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The timeframe available does not permit a "full blown" assessment of the competitive impacts of a mandatory biofuels target in the transport fuels industry. There are two basic issues concerning competition. The first is whether the structure of the industry would have implications for competitive behaviour? That is:

• Could a monopoly situation of a single provider of blending services result from a mandatory biofuels policy?
• What is the prospect of collusion between the incumbents?

The second issue is the extent to which the benefits of competition accrue to those outside of the country? In other words do the existing conditions permit or encourage suppliers to make overseas sales, where prices may be higher?

All of these aspects are concerned with the (negative) effect on consumer welfare, either from anti-competitive behaviour, or from harm in the form of higher prices and/or reduced supply as a result of overseas opportunities removing the focus from the domestic market. These issues will be looked at separately below, with a particular focus on the first issue. This discussion draws heavily on a study by Pickford and Wheeler (2001) which covers issues such as industry structure, market structure, and barriers to entry, oligopolistic pricing, collusion, new entry and non-price competition in the oil industry.

9.1 Industry Structure

Figure 11 below is a stylised depiction of the vertical structure of the oil industry used by Pickford and Wheeler (2001) to assess the effects of deregulation of the petrol industry in 1988.²⁸ There is a relatively high level of vertical integration in the industry. The four major oil companies are significant shareholders and customers in the refinery company. Finished product is distributed in roughly equal proportions either through the Wiri pipeline or coastal tankers and road. Despite the involvement of BP, Caltex, Mobil and Shell, the product only becomes differentiated by company at the point where the retail delivery trucks are loaded and company-specific additives are added.

The four major companies, while being the major wholesalers and retailers of refined products, also own most of the bulk storage facilities, as well as owning or contracting with most of the retail outlets. Pickford and Wheeler (2001) note that not all four majors are represented at all of the ports, and "hosting" arrangements involving leasing capacity from the others are used when one of the wholesalers exceeds its own capacity or has no capacity. There are obvious efficiencies here, given the scale economies inherent in storage, however, such mutual co-operation benefits each of the incumbents, but might hinder an entrant if it were to be denied access on similar terms. Duncan and Copeland (2004) claim that: "[the] most likely location for ethanol to be blended into petrol will be at the principal storage depots of the oil companies" and

"[the] New Zealand oil products storage and distribution network has little or no surplus storage capacity and locations where blending occurs will require additional storage facilities and equipment for blending ethanol into the petrol base stock" (p.14).

Figure 11: Structure of the New Zealand Oil Industry (Excluding Exploration)

Source: Pickford and Wheeler, 2001

9.2 Market Structure

Miller (1989) identified inherent conditions that were thought likely to cause oligopolistic interdependence between the wholesalers: the few sellers; a consumer view of a homogeneous and non-complex product; transactions between sellers and buyers being frequent, stable, and numerous (aiding price monitoring by rivals); an inelastic demand (making collusion potentially more profitable); and a history of cooperation between the companies (because of regulation and joint activities).

A key characteristic of petrol is its technical homogeneity. Stripped of its brand, buyers would not be able to distinguish the offering of one supplier from that of another. Better informed buyers are also aware that all domestically produced petrol comes from the one refinery, albeit that it is mixed to varying degrees with imported petrol. Hence, not surprisingly, buyers seem to treat each brand as being a very close substitute with all other brands, and hence typically will buy from the lowest-priced option. This suggests that the cross-price elasticities of demand between brands will be very high, meaning that a small rise in one company's price will result in a large fall in sales as consumers switch to other brands, and vice versa. All this is consistent with the observation that prices of brands are very uniform, if not identical-down to one-tenth of a cent per litre-across a particular locality. This is often seen as evidence of collusive behaviour.

There are some particular features of the oil industry which further raise suspicions about possible collusion. These are the horizontal arrangements between the companies themselves, and the vertical arrangements between the companies and many of their dealers. As discussed above, the former include the Marsden Point refinery, the Wiri pipeline, the Wiri terminal, and the coastal tankers, all of which are directly owned or controlled by the four majors, together with the "hosting" and "borrow and loan" arrangements between them. ACIL (1997, pp. 29-31) argued that such arrangements are efficiency enhancing, partly because they yield economies of scale, particularly with respect to the refinery, and partly because they allow all four companies to compete over nationwide networks. They are also a feature of the oil industry overseas. On the other hand, it could also be that such joint activities provide opportunities for company representatives to meet and to develop understandings which could soften the competition between their companies.

Vertical arrangements, in terms of the supply arrangements between the oil companies as wholesalers and their retail dealers, may be more difficult to justify on efficiency grounds. According to ACIL, these typically include such restrictive provisions as the following:

• lengthy terms and termination clauses (five years and 6-12 months respectively);
• the supplier having first right of refusal to purchase the site on termination;
• exclusive dealing (solus) arrangements; and
• equipment to be owned and installed by the supplier. However, this length of lease may, for the supplier, both facilitate planning (through establishing a stable demand base) and allow sufficient time to amortise the costs incurred in installing tanks, pumps and signage, while giving the retailer security of supply over its principal product (Scott, 1997, pp. 20-21).

The Commerce Commission has successfully prosecuted one or more of the oil companies under the Commerce Act in two separate collusion cases, though both were what might be termed non-standard pricing issues. It is difficult to prove overt collusion, unless one of the parties involved spills the beans. The "leader-follower" pattern of parallel price changes could be seen as a form of tacit collusion, but it is difficult to see how else price changes needed to reflect changes in raw material costs could be introduced, in a market characterized by a homogeneous product and oligopolistic interdependence between firms.

However, it is possible that this practice could give rise to an upward bias to prices if one company were to become the recognized price leader, and were able to gain the compliance of the others through signaling intended price changes in advance of their implementation (Pickford and Wheeler, 2001). The increase in pump prices as a result of biofuel blending requirements would be scrutinized by the Commerce Commission, motoring organizations, the press and the public at large, and this scrutiny would tend to limit the opportunities for (overt) collusion by the oil companies.

9.3 Entry

The petrol market in New Zealand has been characterised as one in which there has been relatively little entry following deregulation. Depending on which side is expressing their views it may be because the profits are too low as a result of existing competition and "high" margins might indicate "high" distribution and servicing costs rather than "high" profits, or it could be due to entry barriers.

Considering ease of entry is of interest for two reasons. First, it allows an assessment of the "pressure" on incumbents to act competitively, and second, it provides context for considering whether a single, dominant player is likely to enter the market for production and supply of biofuels. It is important to keep in mind that it is not actual entry that is a major constraining force on anti-competitive behaviour (though the entry of Gull and Challenge in 1998/99 coincided with a period of price-cutting). What matters is the threat of, or the potential for, other parties to enter.

Pickford and Wheeler (200, p.33) suggest entry barriers may arise in a number of ways:

• entry may require a substantial investment in sunk costs (including initial business planning and organisation, promotion, and specialised equipment and facilities) which can not be recouped upon exit, together with direct exit costs
• because of environmental clean-up costs. By adding to the "down-side" risk, these may deter entry in the first place;
• an entrant may face a higher cost of capital because it lacks the track record of the incumbent, and hence entails a higher risk;
• the incumbent may enjoy a "first mover" advantage of lower costs from being first on the "learning curve", or of superior product differentiation from being able to establish its brand before others appeared;
• size may allow economies of scale in brand promotion and maintenance;
• the incumbent may credibly be able to threaten potential entrants with strategic forms of behaviour, which would make entry less profitable (especially where sunk costs are a significant component of entry); and
• entry may involve a scale of operations which would be hard to sustain by the share of the market likely to be gained (there are substantial scale economies in bulk shipping and, to a lesser extent, with terminal storage and retail outlet operation).

The critical considerations for an entrant are the post-entry price, and its unit cost given its likely market share, both of which have to be assessed in the context of the changed structure of the market. A study by ACIL (1997) looking into entry barriers in the downstream oil industry, found as follows: "No permanent or long run cost advantages to incumbents were identified and therefore the conclusion can be drawn that there are no barriers to entry." (ACIL, p.108)

However, it conceded that a new entrant could "initially experience a small cost disadvantage" because of the "time to achieve the intended scale of operations." Scott (1997, cited in Pickford and Wheeler (2001)) reached a similar conclusion: "At most, the 'problem' seems to be that, in order for a potential entrant to avoid significant cost penalties and risks, new entry must occur at a scale which is large relative to the overall size of the market." However, he recognised the potential pitfalls associated with entry:

A rational new entrant would have to make complex commercial calculations in order to choose the scale of entry, the distribution of wholesale and retail outlets, internal transport and take measures to offset a range of risks. At the wholesale end there exist potential disruptions to supply and strong economies of scale and therefore 'lumpiness' in the physical size of various facilities. At the retail end there are the possibilities of disrupted internal transport and variations in demand which might overwhelm normal storage facilities. The relationship between the optimal economic scale of transport and storage facilities and the price elasticities of demand for the product need careful balancing also. This industry has strong economies of scale in several places in the chain and a new entrant would have to set up their system in such a way as to take advantage of them in order to be competitive.

Scott (1997, p. 27)

These arguments apply to entry into the downstream oil industry. This is due to an acknowledgement that it would be impractical for a new entrant to build its own refinery, given that the market is too small to allow the Marsden Point refinery to exploit all of the economies inherent in refining technology. It is suggested that the minimum efficient scale for a new refinery is about twice the current size of the Marsden Point refinery (ACIL, 1997, p.103). The principles of the arguments apply to the situation of a potential new entrant considering blending opportunities in terms of ethanol, or biodiesel. While it appears that there are no barriers to entry, the sunk costs (which have largely already been experienced by the incumbents), degree of vertical integration and shared facilities arrangements enjoyed by the incumbents may act as significant disincentives to invest.

While a new entrant could be encouraged to incur capacity costs to enter in order to export the bulk of its biofuel output, there is considerable doubt as to whether New Zealand enjoys a comparative advantage in biofuel blending.

9.4 Oil Company Views on Competition

As part of an assessment of the efficacy of implementing a regional petrol tax, the Auckland City Council commissioned a study by the Law and Economics Consulting Group (LECG). As part of that work, the views of oil companies on the competitive environment were sought. They indicate that the competitive environment has changed significantly since the mid 90's:

• Competition between oil companies is now far stronger than ever before, with huge pressure on profit margins. This is partly due to the entry of new, independent, low-cost operators into the market in recent years. Prices are more volatile as a result; with one oil company estimating that petrol prices may now be changing as often as 50-60 times per quarter, whereas around 1996, petrol prices often remained stable for two or more quarters at a time.
• Oil companies are very aware of each other's price movements in all regions and are also very aware of external price signals. It is estimated that they can react to price signals from other companies within 45 minutes. This makes it almost impossible for any company to follow a particular policy without the others noticing it and acting accordingly.
• There is now significant competition between fuel retailers in one region with those in other regions, and consumers are generally more aware and better informed of fuel prices and the differential between regions.
• Oil companies are extremely sensitive about perceptions of price collusion and at least one company indicated that their awareness of this issue has resulted in them accepting prohibitive corporate guidelines about consultation or even attending industry forums where competitors may be present.
• The presence of low cost, independent operators in urban areas, specifically in Auckland, provides a point of reference for fuel prices that did not exist in the past.

These comments provide a backdrop against which we can place the observations around pricing and the presence of collusion. The addition of Gull and Challenge no doubt intensified the competitive nature of the market, and saw increases in non-price competition as well.

9.5 Summary

We have briefly traversed the industry and market structure for oil in New Zealand. This was thought a useful reference point for considering competition issues in the fuels industry associated with a mandatory biofuels target. We saw that while there was no apparent evidence or history of overt collusion, it is in fact very difficult to prove a case of this nature, unless one of the parties involved confesses. Thus, while there may always be suspicions of collusive behaviour, some aspects of the industry mean that this suspicion is unavoidable and will continue.

On balance, the prospect of the four majors engaging in collusive behaviour that sees prices above competitive levels following mandatory transport biofuels implementation seems possible, but remote. Indeed, Duncan and Copeland (2004) posit that with the degree of shared facilities and interdependence within the New Zealand market, some kind of co-ordination of industry responses is likely. They go on to say that "… there may well be a need for an authorisation from the Commerce Commission, as per the Commerce Act, to enable liaison between the companies" (p.47).

There is some debate as to whether barriers to entry are more apparent than real. While entry costs may be considered high by some, they are not necessarily entry barriers. Entry is never costless, and new entrants incur costs in setting up that incumbents also incurred at the time they entered (Pickford and Wheeler, 2001).

The degree of set-up costs, economies of scale in storage, the relative dearth of entry since deregulation and the established arrangements of the incumbents also mean that the prospect of a new player entering the market for biofuel blending and establishing dominance seems remote. Similarly, there is little reason to believe that New Zealand has a comparative advantage in the production of biofuels such that a player would take advantage of any support offered in terms of introducing biofuels in New Zealand to exploit export opportunities (to the detriment of New Zealand consumers).

In sum, our cursory assessment indicates that possible impacts of the introduction of mandatory biofuels targets on the competitive environment of the fuels industry are likely to be minimal, and certainly not outside those already considered by the Commerce Commission, the industry, the public and other interested parties.