Thank you for the invitation to speak today. The Commission values these opportunities as it allows us to increase awareness of our role within the New Zealand economy and in particular the awareness as to how it carries out its regulatory role. I have to say that the views expressed today are entirely my own and not necessarily those of the Commission.
From a competition perspective New Zealand's unique attributes present interesting challenges. New Zealand's small population and low population density means that markets are naturally more concentrated than in larger countries. Similarly, its geographic isolation means that competition in international markets may not constrain players in the domestic market.
It is therefore vitally important that New Zealand has an effective regulatory regime that promotes competition and effectively constrains market power but provides the right incentives to encourage efficient investment, innovation and production.
Today I am going to talk about how the Commission achieves this balance under its current legislative framework, using examples specific to the aviation industry. I will talk briefly about the Commission, its approach to regulating market power and then some specific examples including the Origin Airlines investigation; the Air Cargo Cartel; the Commission's decision on the Qantas and Air New Zealand proposed Alliance and the Commission's inquiry into whether to control airports.
About the Commerce Commission
The Commerce Commission is New Zealand's primary competition and regulatory agency. The Commission's purpose is to promote dynamic and responsive markets so that New Zealanders benefit from competitive prices, better quality and greater choice. As suggested above, many New Zealand markets are highly concentrated and as a result competitive forces do not necessarily operate so as to benefit consumers.
The Commission is an independent Crown Entity and is not subject to direction from the government in carrying out its enforcement and regulatory activities. The Commission's independence is an important aspect of its credibility as a body responsible for making adjudicative decisions and exercising enforcement powers.
The Commission also seeks to be transparent in its decision making. If it is to have the confidence of consumers and investors, the Commission must be seen to make its decisions based on an objective assessment of the available evidence with open and transparent processes.
Market Power
My theme for today is market power and the evils of monopoly power. There is general acceptance that competition is the best means for ensuring efficient allocation of scarce resources. Competition generally ensures that market signals are clear and that they provide appropriate guidance for future investment decisions. Distorted signals can have a harmful impact on the allocation of the country's limited resources; for example, cartels engaged in price fixing can result in price increases simply by agreement and not due to innovation or superior products. Similarly, competition is an important driver of innovation. With a lessening in competition, innovation will decline and the economy will lose international competitiveness.
One of the Commission's main roles is to keep a watchful eye on the economy and not surprisingly it pays particular attention to industries characterised by market power where there is a greater risk that competition might be prevented from having the desired affect of ensuring efficient behaviour.
Market power in and of itself is not detrimental to the economy. It can give rise to significant efficiencies including economies of scale. Often market power is described as the ability to raise prices or reduce quality free from competitive constraint. Market power is sometimes seen as the goal of competitive endeavour gained through the development of a new innovative product such as the humble hairpin. One of the Commission's main focuses, however, is on companies that may be achieving and/or abusing their market power to the long term detriment of consumers.
Market power can be gained in a number of ways: it can be inherited through acquisition or vesting; through some form of natural monopoly as with infrastructure industries; through merger or acquisition of competing businesses; or parties can collude to fix prices or to exclude competition.
The Commission attempts to regulate market power in a number of ways:
- It investigates alleged abuses of market power where parties are alleged to be deterring competition.
- It seeks to stop abuses of market power through cease and desist orders and/or court prosecutions.
- It investigates agreements between competitors and takes action where agreements seek to fix prices or deter competition through raising artificial barriers.
- It keeps a watchful eye on aggregations of market power through its merger review involving clearances, authorisations and investigation of market activity.
- It also has the ability to consider whether to control companies that have market power and, ultimately, by setting price and quality standards.
I would like to discuss a point about control. Control is not the Commission entering a business and operating it. The Commission will aim to set broad frameworks for the businesses to operate in as it has done for example through the electricity lines business thresholds regime. The Act is structured to provide a wide discretion to the Commission on the form of control.
The control provisions are intended to be a regulatory backstop for when competition can not provide the constraints to ensure appropriate allocation of resources and encourage efficiency and innovation. At the same time, regulation carries various costs including: the regulator's costs; compliance costs; and, the cost of market distortions flowing from imperfectly conducted control. This latter point recognizes the cost of regulatory error due to the information asymmetry that arises with the regulator one step removed from the business.
The control provisions are part of New Zealand's light handed approach to regulation of market power compared with many Western economies. They are designed to deter companies with market power from wroughting the market at the expense of either acquirers or suppliers and earning inefficient excess returns. However, deterrent provisions are only effective if there is a credible threat that they will be enforced. This threat is now more likely to be seen as real given the government's acceptance of the Commission's recommendation to control PowerCo and Vector's gas transmission services.
Today I hope to explain, using examples relating to the aviation industry, how the Commission has dealt with, and is dealing with, market power issues. While the examples I intend to discuss will be aviation specific the underlying principles apply across the economy to everything from telecommunications and electricity to transportation and agriculture.
Origin Pacific Complaint about Air New Zealand
Section 36 of the Commerce Act prohibits a monopolist from taking advantage of their market power to prevent competition either in that market or in any other market.
Section 36 applies when the following three elements are established:
- a business has substantial market power;
- it takes advantage of that power; and
- the purpose of the behaviour is to restrict competition.
In September 2003 Origin Pacific announced the introduction of a new daily Hamilton to Christchurch non-stop return service. The following week Air New Zealand announced its intention to introduce regular Hamilton to Christchurch non-stop services. Air New Zealand closely matched Origin's service in terms of timetables and fares but they operated a larger aircraft. To introduce this new service Air New Zealand removed an aircraft from it existing Hamilton - Wellington - Christchurch route. Origin subsequently announced that it was not proceeding with its proposed new service and contacted the Commission alleging that Air NZ's behaviour represented capacity dumping and so an abuse of market power.
The Commission considered Air New Zealand did have a substantial degree of market power. The key issue for the Commission in this case was whether Air New Zealand took advantage of its market power.
The Commission's approach was to ask whether Air New Zealand removed a service from one route to another without fear of a competitive response on the withdrawn service. This approach assumes it would not be rational for a person without market power operating in a competitive market to incur the opportunity cost of removing the aircraft from the profitable Hamilton to Wellington route to commence non-stop services on the Hamilton to Christchurch route.
In other words, would Air New Zealand have been able to move its aircraft from the Hamilton - Wellington - Christchurch route to the Hamilton - Christchurch direct route had it been in a competitive market. The Commission looked at whether Air New Zealand had the ability to raise prices or reduce quality through lesser service and could safely ignore customers on the indirect route.
The investigation found that when Air New Zealand made the decision to move its aircraft between routes it remained concerned about servicing the Hamilton - Wellington route. If Air New Zealand stopped servicing this route there would have been a shortage of capacity in the market and an opportunity for competitors to fill this capacity. To continue servicing this market Air New Zealand leased an aircraft.
The Commission concluded that in an otherwise competitive market it is likely Air New Zealand would have responded to a move by its competitors in the same way. Air New Zealand decided to meet the competition on the direct Hamilton - Christchurch service being offered by Origin, as otherwise they could have lost customers from the Hamilton - Wellington - Christchurch route. But Air New Zealand also needed to ensure that Hamilton - Wellington customers continued to be serviced.
The Commission did not consider that Air New Zealand's actions breached section 36 of the Commerce Act. The Commission does not seek to prevent monopolies from competing in markets. They can compete but cannot use their market power to do so.
Air Cargo Cartel
Section 27 of the Commerce Act prohibits arrangements that substantially lessen competition. Section 30 deems price fixing agreements to substantially lessen competition. Such agreements provide the parties to the conspiracy monopoly characteristics so as to raise prices. This is a major area for enforcement by competition agencies.
The Commission is currently investigating the international cartel being investigated worldwide. You will have seen details of this in the media. I am unable to comment on our investigation at this stage. But I can refer to the information in the public domain. It is alleged that in Europe major airlines were involved in a cartel involving air cargo services. The allegation is that a group of airlines got together to fix cargo rates by setting the price of certain components of the cargo rates. This involved the vexed fuel surcharge. The way the rates were set meant that it was not easy to fix the total price. A scheme was devised by certain airlines that allowed the fixing of the fuel surcharge by reference to information contained on the airlines' websites. Certain airlines have sought and obtained leniency arrangements around the world. The Commission has entered into a leniency arrangement and is investigating with the assistance of that leniency party.
Price Advertising
A point to note is that the Commission does see the Fair Trading Act as complimentary to the Commerce Act and has a role in ensuring fair competition based on honest dealings. Misleading behaviour is inefficient and creates market distortions. Whilst not part of the Commission's armory in dealing with market power as such it is useful to mention the Fair Trading prosecutions involving price advertising by the airlines. One of the Commission's concerns is that as evidenced by the issues underlying the air cargo cartel, separating out the costs of fares risks the likelihood of collusion to fix prices at least over some component parts. At this stage we have not seen evidence this occurred but it is still a serious risk.
The Qantas/Air New Zealand Alliance
In addition to section 27, which prohibits behavioural agreements, section 47 of the Commerce Act prohibits acquisitions that substantially lessen competition. The Commission is also charged with ensuring that aggregations of market power, whether by way of a merger, or by way of a commercial arrangement such as a joint venture or strategic alliance, do not substantially lessen competition. The Commission can authorise potentially anti-competitive behaviour and mergers if it considers the benefits to the New Zealand public outweigh the detriments.
Qantas and Air New Zealand applied to the Commission for authorisation to form a strategic alliance, consisting of equity holdings and joint decisions on output and pricing. To cement the alliance, Qantas would acquire up to a 22.5 percent share of Air New Zealand. Air New Zealand would effectively control all flights to, from and within New Zealand, under the guidance of a joint Qantas/Air New Zealand strategic committee.
The airlines argued initially that they accepted that the Alliance could reduce competition; that's why they applied for authorisation. Later they argued that the arrangement did not lessen competition but if it did then it should be authorised.
The proposed benefits put forward by the airlines included:
- greater efficiencies/economies of scale;
- more frequent direct flights, and more destinations;
- an increase in tourism income in New Zealand; and
- more engineering work to be undertaken in Christchurch.
The possible detriments included:
- reduced efficiency;
- higher fares; and
- reduced innovation.
The airlines argued that if prices increased one of the benefits of that was that New Zealanders would be deterred from flying and so spend their tourist dollar in New Zealand. We found that a surprising argument and rightly rejected it.
The decision-making process took 10 months. Different economic models were attacked and defended. Thousands of hours of economists' and investigators' time were invested. Numerous parties were interviewed. Complex models were built, analysed and criticised.
The Commission considered that the overall costs of the Alliance far exceeded the benefits and declined the application. The High Court on appeal agreed. The decision was a particularly important one from the point of view of the Commission because it tested the Commission's independence. As mentioned earlier, the Commission's independence is an important aspect of its credibility as a body responsible for making adjudicative decisions and exercising enforcement powers. If it is to have the confidence of consumers and investors, the Commission must be seen to make its decisions based on an objective assessment of the available evidence with open and transparent processes.
Airports Inquiry
The statutory powers for the Commission to consider control of a business, often described incorrectly as price control, are set out in Part IV of the Commerce Act. If control is imposed, Part V of the Act provides the powers for the Commission to determine the form of control using what ever approach is most appropriate in the circumstances.
In considering whether goods or services may be controlled, the Commission must establish the following factors:
- the goods or services are in a market in which competition is limited;
- it is in the interests of acquirers or suppliers of those goods or services that they be controlled.
In the Airports Inquiry, the Commission found that Auckland, Wellington and Christchurch airports faced limited competition in their relative geographic markets for the provision of airfield services.
This may sound like a straight forward conclusion; however, all three of the airports argued that the Commission underestimated the countervailing power or negotiating position of the airlines.
The Commission considered whether any of the three airport companies were able to exercise market power to assess whether competition was limited. Specifically, the Commission assessed:
- the potential competition between airports or from other modes of transport;
- the Commission found that other modes of transport did not constrain airports.
- the potential for new entry;
- the nature of the investment in a major airport facility is such that there are significant entry conditions.
- the potential countervailing power of airlines;
- the Commission recognized that airlines may have some negotiating power but the extent of their power depended on whether they had effective substitutes. Demand for flights is driven by the destination to which customers want to go. Passengers generally travel only from and to the most convenient airport.
- the regulatory environment (which included a requirement to consult on charges and the threat of further regulation);
- Likewise, analysis suggested that meeting demand for flights is the overriding factor determining which airport an airline flies to, rather than the costs of doing so.
The Commission concluded that there were insufficient constraints on all three airports.
Having established that competition was limited, the Commission then had to consider whether control would be in the interests of those who acquired airfield services. To do this the Commission compared the costs and benefits of controlling the airfield services with the costs and benefits absent control.
Airports should be able to earn a normal return on the assets used in providing the services of airfield activities. An actual return in excess of the appropriate WACC (weighted average cost of capital) over time would suggest that the entity was earning an excessive or monopoly return, unless those returns reflected superior performance such as superior productive efficiency improvements.
The Commission's analysis concluded that AIAL had earned excess returns. This finding suggested that AIAL had used its market power in airfield activities by raising prices above the efficient level. With regards to WIAL the Commission found there were slight excess returns. The Commission found no evidence that CIAL earned excess returns historically and there were potentially only small forecast excess returns.
The Commission then considered the net benefit to acquirers by assessing the benefits and costs of control.
The sources of potential benefits of control included the reduction or elimination of:
- excess returns through lower prices, which will lead to a transfer of wealth to acquirers.
- allocative inefficiency through lower prices, further enhancing the benefit to acquirers.
- productive inefficiency.
- dynamic inefficiency.
These benefits were then balanced against the costs of control to determine whether there was a net benefit to acquirers in controlling airfield services. The Commission concluded that there would be a net benefit in controlling AIAL. However, the Commission did not consider it was necessary or desirable in the interests of acquirers to control WIAL or CIAL. The potential benefits to acquirers of controlling WIAL or CIAL were not sufficiently large to warrant control given the costs associated with control.
The Final Report recommended that that the Minister:
- Should recommend control of Auckland International Airport
- Keep a watching brief on the activities of Wellington International Airport; and
- Not recommend control Christchurch International Airport.
There were certain qualifiers as to whether control should be imposed. The Commission considered the Minister could take into account that the Commission could only consider a form of control to determine a proxy for the cost of control and that there could be less costly ways of controlling AIAL. It also noted that on a total welfare, or net benefits approach, control may not be warranted.
Summary
These examples specific to the aviation industry are intended to illustrate how the Commission can seek to constrain the misuse of market power. The fundamental principles underlying the Commission's decision making are common to all competition and regulatory decisions. For instance, a similar process was used to assess whether gas distribution and transmission pipelines should be controlled. Electricity and Telecommunications regulation whilst industry specific is based on similar principles.
My aim today was to give you a greater appreciation of the Commission's role and the tools it has to regulate market power. Hopefully next time you pick up your paper and read about the Commission's activities you will have greater understanding of the analytical process that sits behind the decision.
Once again, thank you for the opportunity to speak today and I am happy to answer questions if there is time available.
