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Contact Officer:	Jeremy Llewellyn
Contact Phone:	03 9290 1893

24 November 2004

NCP Inquiry
Productivity Commission
PO Box 80
Belconnen ACT 2616

Dear Mr Banks

I am writing to you in response to the recent submission, number 134, from the Network Economics Consulting Group (NECG) in relation to the Productivity Commission’s Review of National Competition Policy Arrangements.  

Costs and benefits of integration 

The Australian Competition and Consumer Commission (ACCC), in line with clause 4 of the Competition Principles Agreement (CPA) and also the recommendations of the OECD Council on 26 April 2001 concur that when faced with micro-economic issues, involving vertical structures in network industries, the benefits and costs of structural measures should be carefully balanced. ,  The ACCC’s view is, whether the monopoly be public or private, that a cost-benefit analysis of structural separation would be a prudent starting point in considering such micro-economic issues.  Further, the ACCC notes that the grounds for a presumption in favour of separation were explicitly noted in the conclusion reached in the OECD Secretarial Report, which accompanied the recommendations of the Council.  
We note the contribution of NECG in raising a number of issues for consideration in relation to (largely) the possible benefits of continued integration.  In our view, however, the paper over emphasises the benefits of integration whilst under emphasising the potential for, and the likely costs of, the stifling of competition in the market.  Discussion of the costs and benefits of vertical integration will form part of a further, more comprehensive, submission to the Commission shortly.  These are important issues which need to be addressed.  Briefly, however it is noted that: 

•	economic modelling shows those circumstances (such as where upstream margins are constrained by regulation) under which incentives to discriminate in favour of the vertically integrated firm’s own operations and against non-integrated competitors will be greater (Mandy 2000, Bustos and Galetovic 2003);
•	restrictions on competition caused by discrimination generally will harm consumers (OECD 2001);
•	post fact empirical data shows evidence of discrimination by vertically integrated monopolists (Reiffen and Ward 2002, Mini 2001);and 
•	divestment is welfare enhancing absent major losses in economies of scope (Crew, Kleindorfer 2004). 

Regulatory approach

NECG, under the heading ‘circumstances have changed since the Hilmer inquiry’ note that:

	structural separation may have made practical sense when the goal was to ‘shake up’ 	the bureaucratised structures…the excess capacity that existed in the major 	infrastructure industries in the early 1990s is not as prevalent today 

and then suggest that 

	set against this background, there are strong arguments for leaving it entirely to the 	market forces…to determine the vertical structure of firms. 

Notably, however, in the Hilmer report, conclusions favouring structural separation were made upon consideration, amongst other things, of the ability of a vertically integrated provider to use its monopoly power to stifle or prevent competition in the potentially competitive sector.  Regardless of industry structures then and now, the concern as to the cost of interference in, or distortion of, competitive markets remains and the need for a cost benefit analysis of the benefits of structural separation is as relevant today as it was then.  In fact, the consensus of international academics at the 2003 ACCC Conference, ‘Regulation, industry structure and market power’ was that recent analysis pointed to the need for further consideration of structural separation in a number of different industries.

Regulatory Cost

NECG notes the ‘sometimes raised’ presumption that structural separation is compatible with ‘less costly and more effective regulation’ and suggests that ‘it is not clearly the case that the regulatory task with structural separation would be easier’. The Hilmer report, however, recognised the link between vertical integration and tighter regulatory control when concluding that it ‘strongly supports structural reforms over more intensive conduct regulation’.  In his decision on AGL v ACCC,  French J also recognised that market distortions arising from vertical integration might necessitate the need for regulatory responses. The OECD notes that the primary advantage of vertical separation is a reduced incentive to restrict competition and that this is an important advantage since it decreases the regulatory burden and enhances the quality of the regulation and the level of competition.  Further, in regards to the Telecommunication Industry, the Productivity Commission has previously acknowledged that vertical separation would lead to a more light handed regulation, when discussing the joint application of vertical separation combined with forms of access regulation.  Finally, the ACCC’s view is that vertical integration with monopoly infrastructure inevitably means a more intrusive regulatory regime and that structural separation, where appropriate, would enable a more light handed form of regulation.

If you have any queries re the issues raised in this letter, please do not hesitate to contact me on (02) 6243 1142.  Please find articles referenced enclosed.

Yours sincerely

Ed Willett 
Commissioner