12 Nov 2009
The High Hurdle of Proving Use of Market Power
The Commerce Commission winning a case under section 36 of the Commerce Act has similarities to the All Blacks winning the World Cup - it's happened, but not nearly as often as they would like.
Reasons for both failures abound. Leaving the rugby aside, one reason for the Commission's record is the Courts' interpretation of section 36, especially as it relates to "use" of market power.
Section 36 is intended to prevent firms with market power from misusing that power for an anti-competitive purpose. The benchmark test for measuring potentially anti-competitive conduct, as set down by the Privy Council in its 1995 Telecom v Clear decision, is to ask whether the dominant firm would have acted the same way in a hypothetically competitive market. If it would have, then it will not have "used" its market power in breach of section 36.
It is generally agreed that this test (known as the "counterfactual test") has translated to a very high hurdle for the Commission (or anyone else) proving a breach of section 36. This was a driver for the Government to amend s36 in 2001 by replacing "use of dominance" with "taking advantage of market power" in an attempt to lower the threshold and bring New Zealand more into line with the less restrictive Australian approach. However, that change has had little, if any, effect. The High Court in a recent s36 decision went so far as to say that there was little difference between the thresholds. In that case, the Commission unsuccessfully argued that Bay of Plenty Electricity's refusal to supply meters to competitors was a breach of s36. Although the case failed on various grounds, a significant factor was the Commission's inability to establish that a competitive firm would not have acted in the same way.
Another example of the difficulty and uncertainty inherent in s36 cases is the Commission's prosecution of Carter Holt Harvey for predatory pricing of wool insulation products. After success in the High Court and Court of Appeal, the case was overturned in the Privy Council, largely on the basis that it was not proven that Carter Holt Harvey would have acted differently in a competitive market.
A similar finding occurred in the Commission's recent unsuccessful case against Telecom for introduction of its 0867 telephone package, with the High Court finding that the Commission had failed to prove Telecom's 0867 package would not have been introduced in a competitive situation.
The Commission Finally Gets a Win
In this context, the Commission's success in the High Court last month in a s36 case against Telecom is a major win. The judgment of Justice Hansen (sitting with Professor Martin Richardson) found Telecom guilty of misuse of market power for overcharging competitors for access to its wholesale network. As a result competitors were unable to offer retail high-speed data services that were competitively priced.
It is useful to examine the decision to understand the reasons for success despite the application of the same counterfactual test as in earlier cases.
The case focused on Telecom's pricing of "data tails" to competing telecommunications service providers (TSPs) to enable them to offer retail services to end users. Data tails are the linking bits between a customer's premises and a TSP's network. TSPs have to purchase data tails from Telecom if their networks do not extend to customer premises, to enable them to supply data services to those customers.
The Commission alleged that during 2001-2004 Telecom overcharged downstream competitors for access to data tails in breach of s36 of the Commerce Act. In order to establish a breach, the Commission had to prove that Telecom used its market power to restrict competition.
The first element was easily answered with the Court finding that Telecom had both dominance and a substantial degree of market power in the wholesale market.
The question of "use" formed the crux of the case. In determining whether Telecom's pricing was a "use" of market power, the Court reiterated the counterfactual test, holding that:
"Telecom will not have misused its market power if the prices it charged its competitors were no greater than the prices it would have charged in the hypothetical competitive market which constitutes the counterfactual."
It is necessarily a matter of speculation what an economically-rational competitive firm "would have done" in charging for access. The approach of the Courts has been to apply an economic model to gauge if the dominant firm would have charged the same way for access in a competitive market. The model is known as the Efficient Component Pricing Rule (ECPR) and holds that an economically rational firm would not price above ECPR.
While the ECPR model is not new - somewhat ironically, it was adopted by the Privy Council following advocacy by Telecom in the Telecom v Clear case - the judgment is a clear exposition of its meaning and application. A significant part of the judgment is taken up with a discussion on whether pricing breached ECPR, with claims and counterclaims as to how the ECPR model should be calculated and applied. The model is intended to identify the hypothetically competitive price, which includes compensation for the incumbent's properly incurred costs in providing access (including lost profits) but sets a price sufficiently low so as to enable access by an efficient competitor. The arguments largely centred on Telecom's attempts (only some of which were successful) to argue that a number of costs should be included in the calculation of ECPR. Two interesting findings were:
- where the TSPs self-provided some data tails but acquired others from Telecom, Telecom was entitled under ECPR to recover from its rivals the full opportunity cost in relation to the entire network; and
- when the services purchased (data tails) were part of a bundle of services, Telecom was not entitled to claim lost profits on the whole bundle. The Court found that it should only be compensated in ECPR pricing by the additional profit from the fact of supplying a bundle (not from the actual component parts of the bundle) which was likely to be limited.
Various other matters, such as the identification and amount of avoided marketing and quasi-fixed costs, and the appropriate calculation of comparable retail costs, were also examined in some detail.
A significant difference in this case from earlier cases is that the Court did not appear to have much difficulty in finding repeated "violations" of ECPR pricing. This was no doubt made easier by the fact that in some cases (although not all) Telecom was actually charging more for wholesale data tails than it was charging to retail customers for the equivalent service. The Court acknowledged that the magnitude and extent of these violations was not always clear, but that they were more than de minimis so were sufficient to establish the pricing element of a s36 breach.
Use and Purpose
The specific question of whether charging above ECPR was a "use" of market power essentially answered itself, with the Court finding that a price exceeding ECPR was (almost by definition) a price that only a firm with market power would charge. Following this judgment, it is difficult to see how a price above ECPR could ever not amount to use of market power.
The last issue was that of "purpose" - whether Telecom's use of market power in charging above ECPR was for the purpose of restricting competition. The Court noted that purpose can be inferred from the effects of use, and approvingly once again quoted the Privy Council in Telecom v Clear that use and purpose "will not easily be separated." Although the Court also noted that purpose could be established by direct evidence, and that evidence of Telecom's conduct was consistent with an anti-competitive purpose, this almost seems ancillary to the above finding on "readily foreseeable effects". It appears that once the ECPR hurdle was crossed Telecom was over the s36 line.
Penalties have not yet been determined.
As at the date this FYI went to press, no appeal has been announced. This is unsurprising given the statement by Telecom General Counsel Tristan Gilbertson immediately after the judgment that “We have to focus on the future, not on the past, and in that spirit we now will carefully consider whether we should continue legal action on the data tails issue." The fact that access pricing for data tails is no longer a live issue (as it is now regulated) was no doubt also taken into consideration.
Lessons from the Decision
As noted above it was Telecom's advocacy in the Telecom v Clear decision that helped establish ECPR pricing as a benchmark for s36, and it is generally viewed as favourable for the incumbent monopolist. Therefore while the Court found on the facts that Telecom had breached the hypothetical competitor counterfactual, the case is unlikely to be a silver bullet for potential competitors seeking to rely on s36 for access pricing.
The decision is significant for affirming the centrality of the counterfactual test, and in particular for providing a useful explanation of the framework and application of ECPR. The counterfactual test looks likely to come under further challenge as the Commerce Commission has sought leave to appeal the High Court's 0867 decision. In the High Court proceedings, the Commission submitted that the hypothetical counterfactual was too restrictive and the Court should take a more realistic approach to s36. This argument appeared to gain some traction with the Court of Appeal, but it noted that it was bound by the Privy Council so any change to the interpretation of s36 can only be made by the Supreme Court.
If the Supreme Court does reconsider the counterfactual issue, it may agree that the counterfactual is too restrictive to be relied on as the sole test of use of market power. However, it is still likely to be a benchmark for measuring use, even if other approaches are also accepted (as has happened in Australia). In terms of access cases, ECPR is therefore likely to remain significant. Firms that have substantial market power will need to understand ECPR pricing. The data tails decision, with its clear and detailed exposition of how the elements of ECPR pricing are to be considered, is likely to remain relevant for some time to come.
 Telecom Corporation of New Zealand Limited v Clear Communications Limited  1 NZLR 385 (PC).
 Commerce Commission v Bay of Plenty Electricity Limited (HC Wellington CIV 2001-485-917, Clifford J and Prof M Richardson, 13 December 2007).
 Carter Holt Harvey Building Products Group Ltd v Commerce Commission  1 NZLR 145; (2004) 11 TCLR 200 (PC).
 Commerce Commission v Telecom Corporation of New Zealand Limited  NZCA 338.
 Commerce Commission v Telecom Corporation of New Zealand Limited and Anor (HC AK CIV 2004-404-1333, 9 October 2009).
 The threshold changed from "dominance" to "substantial degree of market power" during the relevant time period, so the Court had to consider both thresholds.
 Above n5, at para 43.
 Above n5, at para 137.
 Above n5, at para 151.
 As quoted in the NZ Herald, 14 October 2009.
 It is of little relevance in the telecommunications industry, as most access issues are now regulated.