2004 Sept Integration AFR-VI-2004

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Integration sometimes stacksupSep 06

Joshua Gans

In a recent speech, the chairman of the Australian Competition and

Consumer Commission, Graeme Samuel, raised concerns about the levelof vertical integration in telecommunications.

Indeed, he went so far as to suggest that competition intelecommunications would be greatly improved if Telstra were to divest itscable network - a principal means of delivering cable television andbroadband internet services.

This follows the ACCC's high-profile attempt to prevent retailer AGLacquiring a stake in a generator, Loy Yang A.

The Federal Court found against the ACCC. Nonetheless, ACCCcommissioner Ed Willett has reiterated his concerns regarding increasing

levels of integration in the electricity sector and called for more powers toregulate the structure of that industry.

Given this heightened level of awareness regarding vertical integration, itappears timely to consider the basic economic forces at work. Put simply,unlike price fixing and collusion, and more so than mergers betweencompetitors, vertical integration has always been a difficult call forregulators.

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It is important torecognise thatany structuralchange that

reduces the costs of bringing a product to market is likely to make a firm amore aggressive competitor and yield consumer benefits.

For us to consider whether vertical integration could achieve suchefficiencies we have to ask the alternative: why can't separate entities dothe same?

Consider a situation when a retailer could make some key investmentsthat improve demand for a supplier's product. If the supplier owned theretailer (that is, there was integration), it could simply make the investmentand bear the relevant costs. Without integration, the retailer must bear

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investment costs with some of the benefits accruing to the supplier.Absent any other arrangement, this might deter some productiveinvestments. However, in many situations, a contract between the twoparties could secure the necessary payments to ensure the investment

went ahead. So if the relevant actions are contractible, then a lack ofintegration is not an impediment to efficiency and integration doesn'tenhance it.

But what if the investment involves effort and other decisions (for example,quality control, creativity and so on) that can't be easily put into a contract?

By owning another set of assets in the vertical production chain, there canbe a more favourable aligning of incentives. This might include incentiveswith respect to pricing; whereas a separate upstream firm might charge

retailers a mark-up, if they were integrated this could be avoided. In theend, costs are lower and efficiencies are achieved.

What this means is that assessing the competitive impact of a verticalmerger is going to be difficult if there are lots of key decisions andinvestments that are hard to contract over. But what about when that isn'tthe case? After all, it is arguable that in electricity, retailers and generatorsperform very distinct functions and that the cable and copper networkoperations have little to do with one another.

The simple anti-competitive story regarding vertical integration is that anintegrated firm may choose to foreclose on rivals (raising prices orexcluding them), thereby impeding competition and leading to consumerharm. A bottleneck monopolist has the ability to foreclose on rivals. Bydenying them supply or access to key markets, their business can becurtailed.

But even in this situation, the incentive may not be there. An independentretailer may have, say, a valuable brand and the monopolist may be betteroff dealing with them than relying on internal selling. So it is the monopoly

that is the problem rather than its integrated status.

Moreover, cutting off supply is only effective if a firm has no other supplysources. When there is no monopoly segment or there is the possibility ofimports from other regions, any attempt at foreclosure merely results inlost sales without any competitive shielding for its own retail units.

It is on this question of alternative sources of supply that the ACCC'sconcerns in electricity and telecommunications appear to be highly validfrom an economic perspective.

In the case of telecommunications, there are potentially insufficientalternative supply sources. Telstra owns both major telecommunications

networks in copper and cable. Separation of the two would provideincentives for new providers that use these networks to come into the

market, giving them options as to how they enter and who they deal with.This would lead to the evolution of a more competitive and innovativetelecommunications industry.

For electricity, the case is more subtle. The whole premise of separatinggeneration from distribution was that the latter could operate through aneasily accessible spot market. Nonetheless, generators and retailers both

need hedge contracts to manage risk and compete effectively.

In the absence of integration, those contracts are freely available forestablished firms and potential entrants alike. But if a retailer buys agenerator, their risks are naturally hedged and the need to trade explicit

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contracts goes away. When large players merge, the liquidity of thecontract market can be substantially diminished.

Herein lies the ACCC's concern. In the absence of another productivereason, one by one, retailers and generators could hook up. The contractmarket would become thinner and thinner, until - as AGL itself has found

in New Zealand - non-integrated retailers and generators could not obtainsufficient hedge cover to manage their risks.Then you have to beintegrated in both to have a chance and the long-term prospects forincreasing competition become bleak.

The problem is that our Trade Practices Act may not be equipped to dealwith these problems. In contrast with the US, divestiture of long-standingintegrated firms is not a solution our courts rely upon. Moreover, creepingintegration can be difficult to assess if each acquisition is analysed in

isolation. We need to answer calls to consider amendments to ourcompetition laws to deal with this.

Nevertheless, there are risks associated with blanket approaches tovertical integration. Unlike other restrictive practices, vertical integration isnot the root of all evil and is not, in itself, a source of power. However, atthe moment, the ACCC has not issued any guidelines regarding whattypes of vertical mergers would trigger competition concerns. Business is

still operating in a vacuum on this topic, unable to forecast when aregulatory barrier may be raised. On this score at least, providing morecertainty is within the control of our competition regulator.

q Joshua Gans is professor of management (information economics) atMelbourne Business School, University of Melbourne. For more writingson this topic see http://www.economics.com.au.

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