PAUL KERIN

But we must adopt a harder line on fu­ture ac­qui­si­tions

The Australian - - FRONT PAGE - PAUL KERIN Paul Kerin is Ad­junct Pro­fes­sor, School of Eco­nomics, Univer­sity of Ade­laide.

Claims by a fed­eral Coali­tion MP that AGL’s clo­sure of the Lid­dell power station in 2022 is anti-com­pet­i­tive and veiled threats to force AGL to divest Lid­dell are overblown.

How­ever, MPs have in­ad­ver­tently touched the tip of a real ice­berg: our too-le­nient ap­proach to ac­qui­si­tions has left us with elec- tric­ity mar­kets that are far less com­pet­i­tive than they should be. What can be done?

Last Thurs­day, Lib­eral MP Craig Kelly claimed that it would be “po­ten­tially anti-com­pet­i­tive” if AGL closed Lid­dell and didn’t of­fer to sell it to a com­peti­tor. He also im­plied that in that case the ACCC could force AGL to divest Lid­dell. How­ever, ACCC chair Rod Sims has cor­rectly stated that the clo­sure and non-sale of Lid­dell would not pass the leg­isla­tive tests for anti-com­pet­i­tive con­duct.

Nev­er­the­less, the gov­ern­ment can pass leg­is­la­tion to force di­vesti­ture of any as­sets. But should it? The is­sue is broader than just Lid­dell. Sub­stan­tial con­sol­i­da­tion in the in­dus­try in re­cent years has raised ma­jor com­pe­ti­tion is­sues.

In the lead-up to the 1998 com­mence­ment of the Na­tional Elec­tric­ity Mar­ket, our gov­ern­ments took con­sid­er­able steps to avoid two po­ten­tial mar­ket struc­ture prob­lems: hor­i­zon­tal con­cen­tra­tion and ver­ti­cal in­te­gra­tion. Hor­i­zon­tal con­cen­tra­tion is when a few firms con­trol a large mar­ket share in a par­tic­u­lar in­dus­try seg­ment, such as gen­er­a­tion or retailing. Ver­ti­cal in­te­gra­tion in when one com­pany op­er­ates in mul­ti­ple in­dus­try seg­ments, such as gen­er­a­tion and retailing.

Hor­i­zon­tal con­cen­tra­tion re­duces com­pe­ti­tion: mar­ket power causes profit-max­imis­ing firms to sup­ply less out­put and charge higher prices. Ver­ti­cal in­te­gra­tion re­duces com­pe­ti­tion even fur­ther: profit-max­imis­ing ver­ti­cally in­te­grated firms have in­cen­tives to sup­ply even less and charge even higher prices in an up­stream seg­ment (gen­er­a­tion) to put their stand-alone (non-ver­ti­cally-in­te­grated) ri­vals in a down­stream seg­ment (retailing) at a com­pet­i­tive dis­ad­van­tage and raise bar­ri­ers to en­try.

As a re­sult, ver­ti­cal in­te­gra­tion can cause even higher prices and less sup­ply at the re­tail level.

That’s why our gov­ern­ments sub­stan­tially re­struc­tured the in­dus­try pre-NEM. The gen­er­a­tion and re­tail arms of ver­ti­cally in­te­grated mo­nop­o­lies were sep­a­rated and bro­ken up to cre­ate com­pe­ti­tion in whole­sale and re­tail mar­kets. Vic­to­ria banned crossown­er­ship of re­tail­ers and gen­er­a­tors, but the ban was sub­se­quently lifted.

How­ever, ac­qui­si­tion ac­tiv­ity in re­cent years has sub­stan­tially re­versed the pre-NEM in­dus­try re­struc­tur­ing and re-cre­ated the twin prob­lems that re­struc­tur­ing was de­signed to avoid.

Today, our whole­sale and re­tail mar­kets are highly con­cen­trated. Three big ver­ti­cal in­te­grated “gen­tail­ers” now ac­count for 70 per cent of re­tail cus­tomers and 48 per cent of gen­er­a­tion. This in­dus­try re­con­sol­i­da­tion has oc­curred de­spite the ACCC’s ob­jec­tions.

The ACCC did al­low some ac­qui­si­tions that they be­lieved didn’t sig­nif­i­cantly lessen com­pe­ti­tion or passed a “pub­lic in­ter­est” test — that is, they gen­er­ated ben­e­fits (such as scale economies or risk man­age­ment) that out­weigh the less­en­ing of com­pe­ti­tion. How­ever, it vi­o­lently ob­jected to others.

In 2003, the ACCC op­posed AGL’s ac­qui­si­tion of a mi­nor­ity stake in the Loy Yang A gen­er­a­tor, the in­dus­try’s first ma­jor step to­wards ver­ti­cal rein­te­gra­tion, be­cause it would “re­sult in higher prices, in­creased bar­ri­ers to en­try and a sub­stan­tial less­en­ing of com­pe­ti­tion”. AGL ap­pealed to the Fed­eral Court, which over­ruled the ACCC.

In 2014, the ACCC op­posed AGL’s 2014 ac­qui­si­tion of the Lid­dell and Bayswa­ter gen­er­a­tors, say­ing that if the ac­qui­si­tion pro­ceeded “the three largest gen­er­a­tors in NSW will have been sold to the three largest re­tail­ers … These ver­ti­cally in­te­grated re­tail­ers will dom­i­nate elec­tric­ity sup­ply”. AGL ap­pealed to the Aus­tralian Com­pe­ti­tion Tri­bunal, which over­ruled the ACCC.

While we shouldn’t ban ac­qui­si­tions if they re­ally do pass the “pub­lic in­ter­est” test, we must recog­nise that ac­quir­ers have in­cen­tives to over­state the ben­e­fits and un­der­state the com­pe­ti­tion ef­fects and we’ve been too le­nient on them.

Putting the Lid­dell case to one side, it is true that the twin mar­ket struc­ture prob­lems that we have recre­ated may well cause ex­ist­ing gen­er­a­tors to be closed ear­lier than they other­wise would have — and not of­fered for sale.

Sup­pose a gen­er­a­tor’s life could be ex­tended by five years if a sig­nif­i­cant in­vest­ment was made and that the ad­di­tional net cash flows from this gen­er­a­tor would de­liver a good re­turn on in­vest­ment. If the gen­er­a­tor was a stand-alone busi- ness, it would ra­tio­nally de­cide to make the in­vest­ment. How­ever, if the gen­er­a­tor’s owner was ver­ti­cally in­te­grated with high whole­sale and re­tail mar­ket shares, its owner may ra­tio­nally de­cide not to, for two rea­sons.

First, clo­sure would ben­e­fit its other gen­er­a­tors through higher whole­sale prices.

Sec­ond, its re­tail busi­nesses also would gain from through higher re­tail mar­gins and mar­ket share (as higher whole­sale prices and lower sup­ply would weaker re­tail com­pe­ti­tion). But these broader ben­e­fits are only re­alised if the gen­er­a­tor is not only closed, but also not sold to a com­peti­tor.

Nev­er­the­less, while we shouldn’t have let our twin prob­lems get this bad, try­ing to un­scram­ble the egg through forced di­vest­ment would be a step too far.

True, there are ex­am­ples of gov­ern­ments forc­ing com­pany breakups for com­pe­ti­tion rea­sons, such as the US gov­ern­ment’s breakup of AT&T in the early 1980s. How­ever, those ex­am­ples are rare and ex­cep­tional. A key rea­son why is the risk that forced di­vest­ment will un­der­mine a crit­i­cal fac­tor on which mar­kets rely: prop­erty rights. Forc­ing own­ers to divest as­sets law­fully ob­tained through ac­qui­si­tions that were vet­ted and ap­proved by the rel­e­vant in­sti­tu­tions is an ex­treme step to take.

Nev­er­the­less, we should cer­tainly adopt a harder line on fu­ture ac­qui­si­tion pro­pos­als. We shouldn’t ban them, as it is al­ways pos­si­ble that an ac­qui­si­tion might pass the pub­lic in­ter­est test. How­ever, the as­sess­ment needs to take full ac­count of the ad­verse ef­fects on both whole­sale and re­tail com­pe­ti­tion.

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