The Pros and Cons of Antitrust in Deregulated Markets Konkurrensverket Swedish Competition Authority Konkurrensverket SE-103 85 STOCKHOLM tel +46 8 700 16 00 fax +46 8 24 55 43 [email protected] © 2004 Konkurrensverket/ Swedish Competition Authority individual chapters © 2004 The contributors ISBN-91-88566-34-X Printed in Sweden by AB Danagårds Grafiska Ödeshög 2004 Preface “The Pros and Cons of Antitrust in Deregulated Markets” is the third in the Swedish Competition Authority’s Pros and Cons series following last year’s “The Pros and Cons of Low Prices” and “The Pros and Cons of Merger Control” from 2002. The book will be officially released on November 12, at a seminar in Stockholm where the authors will present their work and senior officials from competition authorities around the world will act as discussants. I would like to express my gratitude to all the authors who have contributed; without you we would not have a book at all. At the Swedish Competition Authority, our chief economist Mats Bergman has been the editor and Arvid Nilsson has managed the project; they both deserve due credit. Stockholm, September 2004 Claes Norgren Director-General Table of contents The contributors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5 1. Introduction By Mats Bergman . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .7 2. Co-ordinating regulation and competition law- ex ante and ex post By Martin Cave and Peter Crowther . . . . . . . . . . . . . . .11 3. Consumers and antitrust in British deregulated energy markets By Michael Harker and Catherine Waddams Price . . . .29 4. From state monopoly to the “investment ladder”: competition policy and the NRF By Alison Oldale and A. Jorge Padilla . . . . . . . . . . . . .51 5. Managing unilateral market power in electricity By Frank A. Wolak . . . . . . . . . . . . . . . . . . . . . . . . . . . .78 5 The contributors Martin Cave is a Professor and Director of the Centre for Management under Regulation at Warwick Business School, University of Warwick, UK. He is co-author of Understanding Regulation (1999), co-editor of the Handbook of Telecommunication Economics (2002) and author of the Review of Radio Spectrum Management (2002). He is advisor to Ofcom and the Postal Services Commission and a non-executive advisory director of OFWAT. Peter Crowtheris an English qualified solicitor at LeBoeuf, Lamb, Greene & MacRae, and is also admitted to the Brussels Bar. Peter received his PhD from Copenhagen Business School, after completing his Masters in Law and Economics at Oxford University. Peter has advised on the application of competition law and related regulatory matters across a wide range of industries including retail, telecommunications, insurance, upstream oil and gas, energy distribution and supply, banking and capital markets, commercial finance, railways, sea transport, and motorsport. Prior to entering private practice Peter was a lecturer in EC law and Competition law. Peter has published widely and is a Section Author of Butterworths Competition Law. Michael Harker is a member of the ESRC Centre for Competition Policy and a lecturer in Norwich Law School at the University of East Anglia. His main research interests are in the fields of UK utility regulation (which was the subject of his doctoral thesis) and competition law. In the coming years he will be participating (in collaboration with fellow members of the Centre) on research projects on consumer representation and remedies in mergers cases. In addition to this, he also pursues research interests in public law, particularly public law litigation concerning regulation. Catherine Waddams Price is founding Director of the ESRC Centre for Competition Policy and Professor in the School of Management at the University of East Anglia, UK. Her main research interests are in the reform of utility industries, the introduction of competition into previously monopolised markets, and the effect of these changes on income distribution, both in developed and developing countries. She has advised the World Banks and regulatory bodies and government in the UK, Brazil, Argentina and the Netherlands and is a member of the UK Competition Commission. Alison Oldale is Principal at LECG. Dr. Oldale specialises in using economic theory and empirical techniques to analyse the competitive impact of mergers and joint ventures, company conduct and agreements between companies. Dr. Oldale has advised companies in a wide range of industries, including fast moving consumer products, financial markets, transport, industrial goods and she has particular expertise in analysing telecommunications markets. Her merger work has involved providing advice and expert reports during investigations before the MTF and various national authorities. She has advised companies during competition law infringement cases involving various pricing abuses, as well as both vertical and horizontal agreements. In the telecommunications sector Dr. 6 Oldale has offered advice and submitted reports during consultations and proceedings involving competition authorities and telecommunications regulators. Dr. Oldale was educated at Cambridge University and the London School of Economics where she earned a PhD in Economics. She published in the European Competition Law Review and the Journal of Economic Theory and has presented papers at both academic and industry conferences. Atilano Jorge Padillais Managing Director at LECG. Jorge belongs to the Competition Policy group and is based in Madrid. He joined LECG in March 2004. During his years in consultancy Jorge has advised clients on a variety of competition policy and intellectual property issues, covering a wide range of industries, including retail electricity, media, telecommunications, entertainment and technology. Dr. Padilla earned M. Phil and D. Phil degrees in Economics from the University of Oxford. He is a Research Fellow of the Centre for Economic Policy Research (CEPR, London), and a member of the Steering Committees of the Nyenrode Institute for Competition (The Netherlands) and the Association for Competition Economist (ACE). Jorge has written several papers on competition policy and industrial organization in the Antitrust Bulletin, the International Journal of Industrial Organization, the Journal of Economics and Management Strategy, Journal of Economic Theory, the RAND Journal of Economics, the European Competition Law Review and World Competition. He is also a regular speaker at competition policy conference in Europe and the United States. Frank Wolakis a Professor of Economics at Stanford University. His fields of research are industrial organization and econometric analysis. He specializes in the study of privatization, competition and regulation in network industries such as electricity, telecommunications, water supply, natural gas and postal delivery services. He is a Research Associate of the National Bureau of Economic Research and a Visiting Researcher at the University of California Energy Institute. Wolak is also the Chairman of the Market Surveillance Committee for the Independent System Operator of the California Electricity Supply Industry. He has testified several times at the Federal Energy Regulatory Commission (FERC), and at various Committees of the US Senate and House of Representatives on issues relating to market monitoring and market power in electricity markets. 7 1. Introduction This volume, “The Pros and Cons of Antitrust in Deregulated Markets”, is about the intersection of competition law and sector-specific regulation. When is competition law sufficient and when is sector-specific legislation necessary? What are the advantages of relying only on competition law? And which are the drawbacks? Although the authors mainly discuss energy and telecom markets, the principles they base their discussions on are of a general nature. They all subscribe to the view that competition is desirable and that markets should be liberalised, rather than monopolised. Despite this, they hold different views on the necessity of complementing competition law with sector- specific regulation. According to some, competition law is sufficient in deregulated markets; according to others, the special properties of certain markets makes it necessary to introduce specific regulatory measures. In the first chapter, Martin Cave and Peter Crowther discusses the relationship between sector-specific regulation and competition law, with a particular focus on the distinction between ex anteand ex postintervention and the new EU regulation concerning electronic communication. The authors begin by observing that, in principle, a main difference between competition law and sector-specific law is that Articles 81 and 82 are applied ex post, while sector-specific law is applied ex ante. In practice, however, this distinction is less clear-cut than one would think. The EU Commission, in addressing violations of Article 81 and 82, has many times negotiated agreements with the parties or the concerned government(s) and reached agreements which have in effect amounted to an ex ante regulation of the industry. For example, before France Telecom, Deutsche Telecom and Sprint were allowed to form the joint venture Global One,the Commission reached an agreement with the French and the German governments to liberalise the telecom markets of the two countries. In addition, the incumbent telecom operators had to consent to a number of detailed conditions and obligations akin to those typically placed on regulated companies, including third-party access. Another technique used by the Commission is to codify permissible behaviour in so-called Communications. Although formally and legally non-binding, these are ex ante recommendations on how to behave in order not to risk being challenged for violating the antitrust rules. In this way, the EU Commission has been able to use competition law to actively enhance and improve regulation that could be regarded as defective. Often, these initiatives have been followed by subsequent regulatory reform and, Cave and Crowther argue, the Commission’s ability to devise innovative solutions has been augmented by the experience it has gained in antitrust cases. The authors also note that the Commission’s powers in this respect were extended in Regulation 1/2003 (the “modernisation”). The main conclusions of the chapter appear to be that competition law and regulation are complementary and that there is no “bright line” between the two. The authors point to some potential problems with using competition law to put regulation in place. For example, there is a risk that such regulation will be ad hoc, whereas full-blow regulatory reform could be based on a larger base of knowledge and experience. On balance, however, the authors appear to be in favour of the current situation, where 8 competition law complements sector-specific regulation, in particular in areas where desirable reform is stalled for political reasons. The second article in the volume, by Michael Harker and Catherine Waddams Price, focus on gas and electricity retailing in the UK, outlining recent development and the regulatory strategies employed. When monopoly and price regulation gave way to competition and competition law, it was expected that the incumbents would have to face a choice between high market shares or premium prices. However, more than five years after liberalisation, the gas incumbent and the regional electricity incumbents are still able to maintain approximately 60 per cent of their respective “home” markets, despite selling at a considerable premium over the entrants. Harker and Waddams Price report that, despite this, the regulator is still confident that market-share erosion will lead to a well- functioning market. In the UK, the energy regulator, Ofgem, has concurrent power with the competition authority, OFT, to apply the national correspondences of Articles 81 and 82 in energy markets. Harker and Waddams Price argue that Ofgem has been hesitant to challenge behaviour by the incumbents that possibly could have been seen as examples of abuse of dominance. For example, London Electricity used win-back offers to induce consumers to switch back from entrant suppliers and British Gas offered discounts to customers that signed direct debit contracts. These types of targeted discounts, or instances of price discrimination, reduce the incumbents’ cost of maintaining a price premium, since many of the customers that would have switched to another supplier will be able to use the offers to obtain better prices from the incumbents. In addition, fixed-term contracts have been used to raise consumers’ switching costs. The authors suggest that the regulators reluctance to challenge price discrimination and predatory pricing could have the paradoxical result that the regulator ends up protecting the energy incumbents from competition law challenges that otherwise would have come from the competition authorities, in the same vain as industry regulators often have been accused of siding with the industry, rather than with the consumers. They are also somewhat pessimistic as to the effect of “consumer voice”, in the form of consumer organizations and government bodies. Since re-regulation is not an attractive alternative, the main avenues towards better-functioning energy retail markets appear to be active consumers and an active and innovative application of general competition law. In the third article, Alison Oldale and Jorge Padilla argue with force that the current regulatory situation in the European telecom market is an unfortunate one. The begin by a quick tour through the history of telecom regulation since the Second World War, but focus on the so-called New Regulatory Framework (NRF) for telecom, which was enacted in July 2003. The NRF has two main objectives: achieving regulatory harmonization within the Union and promoting the development of competition, so that regulation can give way to general competition rules. The latter objective is to be achieved primarily through the promotion of facilities-based competition. In addition, sound principles from competition law, such as methods for market delineation and for evaluating market dominance, have been introduced into the regulation for electronic communication. However, Oldale and Padilla argue, the talk about stimulating facilities-based competition is just talk. In practice, the NRF favours access- based entry, market fragmentation and micro-management of the telecom 9 industry, despite it paying lip-service to facilities-based entry and the principles of competition law, including a preference for relying on market- based solutions as far as possible. Oldale and Padilla then address what they call “the Investment Ladder”. This can be seen as an intellectual attempt to reconcile what can be perceived as a grave inconsistency in the NRF: that while one of its goals is to promote un-regulated facilities-based competition, in practice, it goes far in requiring access to incumbents’ infrastructure. According to the “investment-ladder theory”, access is necessary in order to achieve the first stage of competition: access-based competition. Only when such competition has given the entrants a foothold can these new firms be expected to invest in infrastructure. The regulator’s task is then to slowly lift the incumbents’ obligations, so as to make it more profitable for the entrants to build their own infrastructure. Eventually, as the dominant’s market power and its control of bottleneck facilities has eroded far enough, sector-specific regulation can be dismantled completely. The authors object strongly to this theory, on the grounds that such micro-management of an industry is beyond the abilities of the regulator and that this type of policy will lead to a fragmentation of the industry. The result will be a huge number of firms that will not be willing to undertake major investments. The authors conclusion is that general competition law is sufficient to ensure healthy competition, while interventionistic regulation, such as the NRF, will be detrimental to the long-run development of the market. Frank Wolak focus on the electricity market and, in contrast to the other contributions, draws mainly on the US experience. In a sense, his main conclusion is exactly the opposite of that of the previous article. He argues that antitrust law will be ineffective as an instrument against the exertion of unilateral market power in the electricity market and that, therefore, antitrust laws must be complemented with sector-specific legislation. The underlying reasons are the special properties of the electricity market: supply must equal demand at every instant and at every location, electricity is very costly to store, capacity constraints are absolute, demand is inelastic, production is large-scale and the industry is concentrated. Because of these special properties, power-generating companies will often be in a position to exert unilateralmarket power, possibly resulting in prices far above the competitive level. Since antitrust law (in particular US antitrust law) is mainly concerned with coordinatedactions (and mergers), it will typically not be able to address these types of concern. A possible response would then be to regulate prices, but that will lead to well-known problems. Another alternative would be to prohibit “market manipulation”; an alternative that has been tried in the US and elsewhere. The inherent problem with such regulation is that it seeks to curb the firms’ natural tendency to maximize profit. But at which point does profit- maximizing behaviour become illegal? Wolak’s proposed solution is the implementation of a sector-specific regulation with three main ingredients. First, a requirement that electricity- generating firms provide extensive information on their market activities, including outages, to the regulator and to the public. Second, a set of well- defined rules for market behaviour, designed so as to support a well- functioning market and backed by penalties and sanctions with a sufficient preventive effect. Third, and perhaps most controversially, a “local market power mitigating mechanism”. According to this mechanism, such behaviour that is detrimental to system reliability and market efficiency and 10 where the behaviour is intentional, should be considered illegal. In order to establish the effect of a certain type of behaviour, a thorough analysis is necessary. When this is done, the regulator will announce its view on the matter. Only if the firm persists, despite being given a warning, will a particular behaviour be considered as intentional. Wolak points to two possible drawbacks with the proposed scheme. First, the regulator may yield to political pressure, e.g., by opportunistically exploiting the sunk-cost nature of power-plant investments. Secondly, extensive information dissemination in combination with a system that involves negotiations may result in price coordination. However, for the reasons given above, he arrives at the conclusion that the general antitrust rules are insufficient to deal with the particular problems of the electricity market and that, consequently, sector-specific regulation is necessary. Wolak ends the article by observing that “industry-specific regulators need not fear for their jobs, because there is much for them to do in the future”. Collectively, the four authors are able to draw on a number of real- world experiments in market designs as well as on their own contributions to the literature on regulated and unregulated markets. The papers in this volume demonstrate that it is not easy to evaluate the pros and cons of regulation, deregulation and competition policy. On the other hand, it is possible to make costly regulatory mistakes. For this reason, it is important to develop the regulatory framework so that effective competition, efficiency and consumer welfare is promoted as far as possible. This volume will help regulators to continue to improve their understanding of how regulation works – and when it does not work. Mats Bergman Editor