part of its network.

In the gas industry, there is an ongoing disagreement between the Natural Gas Corporation and other industry participants over the terms and conditions for access to gas transmission facilities. Rather than being about specific access or pricing, this dispute is fundamentally about the contractual framework to be adopted in gas transmission and therefore is beyond the scope of this paper. There is as yet no compelling evidence that satisfactory access agreements cannot be concluded drawing on existing legislation. However, given that there is a large amount of uncertainty regarding the limits of what behaviour of NGC would be considered legal under the Commerce Act and given the sizeable amounts at stake, the risk of a similar protracted dispute cannot be ruled out.

The Telecommunications Interconnection Dispute

Background

Clear Communications was incorporated in August 1990. By the following April, Clear had successfully concluded a long-distance agreement with Telecom and was offering domestic toll services.[33]

Clear subsequently sought to negotiate an agreement for interconnection in order to operate local telephone services. Matters came to a head when, due to an impasse in negotiations, Clear was unable to fulfil a contractual obligation to provide a local telephone service to the Department of Justice in Wellington.

Clear initiated legal proceedings in August 1991. "Following the start of proceedings, Telecom took advice from American economists that produced a major shift in the way Telecom viewed its case. Up until this time, Telecom had largely based its demand for an access levy to its network on the ground that it was entitled to a contribution towards the costs imposed by the Kiwi Share obligations ('KSO'). The American economists advised that Telecom could, without unlawful use of its dominant market position, require Clear to contribute to the general common cost of Telecom's network. This advice was based upon what came to be known as the 'Baumol-Willig rule'."[34] The Baumol-Willig rule is also known as the 'Efficient Component Pricing Rule' (ECPR) and is equivalent to the 'competitive parity principle' advocated by Dr Kahn.

The High Court hearing took place between June and October 1992. On 22 December 1992 the High Court held that the interconnection terms finally offered by Telecom did not breach s.36 (although Telecom did breach s.36 by wrongly insisting upon the use of an access code and wrongly refusing to supply a DDI service to Clear).[35]

Clear appealed to the Court of Appeal. The appeal was heard in August 1993 and in December 1993 the Court ruled in Clear's favour. Specifically the Court of Appeal held that Telecom could not lawfully charge an interconnection price that included a component of monopoly rents.[36] Telecom appealed to New Zealand's final appellate Court, the Judicial Committee of the Privy Council.

The Privy Council Decision

The Privy Council released its decision in October 1994. The Privy Council:

  1. concluded that the use of the BW rule for pricing interconnection services provides for competitive parity and enables Clear and Telecom to compete on a level playing field in the area in which they are to be competitors. It was considered that the application of the rule would put Clear in a position to compete out over time any monopoly profits obtained by Telecom;
  2. held that Telecom was not acting anticompetitively in seeking to charge its opportunity cost since that is what it would have charged in a fully competitive market;
  3. noted that Clear had not established that Telecom's charges would be so high that Clear would be prevented from entering the market at all;
  4. on the question of monopoly profits, considered that while the BW rule may allow network owners to recover any loss of monopoly profits through their prices for access, the Government could (if monopoly profits were not competed out) introduce price control under Part IV of the Act.[37]

In short, the Privy Council held that the use of the BW rule by Telecom as the basis for determining the price at which Clear could interconnect with Telecom's network was lawful under s.36 of the Commerce Act.

In the months since the release of the Privy Council decision Clear and Telecom have continued to negotiate. Despite concessions on both sides, at the time of writing an agreement does not appear to be imminent. The current views of Clear and Telecom and the other interested parties are summarised in Appendix H.

Issues Arising From New Zealand's Experience With The Light-Handed Regime

The New Zealand experience of negotiations over interconnection in telecommunications and, in particular, the Telecom v Clear decision raises three main issues:

  1. the appropriateness of the BW rule for pricing access to the facilities of a vertically-integrated natural monopolist in New Zealand;
  2. the appropriateness of reliance upon the courts and part II of the Commerce Act for defining the regulatory framework for interconnection negotiations in New Zealand; and
  3. in relation to telecommunications, if the BW rule is not retained, the appropriate means of handling the cost burdens imposed on Telecom by the Kiwi Share.

We examine each of these issues in turn.

The Baumol-Willig Rule

In this document, the BW rule and other interconnection pricing rules will be evaluated on the basis of how well they contribute to overall economic efficiency. Economic efficiency is usually broken down into three components: productive efficiency (i.e., producing the output using the least amount of inputs), allocative efficiency (i.e., pricing that output at the cost of the underlying resources) and dynamic efficiency (i.e., ensuring that the firm has incentives to innovate and to exploit new opportunities as they arise over time).

Essentially, the BW rule states that a firm seeking access should pay the incumbent a sum sufficient to compensate it for the opportunity cost of customers lost to the entrant including its foregone profits, if any. Hence the BW access price may include the monopoly profit that the incumbent loses by selling access in place of retail services.[38]

Here is a simple example[39] to illustrate. An incumbent firm produces an essential input at a constant marginal cost of $2. The incumbent also owns a downstream firm which converts this input into a final product at an additional marginal cost of $3. The final product sells on the market for $10, yielding the incumbent a profit of $5 per item. A new entrant firm wishes to enter the downstream market. In order to do so, the new entrant must purchase the input from the incumbent, convert it into a final product and sell the final product in competition with the incumbent. If every item of the input sold to the competitor results in a loss of one sale of the final product to the incumbent then selling one item of the input to the competitor results in a 'cost' to the incumbent of $2 in physical production costs plus $5 in foregone profits or 'opportunity costs'. Thus, under the BW rule, the new entrant would pay $7 for each item of the essential input.

The BW rule has been hotly criticised on several fronts. Many of these criticisms are due to misunderstandings of the rule itself, or misapplications of the rule in particular contexts. We will focus primarily on two issues: the ability of the BW rule to restrict inefficient entry into the market, and the ability of the BW rule to enable the competing away of monopoly rents.

Restricting Inefficient Entry

The BW rule is designed to be applied to monopolies where both final product price and the intermediate access or interconnection price are regulated.[40]

In this context, provided the regulator is doing its job, the final product prices will be set efficiently. There is no need to rely upon competition to achieve this goal. Given that allocative efficiency has been achieved by other means, a primary remaining goal for the interconnection pricing rule is productive efficiency. Putting aside complications such as sunk costs, uncertainty and dynamic effects from competition, productive efficiency can be achieved by simply ensuring that inefficient firms are not able to successfully enter the market. The BW rule achieves this goal of keeping inefficient firms out of the market.

Consider the example in paragraph 101 again. The efficient final price is $2+$3=$5. Supposing the regulator has set the final price efficiently, the BW interconnection price is $2. With the interconnection price set at the level of $2, only an entrant with costs equal to or less than $3 (the cost to the incumbent of converting the input product into a final product) will be able to enter the market. Inefficient firms will be kept out of the market. Note that when the final prices are set efficiently, the BW price is just equal to the cost ($2) of producing the essential input.

This example can be made a little more interesting by adding in the costs of a Government-imposed social obligation (such as the Kiwi Share obligations that are imposed on Telecom). Suppose that the final product price is fixed by a regulator who, due to a Government-imposed social obligation, imposes an additional cost of $4 per item that is not borne by the competitor. The efficient final product price is $2+$3+$4=$9. This yields a BW interconnection price of $6. At this price, less efficient firms cannot enter and compete in this market.

If the regulator in the above example mistakenly neglects the social obligation and sets the interconnection price at $2 (the cost of producing the essential input), an entrant with costs higher than the incumbent could enter and compete successfully in the related market. This raises overall production costs, lowering productive efficiency and overall welfare.[41]

In these simple examples, the BW rule achieves the goal of permitting entry if and only if the entrant is more efficient than the incumbent. However, if we consider slightly more complicated models this is no longer the case.

The BW rule may, in fact, block efficient entry in those industries where entry involves large sunk costs (e.g., telecommunications). The presence of large sunk costs and uncertainty about the future has the combined effect of deterring entry unless the expected returns exceed the required return on capital.[42] The additional required return effectively raises the 'hurdle' that a potential entrant must overcome for entry to be worthwhile. An interconnection price set according to the BW rule will therefore deter some efficient entry.

Furthermore, the BW rule may fail to achieve productive efficiency for another reason[43]: the BW rule fails to take into account the dynamic benefits of competition. Competition in itself, can be expected to yield productive efficiency benefits. With more firms in the industry, the individual firms are better able to assess their performance through inter-firm comparisons and 'yardstick' competition. In addition, as each firm experiments with innovative activity, having more firms in the industry can be expected to enhance the rate of introduction of successful innovations.[44]

Permitting entry by a number of entrants whose costs are only slightly higher than the incumbent's can be expected, through the competitive effects just mentioned, to yield productive efficiency gains. Therefore, even in the context for which the BW rule was designed, a slightly lower access price may promote economic well-being in certain circumstances.

Lastly, note that inefficient entry is only likely to be a problem when either (a) the downstream market can only sustain a few firms or (b) there is a Government-imposed social obligation (such as the Kiwi Share) cost which is not included in the interconnection price and is not dealt with in some other way. If the downstream market can support a medium to large number of competitors and the social obligation is dealt with by some other means, whatever the level of the interconnection price, inefficient firms will be eliminated from the market through the usual competitive pressures.[45]

Even where the downstream market is not large enough to support more than a few firms, final price competition will drive prices down towards the costs of the most efficient firm. Firms whose costs are even moderately higher than the costs of the most efficient firm will not be able to survive. The effect of final price competition is to keep the undesirable consequences of productive inefficiency to a minimum.

Competing Away Monopoly Profits

The critics and advocates of the BW rule (including Baumol himself) agree that the rule does not achieve all the desired objectives of an interconnection pricing rule. In particular, the BW rule does not achieve (and was not designed to achieve) the allocative efficiency goal. That is, the rule does not permit competition in the final product market to compete away monopoly rents.

Baumol himself argues that the rule does not permit competition to compete away rents:

"The [BW rule] was not designed for that purpose and consequently does not achieve that commendable goal . . . The monopoly-pricing problem may or may not require attention in the telecommunications industry in New Zealand, but to condemn a procedure that performs other useful tasks, the tasks it was designed to carry out, for failing to deal with the monopoly problem as well, is patently non sequitur. It would be equally appropriate to attack the [BW rule] for its failure to contribute to the protection of the environment."[46]

"The [BW rule] . . . if imposed without supplementary safeguards, requires the lessor of the bottleneck facilities to include in the rental payment whatever monopoly profits the bottleneck proprietor has been able to extract from other customers. . . . In our recent book on local telephone regulation we have been most explicit about this concern, emphasising the second economic efficiency requirement that, in addition to the [BW] rule, final product prices must be constrained by market forces or regulation so as to preclude monopoly profits. . . . the one rule, without the other, does not guarantee results that serve the public interest."[47,48]

This can be illustrated by referring back to the example in paragraph 101. In that example, the monopolist produced the essential input at a constant marginal cost of $2, converted it into a final product at a constant marginal cost of $3 and sold the final product for $10. The monopolist is prevented from charging more than the BW price for the essential input, which, as we saw earlier, is $7.

A new entrant wishes to compete in the downstream market and uses identical technology and has identical costs to the incumbent, i.e., the competitor converts the essential input into the final product at a cost of $3. Since the new entrant must pay $7 for the essential input, the new entrant can charge no less than $10 in the final product market. There is no scope for competition to drive down costs. The monopolist can continue to earn any monopoly profits.

If, however, the competitor is more efficient than the incumbent there may be some room for downward movement of the final product price. For example, if the competitor in the example could convert the essential input into final product at a cost of $2.50 then there would be some scope for the competitor to compete by lowering prices in the final product market. The extent to which final prices will be lower will depend upon the nature of the competition between the parties. In a situation such as this, with a very small number of players in the industry, theory suggests that the final product price is unlikely to drop by the full amount of the 50 cent cost saving per item. In other words the final price will lie between $9.50 and $10.[49]

If the access price is periodically reviewed, the extent of the final price reductions may be larger. For example, suppose the final price in the previous example drops to $9.75. The BW access price is now $9.75-$3=$6.75. At the time when the access price comes up for review, it will be reviewed downwards to $6.75; a drop of 25 cents from the previous access price of $7, opening up 'room' for further final price competition.

The total downward movement on prices depends entirely upon the extent of the new entrant's cost savings over the incumbent in downstream market. Theory suggests that when there are only a few competitors in the downstream market, the total final price movement is likely to be significantly less than the competitor's cost savings. In any event, there will be no impact on the natural monopoly. The incumbent will still be able to earn monopoly profits on the natural monopoly portion of the business.[50]

Other Issues

As we have seen, the BW rule permits the incumbent to preserve the existing price-cost margins on the essential input. This allows the incumbent to recover the same contribution towards common costs as the incumbent would receive by 'selling' the intermediate product to its own downstream subsidiary.

In particular, if the incumbent faces costs due to a Government-imposed social obligation such as the Kiwi Share, the BW rule allows the incumbent to recover any existing contributions towards the Kiwi Share costs from the interconnecting competitor. In this way the Kiwi Share costs can be fully covered without any need for separately estimating the magnitude of these costs.

Lastly, in theory the BW price leaves the incumbent indifferent between selling to the entrant and 'selling' to its own downstream subsidiary. It has been claimed that, as a result, the incumbent has little incentive to forestall interconnection negotiations. Although the incentives for restricting competition under the BW rule may be significantly muted, the management of the incumbent firm may have other non-profit maximising motives (such as the desire for a 'quiet life') which lead it to prevent competition, even at the BW prices.

Summary

To summarise, the BW rule was solely designed to achieve the goal of productive efficiency. In the simplest, static and no-uncertainty contexts the rule achieves this goal. However, if other factors are introduced, such as uncertainty and sunk costs, or if the dynamic benefits of competition are considered, the BW rule may, in fact, deter efficient entry.

The BW rule has the advantage of being minimally invasive of the incumbent's property rights and permits recovery of the costs of social obligations (such as the Kiwi Share) without explicit quantification of those costs. However, the BW does not achieve and was not designed to achieve one of the three public policy objectives described in paragraph 99, allocative efficiency. To the extent that the competitor is more efficient than the incumbent in the downstream market, there will be some downward movement of final prices. However, it is likely to be limited and, in any event, will not restrain the ability of the incumbent to charge monopoly rents on the natural monopoly portion of the business.[51]

Together these considerations raise concerns about the appropriateness of the BW rule for pricing interconnection in the New Zealand regulatory environment.

Reliance Upon the Courts and the Commerce Act

At the time when the light-handed regulatory regime was established, it was anticipated that parties desiring access to a natural monopoly facility would negotiate their own terms and conditions, with, as a last resort, the threat of recourse to the courts and the application of the Commerce Act if the monopolist demanded terms that were anticompetitive.

At the present time there is no overwhelming evidence that this policy of reliance upon the courts and the Commerce Act has failed. In fact, several interconnection agreements in natural monopoly industries have been successfully concluded.[52] Although the negotiations between Telecom and Clear over local access have not yet resulted in agreement, it should be emphasised that the mere failure to reach agreement is not, in itself evidence of failure of the regulatory regime, as failure to reach agreement might also occur if either (a) the entrant's costs were so high as to make entry unprofitable at any reasonable interconnection price or (b) the entrant was simply not ready to enter the market.

Although the experience to date with telecommunications, electricity and gas negotiations has not lead to conclusive evidence of failure, analysis of the current policy has raised certain concerns.

Uncertainty about Legal Limits on Behaviour

The first of these concerns relates to the cost and delay of the courts in resolving uncertainty about the terms and conditions the incumbent monopolist can legally charge for access.

Economic theory suggests that two parties are unlikely to reach agreement when their underlying legal 'rights' or 'entitlements' are poorly defined.[53] This problem is exacerbated in the context of the vertically-integrated natural monopoly as the monopolist has no incentive to offer terms and conditions more favourable to the competitor than those terms and conditions at the limit of what is legal under the existing law.[54]

In 1991, when Telecom and Clear commenced negotiations, the application of s.36 of the Commerce Act to the problem of ensuring access to the facilities of an integrated monopolist was largely untested.[55] As a consequence, there was a sizeable amount of uncertainty surrounding what behaviour the courts would hold to be anticompetitive, and, in particular, the legal limits on the terms and conditions that Telecom could legally offer.

Given the amounts of revenue at stake and the extent of the uncertainty, it is not surprising that Clear[56] sought recourse to the courts to clarify the underlying legal rights. After four years the courts clarified one aspect of the parties' legal rights - a pricing rule that Telecom can legally use for local service interconnection.

However, although price is clearly the key factor in any access agreement, there are also a number of other (price and non-price) terms and conditions to which the parties must agree[57]. For most of these, the particular application of the Commerce Act has not been tested so the parties' legal rights are largely undefined. In principle a vertically-integrated natural monopoly could seek to test the limits of what is lawful with respect to any of these other terms and conditions, forcing the entrant to litigate each point in turn,[58] or give up and stay out of the market.

Sustained litigation of this kind will, over time, develop a body of precedents which defines with increasing degrees of precision, the terms and conditions that the monopolist must offer the entrant. Eventually, the regime will be defined sufficiently so that uncertainty will no longer hinder agreement. If the cost and delay in the present case is typical, this might take many years and cost many millions of dollars. In the meantime consumers are denied the benefits of competition.

In principle, s.89 of the Commerce Act allows the court to 'short-circuit' sustained litigation of this kind. S.89 empowers the courts to make "such orders as it thinks appropriate". S.89 could be used to make an order which, in some way, cuts across the process by specifying the limit of the behaviour that would be considered legal across the entire range of terms and conditions.[59] Although s.89 has not been fully tested, the courts have shown themselves to be reluctant to use these powers. Traditionally the courts' role is to comment on the legality of historical behaviour and not to prescribe future behaviour. The courts have signalled very clearly that they are not comfortable being cast in the role of regulators.[60]

In the absence of a greater willingness to use s.89, it might take some time under the current regulatory framework for the access regime in telecommunications and other sectors to be defined sufficiently for uncertainty to no longer act as an obstacle to agreement.[61] Although there is, as yet, no evidence of a significant problem, this analysis raises a concern about the appropriateness of the policy of reliance upon the courts to define the framework for setting terms and conditions for access to natural monopoly facilities by up- or downstream competitors.

Summary

A primary cause of the dispute between Telecom and Clear was the uncertainty in the underlying legal rights. Although the courts have now defined the parties' rights over the particular matters in dispute there remain a large number of terms and conditions over which an integrated monopolist such as Telecom could act anticompetitively, forcing further litigation. Although over time a body of precedents will develop, defining with higher and higher degrees of precision the legal limits that the monopolist can charge, this process could take some time. The entrant may simply choose not to enter rather than incur the costs involved.

These considerations raise concerns about the appropriateness of reliance upon the courts and the Commerce Act to define and enforce the parties' legal rights relating to interconnection terms and conditions.

A Telecommunications Issue: Handling the Kiwi Share Obligations

The previous section emphasised that one cause of the failure of negotiations between Telecom and Clear was the lack of certainty of the parties about their underlying legal rights. This uncertainty is particularly acute in relation to the handling of the Kiwi Share.

When Telecom was privatised, the Crown retained ownership of a single share known as the Kiwi Share. This share imposes upon Telecom certain social obligations in relation to domestic telephone services.[62] In particular, Telecom is required to:

  1. maintain a local free calling tariff option;
  2. restrict the rate of price increases for standard residential rentals to the annual rate of inflation (unless the profits of the subsidiary of Telecom which operates the local loop service are unreasonably impaired);
  3. maintain the network as extensively as it was in 1990; and
  4. ensure that rural rentals do not exceed the standard urban rental rate.

There is strong public support for these terms. The Government is committed as a matter of policy to the principles of the Kiwi Share. [63] This document does not question the continued existence of the Kiwi Share.

Obligation (c), in combination with the other obligations, may force Telecom to supply some customers (possibly those customers in sparsely populated rural areas) at prices that do not cover costs and that Telecom would not serve (at those prices) but for obligation (c).[64]

At the time when Clear and Telecom commenced negotiations a major area of dispute was over the handling of the Kiwi Share. This is not surprising given that important rights were undefined, such as (a) whether or not Clear would have to make a contribution to the Kiwi Share costs; and (b) if so, how those costs would be independently verified; and (c), the methodology by which the costs would estimated.

The Privy Council upheld the decision of the previous courts that Clear should make a contribution towards the costs imposed upon Telecom as a result of the Kiwi Share. However, this has still left undefined the methodology that will be used to estimate the costs and the means of verification.

One of the advantages of the BW rule identified above was that it permits the recovery of a contribution towards the costs of the Kiwi Share without requiring these costs to be separately estimated and verified.

If, as a result of the concerns above, the appropriateness of the BW rule is re-evaluated we must also consider the question of the appropriate handling of Government-imposed social obligations such as the Kiwi Share.

Other Issues

The Ability of the Courts to Deal with Other Anticompetitive Behaviour

The Privy Council decision has given rise to some general uncertainty regarding the application of s.36 to anticompetitive conduct by dominant firms. The Privy Council decision does not appear to preclude the courts from dealing with the full range of anticompetitive behaviour, including excessive pricing carried out for one or more of the proscribed anticompetitive purposes under s.36. The legal implications of the Privy Council decision are discussed further in Appendix F.

Telecommunications and International Negotiations

New Zealand's telecommunications policies are subject to scrutiny by trading partners as telecommunications trade liberalisation is pursued. Currently negotiations are proceeding at the World Trade Organisation under the General Agreement on Trade in Services specifically on Basic Telecommunications. These negotiations are due to conclude in mid-1996. There is a general push for members to commit themselves to practical processes that will provide for timely interconnection by new entrants. More specifically, requests have been made for New Zealand to introduce such a process. Similar issues are being raised in other forums (such as APEC) and in bilateral negotiations.

New Zealand will need to ensure its processes for interconnection meet acceptable standards as these talks develop if it is to obtain enhanced access to other markets of interest.

Are Vertically-Integrated Monopolies in NZ Earning Monopoly Profits?

The pursuit of profit is an important spur to innovation, cost-reduction and the development of new products which better meet the demands of consumers. Public policy concerns only arise when the erosion of such profits is, in some way, constrained by a lack of adequate regulation or a lack of competitive pressures from substitute products either from within the industry (i.e., from competitors) or from without (e.g., from substitutes such as electronic data networks).

Simple analysis suggests that it is likely that Telecom can command significant market power in many parts of its business. Portions of Telecom's network appear to be a natural monopoly, in particular the rural network and portions of the residential network. To a certain extent, this natural monopoly might be eroded over time by other networks capable of carrying telecommunications services, such as cable television networks or wireless telecommunications services. However, given that customers of any network are likely to want access to customers of other networks, interconnection with existing networks is still likely to be required for these services. For the moment, there appear to be few substitutes for the existing telecommunications network.

Further analysis of Telecom's costs and profitability raises the question of whether Telecom is earning monopoly profits. This question is explored further in Appendix G.

It is not yet clear whether monopoly profits are being received by most participants in the energy markets. A requirement that performance measures, covering profitability and other outcomes, be disclosed has been introduced for electricity line businesses under the disclosure regulations. The local electricity companies will be first reporting on those measures at the end of August 1995. These performance measures include the accounting rate of profit, which is designed to facilitate direct comparison with the weighted average cost of capital, which can be assessed independently. Trans Power's performance measures, which have already been reported under the disclosure regulations, do not suggest that monopoly profits were received in the year to June 1994. Similar regulations are planned for gas distribution and transmission, but have yet to be promulgated, and no information is yet available.

The Implications Of The Privy Council Decision For The Energy Sector

The vertically-integrated natural monopoly industry structure also arises in the energy sector. For example, it arises in electricity and gas distribution and gas transmission as these are natural monopoly services and access to them is necessary to compete against their owners in upstream (production) and/or downstream (retailing[65]) markets.

The Implications of the Privy Council Decision

In principle, the Privy Council decision in the case of Telecom v Clear has direct application to these other industries with vertically-integrated natural monopoly structure. In other words, under the current New Zealand law, the incumbent monopoly facility owner can lawfully demand a price for access to the facility given by the BW rule.

In the light of the discussion above, this may raise concerns about the consequences for competition and economic efficiency in these industries.

However, there are various factors that reduce the risks arising from the use of the BW rule in energy markets:

  1. Competition in the telecommunications market typically involves partial duplication of, and interconnection with, the incumbent's network whereas competition in energy retailing does not usually involve asset duplication. Thus unlike the telecommunications market, the service that energy retailers seek from incumbent network owners will be similar to the service that the incumbent provides its own customers.
  2. Trust Power and Energy Brokers[66] have gained access to the distribution networks of other electricity companies without negotiating network access agreements (otherwise known as use-of-system agreements). This has been achieved by the customer or the entrant electricity retailer signing the incumbent's standard customer connection agreement and notifying the incumbent that the electricity would be purchased from an alternative source. By offering network access on prices based on the BW rule, the incumbent risks similar circumvention of network access agreements. Circumvention is not possible in the telecommunications market because a formal agreement for physical interconnection is required before network access is possible.
  3. Energy companies that apply the BW rule risk the same pricing approach being used if they seek access in the reverse situation. However, those energy retailers that do not own networks are not able to exercise this countervailing power.
  4. Access to telecommunications networks enables competitors to sell a wide range of value added services. The range of potential value added services is more limited in energy markets and, accordingly, there are less incentives for incumbents to inhibit network access in energy.
  5. The energy markets are (or will be, in the case of the gas market) subject to significantly more comprehensive information disclosure requirements than telecommunications.[67] Amongst other things, information to be disclosed by companies includes:
    1. Separate audited financial statements, along with cost transfers, and allocation methodologies, where network companies undertake competitive and natural monopoly services. This will help identify anticompetitive behaviour (e.g., leveraging potentially competitive services off natural monopoly services).
    2. Charges for line services, along with the methodology for their calculation. This will help promote competition by facilitating a determination of the (competitive) energy component of bills.
    3. Performance measures, including on financial and efficiency results. This will help, inter alia, identify the existence of monopoly profit.

Summary

A key feature of the 'light-handed' regulatory regime was the possibility of further regulation should the need arise. Several years experience with the regulatory regime in telecommunications, although not producing conclusive evidence that the existing regime has failed, has given rise to a few concerns. The potential exists for the same concerns to arise in the electricity and gas industries.

The first concern is that (i) the large amount of uncertainty in the current regime, (ii) the incentive of the monopolist to exploit that uncertainty, and (iii) the time taken by the courts to resolve that uncertainty, might lead to unacceptable delays before competition is able to emerge. Until that time New Zealand telecommunications users are denied the benefits of competition.[68]

The second concern is that the BW rule may not be appropriate for pricing access to natural monopoly facilities. In the simplest contexts, the BW rule may help achieve the goal of productive efficiency by preventing inefficient entry. However, concern about inefficient entry may be overstated. 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. More importantly, the BW rule does not achieve other efficiency goals such as the goal of allocative efficiency, leaving a risk of continuing monopoly profits.

Lastly, experience with negotiations in telecommunications has highlighted the particular uncertainty and therefore the difficulties of negotiations surrounding the handling of a social obligation such as the Kiwi Share. Under the BW rule, the costs of a social obligation such as the Kiwi Share can be fully recovered without the need for explicit estimation of the magnitude of those costs. If, as a result of the concerns raised here the BW rule is reviewed, a consequent issue is the appropriate handling of the Kiwi Share costs.

It should be emphasised that this section has merely raised concerns. It has not stated that the existing regulatory policy towards vertically-integrated natural monopoly industries is in need of change. The Government has not yet reached the view that some other alternative policy is preferable. To come to such a view requires a careful consideration of the set of options and the evaluation of those options in the light of the Government's objectives.

Part II of this document sets out particular alternatives to the current regulatory policy and seeks consultees' views on these alternatives in the light of the Government's objectives.


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