FINANCIAL INSTITUTIONSENERGYINFRASTRUCTURE, MINING AND COMMODITIESTRANSPORTTECHNOLOGY AND INNOVATIONPHARMACEUTICALS AND LIFE SCIENCESCompetition Policy in Smaller Economies

Balancing Regulation and Investment

Dr Martyn TaylorPartner

Pacific Finance & Investment ConferenceSuva, FijiMay 2013

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Overview

A. Importance of competition law and policy

B. Economic traits of smaller economies

C. Competition law in smaller economies

D. Lessons from Australia and New Zealand

E. Application to Pacific Island economies

Dr Martyn TaylorPartner

Norton Rose Sydney +61 2 9330 8056martyn.taylor@nortonrose.com

A. Importance of competition law and policy

Competition policy – why is it important ?

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• Competition policy is a core tenet of modern regulatory policy.

• Competition policy is any government policy that promotes competition in any part of the economy.

• The objective of competition policy is to ensure the efficient and fair operation of markets in order to maximise total economic welfare.

• Underlying philosophy:

• a market-based system is the optimal way for society’s scarce resources to be allocated between competing uses;

• greater competition will ensure greater efficiency and hence improved levels of total economic welfare.

• Competition policy is inherently deregulatory. It generally promotes the removal of excessive Government regulation in order to ensure that markets can operate freely.

Regulation is selectively targeted at market failures

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• Competition policy recognises that markets are imperfect; hence regulation is still necessary to correct instances of market failure.

• Competition policy promotes a principled approach to regulation:

• regulation is selective and seeks to correct the relevant market failure as directly as possible, hence minimising spillover effects;

• regulation is proportionate and informed by a cost-benefit analysis.

• Competition law is an instrument that gives effect to competition policy.

• Competition law regulates the obtaining and use of market power. Excessive market power can give rise to a key form of market failure:

• in more concentrated markets, firms may use their individual or collective market power to affect market processes;

• market power enables firms to raise prices and reduce output to maximise their profits at the expense of consumers.

Tripartite structure of modern competition law

Competition law

Single party conduct

Mergers and acquisitions

• Misuse of market power• Sectoral regulatory regimes

• Anti-competitive agreements • Collusion, cartels and price fixing

• Anti-competitive acquisitions

Key focus is on regulating ‘market power’

•Firms may already have unilateral market power, so certain of their conduct must be regulated.

•Alternatively, firms can co-ordinate their business activities to achieve market power (whether by agreement or by fully integrating their businesses by acquisition).

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Multi-party conduct

Vertical

Horizontal

• Restraints of trade• Exclusive dealing • Boycotts of suppliers/customers

Balancing regulation against investment

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• All markets are imperfect, so what regulatory role should the Government have? (This inherently depends on one’s political views)

• Regulation affects investment, both positively and negatively:

• market certainty and stability is important to investment, so certain fundamental laws are required (e.g., property rights);

• regulatory uncertainty is anathema to investment, given uncertainty increases risk and hence financing costs;

• excessive regulation can impose unnecessary costs that, in turn, deter investment due to reduced private sector returns.

• The key questions:

• in smaller economies, what should be the appropriate role of competition law?

• what balance should be adopted vis a vis investment?

B. Economic traits of smaller economies

What is a ‘smaller’ economy?

• The competitiveness of markets differs widely within every economy.

• However, smaller economies generally exhibit markets with a lower level of competitiveness than larger economies:

• this conclusion is empirically confirmed and supported by microeconomic theory;

• key factors of competitiveness in smaller economies include market size and the existence of import competition.

• Generally a ‘smaller’ economy is an economy that has markets that can only support a small number of competitors:

• Fiji with a population of 850,000 is small.

• New Zealand with a population of 4.2 million is also small.

• Australia has a population of 22 million, but its population is dispersed and isolated – hence could be regarded as small for some of Australia’s more concentrated sectors.

Competition issues facing smaller economies

• The ability of a market to support competition is determined by the structural features of the market itself:

• The minimum efficient scale (MES) is the smallest level of output for a firm that reduces/optimises its long-term average costs. MES reflects the realisation of economies of scale in production.

• If the MES is achieved at levels of output that are a substantial proportion of the market, there will be fewer competitors.

• In the absence of domestic competitors, smaller economies are more reliant on imports as a source of competition:

• For economies co-located to large markets, imports allow them to be regarded as part of the larger market.

• Market concentration is more likely in isolated smaller economies that have higher import costs, such as Fiji.

• Smaller economies also tend to be less diversified and hence are more reliant on a few key economic sectors.

Summary:

• MES will lead to more concentrated markets.

• Where economy is isolated, imports may not provide sufficient alternative competition.

Investment certainty in smaller economies

• Investments are heavily affected by cost and risk. Any NPV analysis will discount the net cash flows of an investment, adjusted for risk.

• In order to optimise investment in a regulatory context, it is necessary to:

• minimise the cost of regulation, typically by ensuring that it is no more burdensome than necessary to achieve the policy objectives;

• minimise regulatory risk, typically by ensuring that the law and regulatory decisions are transparent, predictable and high quality.

• A smaller economy tends to be subject to the following concerns:

• Because markets are more concentrated and the economy is more dependent on a few key sectors, domestic firms may have greater political influence over regulatory policy (leading to rent seeking).

• Domestic firms may have less ability to tolerate compliance costs.

• Regulators may have less resources.

• To the extent law requires interpretation, a sufficient body of case law may not exist to provide judicial guidance on interpretation.

Key issues for competition law and policy

• The different economic characteristics of smaller economies give rise to the following key issues for competition law and policy:

1. Should a smaller economy adopt different competition laws and policies than a larger economy?

2. How should a smaller and more isolated economy address the fact that it has naturally more concentrated and less competitive markets?

3. How should smaller economies regulate mergers and instances of co-ordinated activities, such as joint ventures?

4. How should smaller economies regulate anti-competitive conduct, particularly if market structures make such conduct more likely?

5. Should differences occur in enforcement and regulation?

6. What techniques should be used to reduce investment risk?

C. Competition law in smaller economies

Objectives and structure remain unchanged

• The general principles underlying competition law are unaffected by differences in the underlying markets subject to regulation:

• Competition law is generic in application, applying to all sectors of the economy, so is inherently based on ‘one size fits all’.

• The objectives of competition law are generally uniform across all economies, namely to promote economic efficiency. Some economies may also include incidental distributional considerations.

• The tripartite structure of competition law reflects international best practice in competition law. Again, there is no need to amend this structure for different economic conditions.

• So what is subject to change?

• Differences in substantive legal thresholds.

• Differences in the application of those legal thresholds.

• Differences in enforcement and prioritisation.

Tolerating greater market concentration

• A key trade-off for competition law occurs in a merger review context:

• By merging, firms realise synergies in production that reduce costs (i.e., increasing productive efficiency).

• By merging, firms also increase market power and can reduce output and increase prices (i.e., reducing allocative efficiency).

• Merger laws trade-off productive and allocative efficiency; as well as effects on dynamic efficiency (i.e., efficiency gains over time).

• As smaller economies achieve MES at higher market concentrations, arguably they should tolerate greater domestic market concentration:

• Competition law should be more sympathetic to the need for firms to increase scale in order to achieve efficiencies in output.

• High levels of concentration may be a ‘necessary evil’ in order to achieve greater productive efficiency in the domestic market.

• In those markets where imports provide an important source of competition, higher domestic market concentration can be tolerated.

Greater recognition of productive efficiencies

• Generally, any increases in co-ordination between firms have the ability to increase productive efficiency:

• Firms may enter into long-term supply contracts with the objective of increasing certainty and reducing the cost of production.

• Firms may enter into joint ventures (JV) to share critical resources and therefore benefit from economies of scale.

• In more concentrated markets, such co-ordination is more likely to lead to anti-competitive effects given that the relevant firms will have substantial market shares within the domestic market.

• Smaller economies should therefore ensure that the benefits and detriments of co-ordination are recognised in any competition analysis:

• Higher substantive thresholds for illegality may be appropriate, hence permitting greater co-ordination to occur.

• Defences may be appropriate, including for joint ventures.

• Public benefit authorisations may enable such analysis to occur.

Greater emphasis on regulating market conduct

• A more relaxed merger policy will tend to result in more concentrated markets and hence a greater risk of anti-competitive conduct:

• Moreover, arrangements between competitors are more likely to affect a greater proportion of the market and confer market power.

• Accordingly, the quid pro quo of a more relaxed merger policy should be a greater emphasis on regulating market conduct:

• Markets that are highly concentrated should be subjected to greater scrutiny, consistent with international best practice.

• Where anti-competitive agreements do not have productive efficiency benefits, they should be subject to enforcement.

• In very highly concentrated markets, sectoral competition regulation may also be appropriate:

• Price controls may be appropriate in instances of monopoly.

• Where monopolies are vertically-integrated and control infrastructure bottlenecks, access regulation may be required.

Promoting greater regulatory certainty

• Competition laws are not prescriptive and instead rely on the application of legal concepts to different factual scenarios, creating some uncertainty:

• A key means for smaller economies to enhance regulatory certainty is to provide guidance on the application of their competition laws.

• Guidelines also reduce compliance costs for firms by enabling the legality of conduct to be more easily ascertained.

• If international best practice approaches are followed, regulators can leverage case law from other jurisdictions and adopt similar approaches.

• The International Competition Network, for example, is an initiative that is seeking to ensure consistency in the regulation of anti-competitive conduct by regulators on a global basis.

• Rent seeking by domestic firms in concentrated markets can be addressed by ensuring that domestic regulation reflects key competition policy considerations:

• Where regulation is imposed, it should be most consistent with the promotion of competition by maximising the number of competitors.

D. Lessons from Australia and New Zealand

Merger thresholds in Australia

• Australia’s approach to the regulation of mergers has changed over time as the Australian economy has matured and diversified:

• From 1974, Australia applied a low ‘substantial lessening of competition’ (SLC) threshold for merger control.

• The threshold was raised to ‘acquisition of dominance’ in 1977, expressly to promote the development of economies of scale in Australian industry.

• In 1992, Australia migrated back to the SLC threshold (which applies today) on the basis that the economy was sufficiently mature for the lower threshold.

• From 1992 – 2008, Australia applied a ‘safe harbour’ in its merger guidelines, based on 40% market share and a four-firm concentration ratio of 75% (CR4).

• From 2008, Australia has now moved to a lower HHI concentration as used in more advanced economies (currently an HHI of 2000 when screening mergers).

• While Australia permits public benefit authorisation when reviewing mergers, the procedure is time consuming and rarely used. Instead, overwhelming emphasis is given to net competitive effects, as one would expect of a larger economy with less concentrated markets.

Merger thresholds in New Zealand

• New Zealand’s competition law has tended to follow Australia, but has diverged in important respects to reflect New Zealand’s naturally more concentrated markets:

• New Zealand initially adopted a higher ‘dominance’ threshold, but followed Australia to the lower SLC threshold in 2001 (lowering its threshold a decade after Australia).

• New Zealand’s safe harbours have tolerated a higher level of market concentration. New Zealand currently uses a 40% threshold and a three-firm concentration ratio of 70% (CR3).

• In early 2013, New Zealand released draft new Merger Guidelines that maintain the CR3 thresholds, but now treat them as factors rather than safe harbours. However, New Zealand will not migrate to the Australian ‘HHI’ approach.

• While New Zealand and Australia have similar procedures for the public benefit authorisation of mergers, New Zealand’s procedure has been used more frequently and is generally regarded as more likely to result in a favourable authorisation decision.

Key differences:

• New Zealand reduced its legal threshold a decade after Australia

• New Zealand will shortly deemphasise its ‘safe harbour’, but still uses a much higher concentration ratio (i.e., CR3).

Differences in regulation of market conduct

Differences in regulation between Australia and New Zealand are consistent with the differences one would expect between large and small economies:

•Australia’s approach to the regulation of market conduct is more prescriptive than New Zealand. Australia generally deems more conduct to be outright illegal:

• Australia’s an approach is more consistent with a larger economy (i.e., Australia is less concerned that anti-competitive behaviour may be justifiable for productive efficiency reasons).

• Australia has authorisation procedures, but they are harder to apply than in New Zealand and subject to greater scepticism.

•Until 2001, New Zealand applied a higher threshold to the regulation of market power based on a dominant position in the market:

• New Zealand lowered this threshold in 2001 to align with the Australian ‘substantial market power’ threshold, but still retains an stricter judicial approach to the regulation of market power.

• Again, New Zealand’s stricter approach is consistent with an economy that allows more concentrated markets to exist.

Differences in enforcement and prioritisation

• New Zealand Commerce Commission (NZCC) has an annual budget of FJD 65 million, which is roughly 20% of the Australian Competition and Consumer Commission’s (ACCC) budget of FJD 330 million.

(The Fiji Commerce Commission annual budget is much lower).

• The different resources available to the regulators impact on their enforcement and prioritisation activities, although the budgets are also commensurate with the volume of issues that each of the regulators are required to process each year:

• The ACCC is more heavily involved in international enforcement activities, including co-ordinating with regulators in US and EU.

• The ACCC is more likely to take ‘test cases’ that seek to clarify important aspects of the law in order to provide greater certainty.

• NZCC draws from the ACCC’s expertise in relation to matters that have a trans-Tasman aspect, thereby pooling resources. Such pooling of resources is providing important regulatory benefits.

E. Application to Pacific Island economies

More tailored approach to competition policy

• As evidenced by New Zealand, smaller economies generally prefer a more tailored approach to the application of competition law and policy.

• Generally, competition laws in smaller economies are more sympathetic to the realisation of productive efficiencies:

• Greater co-ordination of business activity may be permitted, provided it can be justified on a productive efficiency basis.

• Greater levels of market concentration may also be permitted, particularly in sectors subject to import competition.

• In smaller economies, markets tends to be more concentrated hence are more prone to market failure. This may result in a need for:

• more heavy-handed regulation in heavily concentrated economic sectors, including price controls; and

• additional regulation, if consistent with competition policy.

• Given the importance of import competition, openness to trade can be as important as the application of competition law and policy.

Different application of competition laws

• In relation to the application of competition laws themselves, the objectives and structure of modern competition laws can be applied without change

• However, differences in thresholds and their application may be appropriate:

• Substantive thresholds for merger control should normally be higher, thereby enabling more concentrated markets to exist. Merger safe harbours may also be appropriate based on high concentration ratios.

• Screening of mergers and other forms of business co-ordination should generally have regard to productive efficiency gains.

• Import competition should be an important feature of any analysis.

• Resources of the regulator may be limited, hence:

• enforcement priority should be given to highly concentrated markets that are economically important where the conduct is not net efficient;

• guidelines should be used to reduce compliance costs, provide certainty, and promote compliance at least regulatory cost.

• Care needs to be taken that enforcement does not damage a firm to the extent they exit a market (with a resulting loss of competition).

Should ‘micro’ economies have competition laws?

• What about very small ‘micro’ economies (e.g., population < 100,000): should such economies have competition laws ?

• Competition law is costly to administer and enforce. At some point, the costs of regulation will exceed the benefits.

• In micro economies, competition laws are generally of lower priority than laws that create and maintain the markets themselves (e.g., property rights).

• However, this is not to say that competition law does not have a role, just that different regulatory solutions may be appropriate:

• Competition regulation may be pooled with other regulatory functions.

• Jurisdictions may consider creating a multi-jurisdictional competition regulator that is shared across a number of different jurisdictions.

• Competition regulation may be selectively applied to a few critical sectors that are highly concentrated and not subject to import competition.

• Where competition regulation is applied, regard would generally need to be had to net public benefits.

F. Conclusions

Points for discussion

1. How prevalent are competition policy considerations in the development of regulatory policy in the Pacific region?

2. How frequently do competition concerns actually arise in practice?

3. To what extent do competition laws and policies in the Pacific region already reflect the approach identified in this presentation?

4. To what extent would a multi-jurisdictional regulator be appropriate in order to pool resources and reduce regulatory costs in the Pacific? (Such a proposal has been developed by the Pacific Islands Forum Secretariat)

5. Which are the economic sectors that are likely to give rise to the greatest competition concerns?

6. How does openness to trade sit with other policy objectives, such as promoting the development of infant industries in small economies?

7. How should smaller economies address offshore mergers and conduct that have substantive local effects?

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Our international practice

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