News
Market power and the power market
First published NZLawyer, 26 June 2009.
Last month the Commerce Commission finished its three year investigation into whether any wholesale or retail electricity companies had breached the Commerce Act. The investigation evolved from complaints about high electricity prices, large company profits, a perceived low level of competitive activity and allegations of anti-competitive conduct.
The Commission's analysis (performed by Professor Wolak of Stanford University) suggested that "wholesale prices charged over the period 2001 to mid-2007 resulted in an extra $4.3 billion in earnings to all generators over those that they would have earned under competitive conditions". A number of highly respected commentators have levelled significant criticism at the basis on which this figure was assessed but a detailed analysis of that issue is beyond the scope of this article. However, even putting aside those criticisms, the Commission concluded that there was no evidence of conduct that breached the Commerce Act.
To the casual observer these conclusions must appear completely contradictory. How can the Commission conclude that generators have earned an extra $4 billion but not have acted anti-competitively? Isn't the Commerce Act there to prevent these sort of prices being charged?
The answer to that is yes...... and no.
The role of the Commerce Act
The Commerce Act's underlying rationale is to promote New Zealand's economic interests and economic efficiency and is premised on the belief that competition is the best way to achieve this. However, the distinction between outcome (economic efficiency) and the process to achieve it is important.
The Commerce Act itself recognises this distinction in its three distinct operative parts:
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Part II, which prohibits "restrictive trade practices" e.g. section 36 which prohibits a firm from taking advantage of substantial market power for anti-competitive purposes and section 27 and 30 which, among other things, prohibits firms entering into or giving effect to collusive arrangements that have an anti-competitive purpose or effect.
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Part III which contains New Zealand's merger laws; and
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Part IV which contains regulatory control provisions.
Parts II and III focus on protecting the process for ensuring there is true competition. Part IV is designed as a back-stop so that if competition does not deliver the desired outcome, the desired outcome can be imposed on a market via regulation.
The Commission's investigation was under Part II and asked: was the cause of the "extra profits" collusive conduct between firms, or individual firms with substantial market power seeking to prevent competition from occurring?
The role of profits in markets
Importantly, Part II does not prohibit firms earning a profit (sometimes called an economic rent). Profits play an important role in either providing the right signals for people to enter markets or the incentives for people to develop products which they hope will earn them above normal returns. The importance of profit in driving desirable investment in product innovation is the reason why patent protections exist for example.
Part II and Part III of the Commerce Act seek to ensure that there is nothing in place that would prevent or hinder a new firm entering a market or expanding in a market in an effort to earn some of the profits earned by existing participants. There may be a number of reasons why such a reduction in profits cannot occur:
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It might be because firms are engaging in restrictive trade practices, e.g., existing firms agree to deter new entry or maintain profits at a certain level by sharing markets or not competing as strongly as they otherwise would. This type of conduct is a Part II issue.
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Equally, entry and expansion may be hindered by matters entirely independent of the market participants, e.g., government policy decisions or the existence of an industry with natural monopoly characteristics. This could be a Part IV issue or alternatively, could require a different policy decision to alter the characteristics of the market as happened for example with the forced unbundling of Telecom's local loop.
Therefore sustainable profits could be a symptom of a Part II breach; however, they are not and cannot be conclusive of a Part II problem.
The Commission's decision
Essentially, the Commission's concluded that in a normal market the alleged "4.3 billion" in extra profits should have attracted new entry or caused the existing firms to expand so as to compete for these profits. But, the Commission also had to accept that the fact this did not occur was not the result of a Part II issue. It found no agreement between generators to pull their competitive punches. Nor had any of them acted to deter new entry. They had simply acted as any profit maximising firm would in the same circumstances.
Of course, one should not be lulled into believing that the Commission is convinced there isn't a problem with the effectiveness of Part II itself and the difficultly it faces in proving breaches of this Part in this and other cases will no doubt inform its current review of the scope of section 36.
Rather, the Commission's conclusions suggest the ability for the power companies to earn the alleged extra profits sustainably was due to the peculiar nature of electricity as a commodity, the difficulties in gaining new entry due to Resource Management Act constraints etc, and various issues associated with the way the market was designed by policy makers.
Dealing with those issues is a matter for policy makers not the Commerce Act. Indeed, when it granted authorisation for the rules which now form the basis of the market the Commission rightly said "The Commission does not have the mandate, nor the expertise, to be the market designer".
Questions of how market design can be improved and/or barriers to entry and expansion can be lowered and what weight should be given to Professor Wolak's analysis must now be grappled with by others and to that end, the Government's taskforce to review the operation of the electricity markets will be critical.
David Blacktop specialises in advising on competition and regulatory law.
