From Open Access to Convergence Mergers: An Antitrust Perspective on the Transition to Electricity Competition (Revised: February 6, 1998)

The Competition Symposium, Brubaker & Associates, Omni Shoreham

Washington, D.C.

Date:
By: 
Jonathan B. Baker, Former Director

INTRODUCTION

In looking over the program before you arrived this morning, some of you may well have asked: what is someone from the Federal Trade Commission doing as our luncheon speaker? I thought this was an electricity conference. After all we've got FERC and the state commissions looking over our shoulders, including looking at mergers. What have we got here, some sort of party crasher? Besides violating the obvious adage and giving an economist a free lunch, what's the point?

In the course of the next few minutes I hope to convince you that we are not party crashing. In fact, we antitrust enforcers have been around for more than 75 years. It's just that your party has moved and now we are inside your tent and you are inside ours.

As all of you are well aware, the electric industry is the one of the last great arenas for regulatory reform in the U.S. Like most economists, I am delighted that the benefits of competition can now spread to this important sector of the economy. Regulatory reform in other industries has led to productivity gains, increased innovation, lower prices, and enhanced consumer choice. I hope that the same types of improvements in economic performance can be realized in the electric industry.

Another nice thing about regulatory reform is that we get to meet a new group of people -- such as yourselves. We have not had much to do with each other recently, but when your tent moves, you get new neighbors. Sometimes we will rub elbows around the same table at gatherings like this and at others we may sit at separate tables in front of a judge. Less amiable folks, using a different metaphor, might see you as jumping out of the frying pan of regulation into the fire of antitrust, but we make a sincere effort to help both veterans and newly competitive industries steer their way clear of the flames through speeches like this and guidelines.

This afternoon I would like to cover two areas where we may be meeting each other more in the future.

CONCERNS ABOUT THE TRANSITION TO COMPETITION

The first place we are likely to meet is in helping society figure out where the regulatory reform process in electricity ought to move next. Our competition advocacy program attempts to help government decision makers keep competition and consumer protection concerns in focus as the reform process goes forward. We hope that many of you share these concerns and will help the industry and society address them. Here are a few of the economic concerns that help guide the FTC's competition advocacy program, our merger policy, and our unfair competition conduct reviews.

FTC Chairman Robert Pitofsky, in recent Congressional testimony,(2) explained one such concern. While firms under regulation may be used to coordinated pricing and tactics that restrict entry, such practices may be illegal under competition. Firms in recently deregulated industries may be especially susceptible to relapses into problematic conduct. Aside from this general concern about collusive behavior, three specific economic concerns in electricity deregulation stem from the fact that only the generation and marketing stages of the industry presently appears ready for effective competition, given current technology and equipment.(3)

First, efficient transmission pricing must accompany open access or many of the potential benefits of regulatory reform will not be realized. Unless prices and terms for transmission services also become economically efficient signals about investment and output, inefficiencies in generation will persist and become entrenched and uneconomic siting decisions will continue to be made with long-lasting detrimental effects. Achieving the economic benefits of unbundling will therefore depend strongly upon FERC's concurrent reform of transmission pricing.(4) Getting transmission pricing right will not be an easy exercise. Indeed, it is technically difficult and alternative approaches are still in contention. And, while transmission regulatory regimes potentially are in flux, the antitrust task of defining the relevant geographic market is more complex.

Unfortunately, developing efficient pricing to deal with congestion in transmission may be proving to be politically difficult as well as technically difficult. Recent experience in the Pennsylvania-Jersey-Maryland interchange, for example, argues persuasively for making greater efforts to incorporate efficient pricing mechanisms to internalize transmission congestion.(5)

Second, assuming a reasonable transmission rate structure, efficient markets may need protection from discriminatory transmission pricing and access policies. FERC's plan for open access rules for transmission services addresses a critical competitive issue by requiring vertically integrated utilities to grant open access and equal treatment to their competitors. As FERC noted in adopting these rules, however, this approach may leave in place the incentive and the opportunity for some utilities to exercise market power in the regulated system.(6) If so, a regional independent system operator (ISO) arrangement could provide additional help in preventing discrimination. In addition, an ISO arrangement could avoid the costs and uncertainty that the alternative remedy of full divestiture might entail.

Third, even if reasonable transmission pricing is in place and discriminatory transmission strategies have been discouraged, the achievement of economic efficiency might still be stymied by market power in generation. Open access will likely reduce, but not obviate, the need for antitrust assessment of competitive conditions in electric power generation, including the analysis of "generator dominance." Expanding the number of suppliers potentially available is likely to make the electric power system more efficient and more competitive, but there may be circumstances, even under open access conditions, in which dominant suppliers might be able to exercise market power. Competitive conditions among mid-cost plants could be particularly significant for antitrust analysis of generation markets. Low cost plants nearly always produce and therefore are seldom determinative of price and high cost plants do not normally affect pricing except in rare periods of peak demand. As a result, price is most often determined by the costs of the mid-cost plants.

CONVERGENCE MERGERS

Having noted some issues over which we may meet you in common purpose, let me turn to my second topic -- mergers between electric utility companies and their fuel suppliers. These are sometimes termed convergence mergers.(7) Convergence mergers between utilities and their fuel suppliers may represent an "opportunity," for you to meet us sooner than you had expected, for example as a participant, a complaining customer, or a third party witness.

While most of our cases in recent years have focused on horizontal issues, including interfuel competition questions, some recent convergence mergers appear to raise issues regarding vertical conduct.(8) For those of you who find these antitrust terms unfamiliar, horizontal practices involve competitors, while vertical agreements are made between a firm and its suppliers or customers. Should anyone ask how real these vertical antitrust concerns are, let me remind you of the AT&T divestiture settlement -- the largest antitrust divestiture case in decades. Here essentially is a case based on anticompetitive vertical practices and evasion of regulatory restraints. The AT&T case highlights antitrust concerns that discrimination by vertically integrated firms against competitors can be a threat to competition, notwithstanding regulatory efforts to curtail discrimination.

Let me highlight two potential antitrust problems arising from vertical practices that may be associated with convergence mergers. The first is market power that comes from raising rivals' costs, and the second is price increases resulting from unfair access to proprietary information of competitors.

This is not intended to be an exhaustive list of potential antitrust theories concerning convergence mergers. For example, I will not be discussing the prospective opportunities for evasion of rate-of-return regulation through convergence mergers, or talking about the horizontal "potential competition" theories that are often associated with convergence mergers in other industries.

In addition, I will not be discussing any of the potential procompetitive aspects of convergence mergers. For example, a convergence merger might enhance efficiency by eliminating double marginalization on the costs of some inputs. Double marginalization occurs when firms at one level of the supply chain price in excess of marginal cost, and those expensive inputs are marked up again at another level of the supply chain.

RAISING RIVALS' COSTS

Vertical practices that achieve market power by raising rivals' costs may be a key antitrust concern about some convergence mergers between electrical utilities and their fuel suppliers. This is not a novel issue. Indeed, antitrust concerns about vertical convergence mergers are similar to the concerns that led to FERC's open access order.

The problem FERC sought to address in Order 888 is the risk that vertically integrated transmission monopolists will control access to transmission services in ways that inefficiently favor their own generation operations.(9) The utility that controls the transmission capacity may have an ability to raise the costs of an actual or potential rival, allowing the advantaged utility to favor its own generation or to raise its prices for electricity directly. The resulting improved capital utilization or higher revenues would translate to higher profits for the transmission owner.

The anticompetitive incentive in a vertical convergence merger is similar. The acquiring firm raises the costs of a current or prospective competitor -- not the competitor's transmission costs this time, but some other cost element. The acquiring firm may be able to increase profits by raising price or by selling more electricity that it generates. The result may be two types of market failure: higher prices that distort customer choices or electricity produced at high cost facilities while lower cost plants are idle. If low cost plants are taken out of service, moreover, the wrong production assets may be "stranded" from a production efficiency point of view.

I like to think about anticompetitive practices that raise rivals' costs as creating an "involuntary cartel."(10) Raising a rival's costs is a way to force that firm to raise price and restrict output, even if it would otherwise have refused to take such actions in coordination with the acquiring firm.

Take for example, an electric utility buying a coal firm that supplies other electric utilities that serve some of the same wholesale customers as the acquirer. Assuming localized markets for coal exist or that coal may be differentiated with respect to other characteristics besides distance, the acquiring utility could be in a position to raise the costs of other area utilities, by raising coal prices to them.

The issue is most clearly joined when a competitor's generating plant, served exclusively by the acquired coal company, is the price setting or market clearing facility for a relevant electricity market from time to time. In this instance, raising the coal customer's costs may increase the wholesale price of electricity in the area. The acquirer may gain from increased wholesale sales of its own electricity into the area or from increased margins on its sales of electricity into the area.

Whether this theoretical concern about the anticompetitive consequences of raising rivals' costs is likely to translate into a significant effect on electricity customers depends on the details. It is not a question that has a predetermined answer from economic theory. Some of the questions of detail may include: Would switching to an alternative coal supplier entail major costs? How binding are the price and quality conditions in any already existing long-term coal supply contracts? What is the relative cost of the affected coal-fired generating station relative to other generating plants? Do downstream customers or the captive customer have the ability and incentive to discourage the discrimination?

PROPRIETARY INFORMATION PERSPECTIVE

In addition to issues of price and quality discrimination, the vertical aspects of convergence mergers may give rise to questions about unfair access to proprietary information. The problem arises in auction markets where electricity generators bid to supply power -- to other utilities today, and also to large industrial electricity customers and perhaps all consumers tomorrow. Unfair access to proprietary information about competitors' costs, for example, could lead to higher prices when there are only a few low-cost bidders. With real-time access to proprietary cost information of competitors, an electricity generator could bid less aggressively and still win the bidding.

The explanation is straightforward. Absent proprietary information about its rivals costs, the firm may cut its bids close to its own costs. With proprietary information about other low-cost competitors' costs, in contrast, the acquiring firm is more likely to raise its bids, bidding just slightly below its estimates of the competitors' bids. Raising bids in this manner is profitable because the estimates are better informed and therefore there is less risk that the other low-cost competitors will win by bidding less than the acquirer's estimate of their bids. So when the acquiring firm wins bids, it will win at a higher price than before. This could distort customer choices among alternative sources of energy.

Here are some questions that might arise in this type of inquiry. Does the acquisition provide proprietary information about customers to the acquirer? Are there other ways that this information is made available to the market in a similar time frame? Can this information assist the acquirer in estimating costs and prices of competing low-cost firms? Can the complaining customers quickly and cheaply change suppliers to avoid the problem? Are confidentiality provision already in the supply contracts sufficient to minimize the risk of anticompetitive use of such information? Does the proprietary information pertain to the closest, low-cost competitors of the acquirer? Would other suppliers, who recognized that they are bidding against an informed rival, respond by shading their own bids closer to their costs, leading those suppliers to win some bids at lower prices than would otherwise have obtained?

The effects of unfair access to proprietary information might be felt industry-wide, rather than merely limited to specific competitors of the acquirer. For example, would such information in the hands of an association of industry members help them to detect cheating on a collusive price agreement? Could common access to an important component of cost information help establish a reference point that would facilitate reaching a pricing agreement among competitors?

CONCLUSION

Now that the electric industry is moving toward increased competition, you will probably be seeing a little less of state and federal utility regulators and a little more of the federal antitrust enforcement agencies such as the FTC. Today I have sketched some of the types of concerns and questions that the antitrust agencies are likely to have as the transition to competition and consequent restructuring of the electric industry move forward. I have also highlighted the wide array of ways we can help private competition -- from enforcement actions in individual cases to the FTC's competition advocacy program, where we seek to share our competition expertise with federal, state and local policy-makers. Thanks for your attention and I would be glad to try to answer any questions that you may have.

Endotes:

1. Jonathan B. Baker is Director, Bureau of Economics, Federal Trade Commission. The views expressed are those of the author and not necessarily those of the Federal Trade Commission or any Commissioner. These remarks were originally delivered before The Competition Symposium sponsored by Brubaker & Associates, Omni Shoreham Hotel, Washington, DC (October 29, 1997).

2. Prepared Statement of the Federal Trade Commission, presented by Robert Pitofsky, Chairman, before the Committee on the Judiciary, United States House of Representatives, June 4, 1997.

3. Scale economies and complex congestion problems in transmitting electricity mean that regulation may need to persist in transmission and distribution for the indefinite future. See Comments of the Staff of the Bureau of Economics of the Federal Trade Commission In the Matter of Promoting Wholesale Competition Through Open Access Non-discriminatory Transmission Services by Public Utilities, Recovery of Stranded Costs by Public Utilities and Transmitting Utilities; Proposed Rulemaking and Supplemental Notice of Proposed Rulemaking, FERC Docket Nos. MR95-8-000 & RM94-7-001, August 7, 1995. These points are also discussed in Brennan, Timothy, et. al, A Shock to the System, Washington, D.C.: Resources for the Future, 1996.

4. See, Pierce, Richard J., "FERC Must Adopt An Efficient Transmission Pricing System -- Now," The Electricity Journal 10:8 (October 1997), pp. 79-85.

5. Williams, Andrew, "Restructuring PJM to Facilitate Electric Competition," The Electricity Journal 10:8 (October 1997), pp. 72-78 and Thomas, Samuel, "An East Coast View: The Right Price for PJM," Public Utilities Fortnightly 135:18 (October 1, 1997), pp. 40-44.

6. FERC Order 888 in The Matter of Promoting Wholesale Competition Through Open Access Services by Public Utilities and Recovery of Stranded Costs by Public Utilities and Transmitting Utilities, Dockets RM-95-8-000 and RM94-7-001 at Section IV.A.2 states: "As a further precaution against discriminatory behavior, we will continue to monitor electricity markets to ensure that functional unbundling adequately protects transmission customers. At the same time, we will analyze all alternative proposals, including formation of ISOs, and, if it becomes apparent that functional unbundling is inadequate or unworkable in assuring non-discriminatory open access transmission, we will reevaluate our position and decide whether other mechanisms, such as ISOs, should be required."

7. See, for example, "FERC Approves Two Convergence Combos," Public Utility Fortnightly 135:17 (September 15, 1997), p. 52.

8. Baker, Jonathan, "Vertical Restraints with Horizontal Consequences: Competitive Effects of "Most-Favored-Customer" Clauses,"Antitrust Law Journal 64 (1996), pp. 517-34. [Webmaster Note: An earlier version of this article was presented in a speech before Business Development Associates, Inc., Antitrust 1996 Conference, September 28, 1995]

9. From the Introduction to the FTC Bureau of Economics' comments on FERC's proposed open access order (August 7, 1995) and from the final order itself, FERC Order 888 in "The Matter of Promoting Wholesale Competition Through Open Access Services by Public Utilities and Recovery of Stranded Costs by Public Utilities and Transmitting Utilities," Dockets RM-95-8-000 and RM94-7-001, at Section IV.A.2, issued April 24, 1996.

10. See, generally, Baker, Jonathan, "Vertical Restraints with Horizontal Consequences: Competitive Effects of "Most-Favored-Customer" Clauses," Antitrust Law Journal 64 (1996), pp. 517-34.  [Webmaster Note: An earlier version of this article was presented in aspeech before Business Development Associates, Inc., Antitrust 1996 Conference, September 28, 1995]