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Telecommunications regulation in New Zealand
Telecommunications Policy 1994 18 (9) 725-733
Telecommunications regulation in New Zealand The Court of Appeal’s decision in Clear Communications v Telecom Corporation
Carl Blanchard
In December 1992 the High Court of New Zealand ruled In favour of Telecom New Zealand’s negotiating strategy with Clear Communications. This atticle reviews the Court of Appeal’s judgment, a judgment which overturned the High Court’s acceptance of Teiecom’s ‘Baumol-Wlllig’ pricing model. The Court dismissed the use of the model beceuse it priced access at the opportuntty cost of supply - a price built on perfect market contestability and monopoly profits. This article reviews the judgment and its implications for telecommunications regulation in New Z&and. Carl Blanchard is an analyst at the New Zealand Treasury, PO Box 3724, Wellington, New Zealand (Tel: +64 4471 5140; fax: +64 4472 4942). The views contained in this paper are personal, and do not necessarily relate to those held by the Treasury. Lindsay Hampton, a senior lecutrer in Competition Law and Policy at the University of Canterbury, helped in the preparation of this paper. However, any remaining errors or omissions are those of the author. ‘Clear
Communications Limited v The Telecom Corporation of New Zealand (1993) 5 TCLR 413 continued on page 726
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1994
On 17 December 1993 the New Zealand Court of Appeal delivered its judgment on the appeal case Clear Communications Limited v The Telecom Corporation of New Zealand Limited.’ The case came before the Court because of an appeal lodged by Clear following the previous December 1992 High Court decision. Telecom subsequently crossappealed the Clear appeal. This article follows an article published previously in Telecommunications Policy which discussed New Zealand’s ‘light-handed’ regulatory environment, and the difficulties new entrants, primarily the longdistance wire carrier Clear Communications, has had in negotiating interconnection agreements (primarily the price and terms of connection) with Telecom New Zealand.2 This article builds on the previous article by discussing the grounds of the Clear and Telecom appeals, the verdict of the Court and the implications of that verdict for telecommunications regulation in New Zealand.
The grounds of appeal On 22 December
1992 the High Court delivered its judgment in Clear Corporation. In that case the Court reached the following substantive conclusions: Communications
v The Telecom
(i) Telecom was up until its final stance at trial [when it adopted the Baumol-Willig pricing model described below] in breach of section 36 [of the Commerce Act] in that it asked too much for connection [telecommunications] loop; (ii) However, Clear has not suffered any loss as a result;
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(iii) Delays in negotiations do not of themselves amount to breach of section 36; (iv) Telecom was in breach of section 36 in not accepting Clear as an ordinary DDI [Direct Dialling In] customer for the purposes of the Justice Department contract; (v) Clear is entitled to damages flowing from that breach.3 The substantive cause of Clear’s appeal related to point (i) above. Clear was convinced that Telecom’s adoption and use of a pricing model developed by US Professors Baumol and Willig was for an anticompetitive purpose and therefore breached section 36 of the Commerce Act. Briefly stated, section 36 prevents organizations that are in a dominant position in a market from using that position for the purpose of restricting, preventing or eliminating competition in any market. The key principles underlying the ‘Baumoul-Willig’ model are that Telecom could price network access at a level sufficient to compensate for the profits forgone now - and any future profits forgone - by supplying a competitor. In other words Telecom could price access based on its opportunity cost of suppl~.~ To apply this model, Professors Baumol and Willig derived four points of application:
There should be differential pricing, with prices that vary in their ratio to marginal costs, from one product to another and from one customer group to another, inversely with elasticity of demand. For each product or service, price should at least cover marginal cost or average incremental cost. Where a firm supplies components to another firm, ‘and this process entails some sacrifice of profit (which could include payment to meet cross-subsidy obligations or a portion relating to monopoly profit) by the supplier firm’, then the supplier firm must be permitted to price the article in question at a level sufficient to compensate it for the profit sacrificed to the other firm. In the long run, firms should be free to earn a full competitive rate of return, that is, total revenues would cover total costs.’
continued from page 725 *See Blanchard, C ‘Telecommunications regulation in New Zealand: How effective is the use of ‘light-handed’ regulation?’ Telecommunications Policy 1994 18 (2) 154-164. For a definition of light-handed and heavy-handed regulation see pp 155 156. 3Clear Communications, op tit Ref 1, 415 4For a greater description of the BaumolWillin model and its application to telecommu&cations pricing in New Zealand see Blanchard OD tit Ref 2. 161-162. ‘Clear Conimunicatiohs v Telecom Corporation of New Zealand Limited and Others (1993) 5 TCLR 166, at 203
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The application of the model, specifically the third point above, was supported by another US economist, Professor Kahn. He was of the view that Telecom could charge competitors a price which included a monopoly component, provided that price was also charged to Telecom subsidiaries which were competing in the same market. He termed this principle one of ‘competitive parity’, and claimed that, if applied, it could not breach New Zealand’s monopoly laws. Counsel for Clear were, however, of the opinion that the ‘Baumol-Willig’ model continued to breach the purpose requirement of section 36. Related to the above appeal, Clear also sought damages denied by the High Court in (ii) above. Telecom’s appeal related to points (i), (iv) and (v) above. Counsel for Telecom did not consider that Telecom’s conduct before the application of the Baumol-Willig pricing model breached section 36, or that its refusal to provide Clear DDI facilities breached that section.
The Court of Appeal’s verdict The role of the Court of Appeal in New Zealand is to determine whether judgments reached in the High Court are correctly founded, given the facts surrounding the case. Generally, neither party can
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introduce new evidence which was not available to the lower court. In this case the Court of Appeal, headed by its President Sir Robin Cooke, Justice Richardson and Justice Gault, was asked by Clear and Telecom to determine whether the High Court gave appropriate weight to the actions of Telecom - when negotiating local-loop interconnection with Clear - in light of section 36 of the Commerce Act. As stated before, section 36 prohibits the use of market dominance if it has the purpose of restricting, preventing or eliminating competition in any market. In Justice Gault’s opinion this required: consideration of whether the conduct would have been open if the party concerned were not in a dominant position - if it were in a fully competitive market. Such a test reflects the underlying purpose of the section which is to promote competition. Even monopolists are entitled to act competitively and the section must not be applied so as to constrain them. It is the purpose of the conduct which distinguishes what is proscribed from what is legitimate. If the conduct in question does not involve use of a dominant position in the market, purpose alone will not contravene.6 Justice Gault also cautioned against substituting a test which could be helpful in applying the statutory rule for the rule itself. He was concerned that applying economic principles to a situation might supplant the statutory process.7 For the reasons stated below, the Court considered that Telecom’s adoption of the Baumol-Willig model breached section 36. This finding overturned part of the High Court’s judgment of December 1992. The members of the Court of Appeal did not consider that the High Court gave appropriate weight to the evidence presented by the plaintiff and defendant. In particular the Court of Appeal considered two key premises which underlay the Baumol-Wilig model; these were that: l
l
the telecommunications market could be likened to a market which exhibited features of perfect contestability; and it was appropriate for Telecom to price on the basis of opportunity cost, a cost which might include monopoly profits.
The Court, by contrast, rejected Telecom’s cross-appeal. Perfectly contestable telecommunications %Eear Communications, 430
op tit Ref 1,42%
7Briefly stated, the types of economic principles which might supplant a statutory process could be a rule like the ‘Essential Facilities Doctrine’. The Doctrine was formulated by courts in the USA and allows competitors access to facilities deemed essential to a product or service, but cost parameters do not allow for multiple facilities. A example of such facilities might be a telecommunications local loop or an electricity transmission grid. New Zealand courts have exercised caution in introducing economic principles of this type into New Zealand law; see Union Shipping New Zealand Ltd v Port Nelson Ltd (1990) 3 NZBLC 101, 616. ‘See Bain, J S Industrial Oraanisation 2nd edn, John Wiley & Sons, New York (1966). ‘See Baumol, W, Panzar, J and Willig, R Contestible Markets and the Theory on Industry StrucUre Harcourl Brace Jovano-
vich, San Diego, CA (1962).
market
A key premise underlying the Baumol-Willig model was that telecommunications markets could be likened to a market which exhibited features of perfect contestability. The theory of perfect market contestability is a relatively recent addition to economic literature because economists have traditionally considered that the number of participants in a market determined the ability of an individual firm in a market to exploit consumers in that market.’ However, more recently economists like Professor Baumol have considered that competition for a market - that is, the potential for entry to a market - rather than competition in a market will determine the ability of the monopolist to exploit consumers. 9 For entry to limit the ability to exploit, certain market features must be present; these are that a firm can enter and exit a market rapidly, and where entry and exit does occur, this happens at little cost. Justice Gault built his judgment around the issue of whether the telecommunications industry was a perfectly contestable market. In his brief of evidence, Professor Baumol asserted that perfect contestibility was the appropriate competitive standard, because industry economies
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of scale and scope - represented by network fixed costs - may not allow more than one firm to be in the market at any particular time. Therefore the incumbent telecommunications company could not price at the marginal cost of supply. Instead, that company would recover fixed network costs by changing the average cost of supply allocated on the inverse of consumer demand elasticities. lo In an economic sense average cost would include all of Telecom’s costs, including fixed and variable costs, and opportunity costs, which include any profits sacrificed by Telecom as a result of interconnecting another party to its existing and potential network structure. Professor Baumol then related this behaviour to section 36 - New Zealand’s competitive standard. He asserted that the behaviour described is identical to that which one would expect in a competitive environment, therefore it is incorrect to assert that pricing above marginal cost involved the use of a dominant position. However, Justice Gault was of the opinion that in a perfectly contestable market there will be ‘a rival or potential entrant in a position to supply without sacrificing profit’. l1 He argued that if this premise was not present, a sustainable monopoly supplier would exist, which in itself is contrary to the hypothesis of perfect market contestability. At this point Justice Gault was no longer convinced of the logic of applying the thesis of perfect market contestability to the case before the Court. Opportunity costpricing
Another key premise underlying the Baumol-Willig model was that Telecom could charge competitors a price which included a component of opportunity cost. These costs are the difference between accounting and economic profits and are defined as the potential return a firm could have achieved if it invested shareholders’ funds in an industry or for a use other than the one for which it is currently used. An example of this would be Telecom placing funds in a bank rather than a telecommunications network. This return is what Telecom would expect in a fully competitive environment, but given that the telecommunications market is less than fully competitive, you could expect an element which related to any monopoly profit lost by interconnecting a competitor to its network. The profit may also include future profits that Telecom would achieve by increasing the size of its network. Justice Gault turned his attention to whether Telecom could charge Clear for the opportunity cost of supply; in the Baumol-Willig model this was termed a network access levy. The levy allows Telecom to recover from Clear a contribution for: “‘This type of pricing is referred to as Ramsey Pricing. For further discusion on Ramsey Pricing see Sherman, R The Regulation bf Ado&o/y Cambridge University Press. New York (19891 124-144. I1 Clear Communi&tion& op tit Ref 1,432. 432.
‘qelecom has argued that the Kiwi Share maintains a cross-subsidy between local, business and toll calls. The share was a part of the sale agreement between the New Zealand government and the Bell Atlantic and Ameritech consortium. For greater detail on the terms of the Kiwi share see Blanchard op tit Ref 2, 158. 13See Clear Communications, op tit Ref 1, 432.
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0 its Kiwi Share obligations - obligations limiting Telecom from raising the price of residential calls above the consumer price index;12 l all existing capacity lost by Telecom, plus any additional capacity generated by Clear; and l any monopoly profits included in Telecom’s revenue, which would allow Telecom to maintain its present benefits and future expectations. Telecom would calculate the total cost and update it on a regular basis to take into account any competitive pressures causing any of the factors to change, for example erosion of the monopoly component of price.13 Justice Gault considered that allowing Telecom to recover the opportunity costs of supply, especially the monopoly component of
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those costs, was not consistent with section 36 of the Commerce Act. He remarked as follows: that the employment of the perfectly contestable standard can lead to a price incorporating monopoly profits suggests to me a contradiction. In a perfectly contestable market I would not expect any monopoly profits to be chargeable. I therefore do not see how monopoly profits legitimately can be included in any opportunity cost. That they can be in Professor Baumol’s model invites a conclusion that the model is imperfect . . . Bearing in mind the purpose of the inquiry (the price which may be charged to a prospective competitor entering a market in which the supplier is dominant) I cannot accept as appropriate pricing that would cement in any monopoly profits derived by the firm in a dominant position.14 He then related this standard to the position of such pricing in law. New Zealand law does not prohibit monopoly pricing per se; however, under section 36 monopoly pricing is illegal if it has the purpose of restricting, preventing or deterring competition in any market. Telecom used Professor Kahn to argue that because the law did not prohibit monopoly pricing per se, Telecom could charge its competitors a price including a monopoly element, provided it offered all other providers of service, including itself, the same price. This he termed the concept of ‘competitive parity’. This principle would allow all organizations to compete on the basis of relative efficiency and therefore such a price could not be anticompetitive. The Court of Appeal did not accept Telecom’s defence for a number of reasons. Sir Robin Cooke thought it pertinent to consider the environment in which the Baumol-Willig model was developed. He commented: It is important, I think, to appreciate that the theory has been developed primarily for a country of regulated markets where prices for ultimate consumers may be controlled by regulatory agencies. That is not the present situation in New Zealand: the system is one of ‘light-handed’ regulation, the Commerce Act and competition being relied upon to provide built-in safeguards against consumer exploitation.15
’ ?bid 433 Is/bid 416
Justice Gault did not accept Telecom’s defence for three reasons. First, he considered that the inclusion of a component of monopoly price in the opportunity cost (access charge) deters or restricts competitive conduct by acting as a barrier to market entry because it affects the price at which a competitor can enter a market. He referred this view to the issue of a regular pricing review (suggested at every six months to a year) advanced by Baumol-Willig to take into account any alterations to the components of the access price. He was of the view that this administrative solution would not allow Clear to compete because Telecom would have a competitive advantage over Clear in the period between any reviews of the access levy. He considered this advantage would constitute a barrier to market entry. Second, he discarded Telecom’s suggestion that if the Court was concerned about the monopoly component of the opportunity cost, and if the inclusion of that component did not breach section 36 (which Telecom believed it did not), then the most appropriate forum to address that component was not the Court, but through the section 53 price control provisions of the Commerce Act. He concluded this was not appropriate because he considered that such a stance was inconsistent with the government’s policy of a ‘light-handed’ regulatory solution to telecommunications regulation.
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Finally, he rejected Telecom’s proposition that if the Court did not adopt the ‘Baumol-Willig’ pricing formulation, other pricing formulations would allow inefficient industry investment because competitors would not bear the full costs of their investment decision. Telecom considered it would bear that cost through the alleged Kiwi Share cross-subsidy. For these reasons, Justice Gault concluded: I am . . . driven to reject as inappropriate an access levy calculated from the base of what Telecom chooses to charge for its services and by reference to opportunity cost. I cannot accept that the objectives of the Commerce Act are served by a method of pricing that secures the profits of a firm in a dominant position. Further between these parties such an agreement potentially places Telecom in a position to secure from Clear a subsidy for Telecom’s toll business needed to overcome the vigorous price competition from Clear in that area. That cannot be right.16 Otherpoints
of consideration
Besides the issue of pricing, the Court was asked - by both Clear and Telecom - for additional rulings on the other aspects of Telecom’s interconnection proposal. Telecom’s proposal included the requirement for an access code, an intention to pass to subscribers Clear’s termination charges, and a refusal to interconnect the Department of Justice as a DDI customer of Clear, in lieu of a local interconnection agreement. Justice Gault affirmed the decision of the High Court that an access code was not necessary, he did not consider that Telecom should pass on to its consumers Clear’s termination charges, and he confirmed the High Court’s decision that Telecom’s refusal to give Clear DDI was anticompetitive. In other words, he dismissed Telecom’s cross-appeal considering that: Taken together as a package Telecom’s terms for interconnection were more onerous than could have been insisted upon in a fully competitive market. They were not justified. Insistence upon them was use of Telecom’s dominant position and necessarily they prevented Clear from entering the market. i7 Points
of departure
on appeal
For the above reasons, the Court of Appeal departed from the High Court’s acceptance of the Baumol-Willig rule in a number of respects. The Court: took a significantly different view on the issue of monopoly price and cross-subsidy, both to their existence in Telecom’s pricing structure and to their application in respect of section 36; l took a broader view on the terms of section 36. The High Court was of the opinion that if there was some overall improvement in the competitive process, the dominant party could not breach section 36. However, it was Justice Gault’s view that section 36 focuses on the conduct in question, not the overall picture; 0 considered that the price and terms of conditions offered by Telecom after it sought specialist economic advice did not differ significantly from its position before it sought such advice. Telecom was still seeking an access price which included a monopoly element; and l considered that the High Court might have felt obliged to accept the Baumol-Willig model, even with its recognized defects, in the absence of another acceptable formula. l
“Ibid 436; emphasis added
’ 71bid437
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Taken as a package, Justice Gault considered that Telecom’s interconnection offer to Clear had the purpose of preventing and restricting Clear’s endeavours to enter the central business district calling market. He was of the view that Telecom would hold its position ‘until it could secure conditions which would result in competitive disadvantage’.l’ For this reason he considered that Telecom’s position before and after it received specialist economic advice breached the requirements of section 36. Relief In terms of relief, the Court was united. Sir Robin Cooke focused his attention on whether it was appropriate for the Court to determine how Clear and Telecom should determine the price each other charged for connection.” He did not consider this appropriate, and was of the opinion that: It may be regrettable that the Court cannot resolve the matter [of price], perhaps painting with a broad brush, but the Act rightly does not contemplate this. We are not a price fixing authority. The most that can be done is to state a principle, which can only be that Telecom is entitled to a fair commercial return for granting Clear use of the network assets, without regard to the present monopoly.20 Turning to the issue of the broader negotiation, Justice Gault was not prepared to issue separate declarations and injunctions relating to Telecom’s negotiating position before the trial. Instead, he thought it sufficient to say that Telecom’s position before the High Court trial contravened section 36 of the Commerce Act. He went further to say that separate orders could impede future negotiations, and was adamant that: the parties must return to the negotiations. It is unprofitable to reflect upon the economic efficiency of the process by which they have reached this point. This Court clearly has no jurisdiction to direct the negotiations nor terms for interconnection. In my view agreement might be reached sooner if there is some re-evaluation of approach by each side.*l
“ibid 438 “For further discussion on the role of the courts determining the price and terms of interconnection, see Blanchard op cif Ref 2, 160; also Pengilley, W ‘Queensland Wire and its progeny decisions: How competent are the courts to determine supply prices and trading conditions?’ Western Australian Law Review 1991 21 225-257; and Wright, R ‘Injunctive relief in cases of refusal to supply’ Ausfralian Business Law Review 1991 19 65-97. %/ear Communications, op tit Ref 1,417 “ibid 442
He cautioned both parties that if negotiation proved unsuccessful, and if they could not successfully arbitrate their respective positions, the government would have no choice but to regulate the industry more heavily than at present. Turning to the issue of damages, Justice Gault focused on whether Clear had suffered damage as a result of Telecom’s position. Loss, and quantification of the loss, is necessary before a court can award damages. In this respect the Court considered whether all access charges were anticompetitive, because in the High Court counsel for Clear conceded that Clear would not have signed any interconnection agreement which included an access charge. Justice Gault was of the opinion that a price which included monopoly and cross-subsidy components was anticompetitive. Specifically, in relation to cross-subsidy he considered: The Kiwi Share obligation has been imposed by reference to prices to subscribers and not to costs. However any calculation of the extent of any cross-subsidy must include identification of the true costs of providing services said to be subsidised. There seems no reason, therefore, not to fix the relevant component of the charge for interconnection directly by reference to those costs. Should the charge be set other than by reference to actual costs it should
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not exceed the amount that represents the appropriate proportionate part of those costs. That is the level of charge that could be recovered in a competitive market? Justice Gault concluded that an access charge based on the true costs of the service provided to Clear would be competitive in nature. He was also of the view that Telecom’s and Clear’s positions were so far apart that it was unlikely that both parties would have reached agreement without the need for litigation. For this reason, Clear suffered no loss and could not receive damages.
Implications of the verdict The Court of Appeal judgment has significant implications for the future direction of telecommunications regulation in New Zealand. Clearly the principles used by the Court of Appeal departed significantly from those used by the High Court. In particular, the Court of Appeal considered: Injunctive relief for the specific terms and conditions contained in the Telecom offers is not appropriate. Instead, the Court considered it more appropriate to judge the terms of interconnection in totality. 0 A price which included components of monopoly price and crosssubsidy was anticompetitive. A monopolist could only charge the price which it could charge in a competitive environment. l It should not recommend to the plaintiff and defendant a pricing model to allow interparty charging. The Court’s role was to determine whether that model was of a competitive or anticompetitive nature and to lay foundations on which the parties could set about developing a pricing formula. 0 The Court should focus on specific issues of conduct rather than view the overall competitive environment. Therefore, if the competitive environment was improved, that would not be a defence under section 36 if some actions were still clearly anticompetitive. l
=/bid 442
23Blanchard op cif Fief 2 “Clear Communications, op tit Ref 1, 443
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These principles place the onus on negotiating parties to determine the terms of an agreement within the ambit of section 36. However, to the extent that either party cannot reach agreement and the Court cannot guide the parties on the terms of the agreement by way of injunction or damages, then the government may wish to consider the regulatory environment under which negotiation proceeds. I do not wish to open this discussion again - for that refer to my previous articlez3 - but certainly the issue of revisiting the regulatory environment was apparent to the Court. Justice Gault considered that the future of the current ‘light-handed’ framework depended on the negotiating parties’ resolve to reach agreement. He commented that ‘in the end if agreement cannot be reached the parties may need to arbitrate or face direct Government regulation’.24 In my opinion the Court’s judgment is consistent with the state of regulation in New Zealand. Their Honours do not prescribe a pricing model or discuss specific terms of interconnection, terms which may interfere with, and perhaps even supplant, the negotiating process. Instead they urge both parties to return to negotiation, after recognizing that the results of prior negotiations in totality were anticompetitive. The courts could, in turn, consider any results of further negotiation if either party felt aggrieved, but the time taken to achieve courtroom
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2S’Williamson warns feuding carriers to settle differences’ The Dominion, 7 Februsty 1994, 1 Zs’Clear/Telecom interconnect settlement imminent’ National Business Review March 1994, 1
resolution might not suit the government, consumers or negotiating parties. It would seem that Clear and Telecom used the judgment and the advice of the Court as the basis for re-entering negotiations on the terms of local network interconnection. However, that avenue seemed prematurely closed when Telecom lodged an appeal on the whole judgment to the London-based Privy Council. Clear has also counter-appealed, with the case due to be heard by the Law Lords in June 1994. At the time of writing the Law Lords have not yet given their judgment in this case. Their judgment will be the subject of a subsequent article. The government has also become increasingly concerned about the failure of telecommunications companies to reach agreement on the terms of interconnection. The Communications Minister, Maurice Williamson, recently warned Telecom and Clear to settle their differences quickly or ‘face the prospect of unpalatable legislation . . . Such regulation would probably require legislation, the form of which could be driven as much by political imperatives as commercial ones . . . It may well be more extensive than any party wanted and it would take time to put in place. ‘25 More recently Telecom and Clear have entered into renewed negotiations over the terms of local call network interconnection and have reached agreement on the roll-out of Clear’s toll network. Now the company has 100% toll coverage irrespective of whether a particular town is served directly by it. 26 Negotiations for a local call interconnection agreement have also appeared increasingly likely, with both Clear and Telecom signalling that if agreement can be reached by June, then the appeals to the Privy Council will not proceed. However, this was not the case, so it appears that resolution of these difficulties will be left to the Privy Council and the judgment of the Law Lords.
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Telecommunications regulation in New Zealand The Court of Appeal’s decision in Clear Communications v Telecom Corporation
Carl Blanchard
In December 1992 the High Court of New Zealand ruled In favour of Telecom New Zealand’s negotiating strategy with Clear Communications. This atticle reviews the Court of Appeal’s judgment, a judgment which overturned the High Court’s acceptance of Teiecom’s ‘Baumol-Wlllig’ pricing model. The Court dismissed the use of the model beceuse it priced access at the opportuntty cost of supply - a price built on perfect market contestability and monopoly profits. This article reviews the judgment and its implications for telecommunications regulation in New Z&and. Carl Blanchard is an analyst at the New Zealand Treasury, PO Box 3724, Wellington, New Zealand (Tel: +64 4471 5140; fax: +64 4472 4942). The views contained in this paper are personal, and do not necessarily relate to those held by the Treasury. Lindsay Hampton, a senior lecutrer in Competition Law and Policy at the University of Canterbury, helped in the preparation of this paper. However, any remaining errors or omissions are those of the author. ‘Clear
Communications Limited v The Telecom Corporation of New Zealand (1993) 5 TCLR 413 continued on page 726
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1994
On 17 December 1993 the New Zealand Court of Appeal delivered its judgment on the appeal case Clear Communications Limited v The Telecom Corporation of New Zealand Limited.’ The case came before the Court because of an appeal lodged by Clear following the previous December 1992 High Court decision. Telecom subsequently crossappealed the Clear appeal. This article follows an article published previously in Telecommunications Policy which discussed New Zealand’s ‘light-handed’ regulatory environment, and the difficulties new entrants, primarily the longdistance wire carrier Clear Communications, has had in negotiating interconnection agreements (primarily the price and terms of connection) with Telecom New Zealand.2 This article builds on the previous article by discussing the grounds of the Clear and Telecom appeals, the verdict of the Court and the implications of that verdict for telecommunications regulation in New Zealand.
The grounds of appeal On 22 December
1992 the High Court delivered its judgment in Clear Corporation. In that case the Court reached the following substantive conclusions: Communications
v The Telecom
(i) Telecom was up until its final stance at trial [when it adopted the Baumol-Willig pricing model described below] in breach of section 36 [of the Commerce Act] in that it asked too much for connection [telecommunications] loop; (ii) However, Clear has not suffered any loss as a result;
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(iii) Delays in negotiations do not of themselves amount to breach of section 36; (iv) Telecom was in breach of section 36 in not accepting Clear as an ordinary DDI [Direct Dialling In] customer for the purposes of the Justice Department contract; (v) Clear is entitled to damages flowing from that breach.3 The substantive cause of Clear’s appeal related to point (i) above. Clear was convinced that Telecom’s adoption and use of a pricing model developed by US Professors Baumol and Willig was for an anticompetitive purpose and therefore breached section 36 of the Commerce Act. Briefly stated, section 36 prevents organizations that are in a dominant position in a market from using that position for the purpose of restricting, preventing or eliminating competition in any market. The key principles underlying the ‘Baumoul-Willig’ model are that Telecom could price network access at a level sufficient to compensate for the profits forgone now - and any future profits forgone - by supplying a competitor. In other words Telecom could price access based on its opportunity cost of suppl~.~ To apply this model, Professors Baumol and Willig derived four points of application:
There should be differential pricing, with prices that vary in their ratio to marginal costs, from one product to another and from one customer group to another, inversely with elasticity of demand. For each product or service, price should at least cover marginal cost or average incremental cost. Where a firm supplies components to another firm, ‘and this process entails some sacrifice of profit (which could include payment to meet cross-subsidy obligations or a portion relating to monopoly profit) by the supplier firm’, then the supplier firm must be permitted to price the article in question at a level sufficient to compensate it for the profit sacrificed to the other firm. In the long run, firms should be free to earn a full competitive rate of return, that is, total revenues would cover total costs.’
continued from page 725 *See Blanchard, C ‘Telecommunications regulation in New Zealand: How effective is the use of ‘light-handed’ regulation?’ Telecommunications Policy 1994 18 (2) 154-164. For a definition of light-handed and heavy-handed regulation see pp 155 156. 3Clear Communications, op tit Ref 1, 415 4For a greater description of the BaumolWillin model and its application to telecommu&cations pricing in New Zealand see Blanchard OD tit Ref 2. 161-162. ‘Clear Conimunicatiohs v Telecom Corporation of New Zealand Limited and Others (1993) 5 TCLR 166, at 203
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The application of the model, specifically the third point above, was supported by another US economist, Professor Kahn. He was of the view that Telecom could charge competitors a price which included a monopoly component, provided that price was also charged to Telecom subsidiaries which were competing in the same market. He termed this principle one of ‘competitive parity’, and claimed that, if applied, it could not breach New Zealand’s monopoly laws. Counsel for Clear were, however, of the opinion that the ‘Baumol-Willig’ model continued to breach the purpose requirement of section 36. Related to the above appeal, Clear also sought damages denied by the High Court in (ii) above. Telecom’s appeal related to points (i), (iv) and (v) above. Counsel for Telecom did not consider that Telecom’s conduct before the application of the Baumol-Willig pricing model breached section 36, or that its refusal to provide Clear DDI facilities breached that section.
The Court of Appeal’s verdict The role of the Court of Appeal in New Zealand is to determine whether judgments reached in the High Court are correctly founded, given the facts surrounding the case. Generally, neither party can
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introduce new evidence which was not available to the lower court. In this case the Court of Appeal, headed by its President Sir Robin Cooke, Justice Richardson and Justice Gault, was asked by Clear and Telecom to determine whether the High Court gave appropriate weight to the actions of Telecom - when negotiating local-loop interconnection with Clear - in light of section 36 of the Commerce Act. As stated before, section 36 prohibits the use of market dominance if it has the purpose of restricting, preventing or eliminating competition in any market. In Justice Gault’s opinion this required: consideration of whether the conduct would have been open if the party concerned were not in a dominant position - if it were in a fully competitive market. Such a test reflects the underlying purpose of the section which is to promote competition. Even monopolists are entitled to act competitively and the section must not be applied so as to constrain them. It is the purpose of the conduct which distinguishes what is proscribed from what is legitimate. If the conduct in question does not involve use of a dominant position in the market, purpose alone will not contravene.6 Justice Gault also cautioned against substituting a test which could be helpful in applying the statutory rule for the rule itself. He was concerned that applying economic principles to a situation might supplant the statutory process.7 For the reasons stated below, the Court considered that Telecom’s adoption of the Baumol-Willig model breached section 36. This finding overturned part of the High Court’s judgment of December 1992. The members of the Court of Appeal did not consider that the High Court gave appropriate weight to the evidence presented by the plaintiff and defendant. In particular the Court of Appeal considered two key premises which underlay the Baumol-Wilig model; these were that: l
l
the telecommunications market could be likened to a market which exhibited features of perfect contestability; and it was appropriate for Telecom to price on the basis of opportunity cost, a cost which might include monopoly profits.
The Court, by contrast, rejected Telecom’s cross-appeal. Perfectly contestable telecommunications %Eear Communications, 430
op tit Ref 1,42%
7Briefly stated, the types of economic principles which might supplant a statutory process could be a rule like the ‘Essential Facilities Doctrine’. The Doctrine was formulated by courts in the USA and allows competitors access to facilities deemed essential to a product or service, but cost parameters do not allow for multiple facilities. A example of such facilities might be a telecommunications local loop or an electricity transmission grid. New Zealand courts have exercised caution in introducing economic principles of this type into New Zealand law; see Union Shipping New Zealand Ltd v Port Nelson Ltd (1990) 3 NZBLC 101, 616. ‘See Bain, J S Industrial Oraanisation 2nd edn, John Wiley & Sons, New York (1966). ‘See Baumol, W, Panzar, J and Willig, R Contestible Markets and the Theory on Industry StrucUre Harcourl Brace Jovano-
vich, San Diego, CA (1962).
market
A key premise underlying the Baumol-Willig model was that telecommunications markets could be likened to a market which exhibited features of perfect contestability. The theory of perfect market contestability is a relatively recent addition to economic literature because economists have traditionally considered that the number of participants in a market determined the ability of an individual firm in a market to exploit consumers in that market.’ However, more recently economists like Professor Baumol have considered that competition for a market - that is, the potential for entry to a market - rather than competition in a market will determine the ability of the monopolist to exploit consumers. 9 For entry to limit the ability to exploit, certain market features must be present; these are that a firm can enter and exit a market rapidly, and where entry and exit does occur, this happens at little cost. Justice Gault built his judgment around the issue of whether the telecommunications industry was a perfectly contestable market. In his brief of evidence, Professor Baumol asserted that perfect contestibility was the appropriate competitive standard, because industry economies
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of scale and scope - represented by network fixed costs - may not allow more than one firm to be in the market at any particular time. Therefore the incumbent telecommunications company could not price at the marginal cost of supply. Instead, that company would recover fixed network costs by changing the average cost of supply allocated on the inverse of consumer demand elasticities. lo In an economic sense average cost would include all of Telecom’s costs, including fixed and variable costs, and opportunity costs, which include any profits sacrificed by Telecom as a result of interconnecting another party to its existing and potential network structure. Professor Baumol then related this behaviour to section 36 - New Zealand’s competitive standard. He asserted that the behaviour described is identical to that which one would expect in a competitive environment, therefore it is incorrect to assert that pricing above marginal cost involved the use of a dominant position. However, Justice Gault was of the opinion that in a perfectly contestable market there will be ‘a rival or potential entrant in a position to supply without sacrificing profit’. l1 He argued that if this premise was not present, a sustainable monopoly supplier would exist, which in itself is contrary to the hypothesis of perfect market contestability. At this point Justice Gault was no longer convinced of the logic of applying the thesis of perfect market contestability to the case before the Court. Opportunity costpricing
Another key premise underlying the Baumol-Willig model was that Telecom could charge competitors a price which included a component of opportunity cost. These costs are the difference between accounting and economic profits and are defined as the potential return a firm could have achieved if it invested shareholders’ funds in an industry or for a use other than the one for which it is currently used. An example of this would be Telecom placing funds in a bank rather than a telecommunications network. This return is what Telecom would expect in a fully competitive environment, but given that the telecommunications market is less than fully competitive, you could expect an element which related to any monopoly profit lost by interconnecting a competitor to its network. The profit may also include future profits that Telecom would achieve by increasing the size of its network. Justice Gault turned his attention to whether Telecom could charge Clear for the opportunity cost of supply; in the Baumol-Willig model this was termed a network access levy. The levy allows Telecom to recover from Clear a contribution for: “‘This type of pricing is referred to as Ramsey Pricing. For further discusion on Ramsey Pricing see Sherman, R The Regulation bf Ado&o/y Cambridge University Press. New York (19891 124-144. I1 Clear Communi&tion& op tit Ref 1,432. 432.
‘qelecom has argued that the Kiwi Share maintains a cross-subsidy between local, business and toll calls. The share was a part of the sale agreement between the New Zealand government and the Bell Atlantic and Ameritech consortium. For greater detail on the terms of the Kiwi share see Blanchard op tit Ref 2, 158. 13See Clear Communications, op tit Ref 1, 432.
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0 its Kiwi Share obligations - obligations limiting Telecom from raising the price of residential calls above the consumer price index;12 l all existing capacity lost by Telecom, plus any additional capacity generated by Clear; and l any monopoly profits included in Telecom’s revenue, which would allow Telecom to maintain its present benefits and future expectations. Telecom would calculate the total cost and update it on a regular basis to take into account any competitive pressures causing any of the factors to change, for example erosion of the monopoly component of price.13 Justice Gault considered that allowing Telecom to recover the opportunity costs of supply, especially the monopoly component of
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those costs, was not consistent with section 36 of the Commerce Act. He remarked as follows: that the employment of the perfectly contestable standard can lead to a price incorporating monopoly profits suggests to me a contradiction. In a perfectly contestable market I would not expect any monopoly profits to be chargeable. I therefore do not see how monopoly profits legitimately can be included in any opportunity cost. That they can be in Professor Baumol’s model invites a conclusion that the model is imperfect . . . Bearing in mind the purpose of the inquiry (the price which may be charged to a prospective competitor entering a market in which the supplier is dominant) I cannot accept as appropriate pricing that would cement in any monopoly profits derived by the firm in a dominant position.14 He then related this standard to the position of such pricing in law. New Zealand law does not prohibit monopoly pricing per se; however, under section 36 monopoly pricing is illegal if it has the purpose of restricting, preventing or deterring competition in any market. Telecom used Professor Kahn to argue that because the law did not prohibit monopoly pricing per se, Telecom could charge its competitors a price including a monopoly element, provided it offered all other providers of service, including itself, the same price. This he termed the concept of ‘competitive parity’. This principle would allow all organizations to compete on the basis of relative efficiency and therefore such a price could not be anticompetitive. The Court of Appeal did not accept Telecom’s defence for a number of reasons. Sir Robin Cooke thought it pertinent to consider the environment in which the Baumol-Willig model was developed. He commented: It is important, I think, to appreciate that the theory has been developed primarily for a country of regulated markets where prices for ultimate consumers may be controlled by regulatory agencies. That is not the present situation in New Zealand: the system is one of ‘light-handed’ regulation, the Commerce Act and competition being relied upon to provide built-in safeguards against consumer exploitation.15
’ ?bid 433 Is/bid 416
Justice Gault did not accept Telecom’s defence for three reasons. First, he considered that the inclusion of a component of monopoly price in the opportunity cost (access charge) deters or restricts competitive conduct by acting as a barrier to market entry because it affects the price at which a competitor can enter a market. He referred this view to the issue of a regular pricing review (suggested at every six months to a year) advanced by Baumol-Willig to take into account any alterations to the components of the access price. He was of the view that this administrative solution would not allow Clear to compete because Telecom would have a competitive advantage over Clear in the period between any reviews of the access levy. He considered this advantage would constitute a barrier to market entry. Second, he discarded Telecom’s suggestion that if the Court was concerned about the monopoly component of the opportunity cost, and if the inclusion of that component did not breach section 36 (which Telecom believed it did not), then the most appropriate forum to address that component was not the Court, but through the section 53 price control provisions of the Commerce Act. He concluded this was not appropriate because he considered that such a stance was inconsistent with the government’s policy of a ‘light-handed’ regulatory solution to telecommunications regulation.
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Finally, he rejected Telecom’s proposition that if the Court did not adopt the ‘Baumol-Willig’ pricing formulation, other pricing formulations would allow inefficient industry investment because competitors would not bear the full costs of their investment decision. Telecom considered it would bear that cost through the alleged Kiwi Share cross-subsidy. For these reasons, Justice Gault concluded: I am . . . driven to reject as inappropriate an access levy calculated from the base of what Telecom chooses to charge for its services and by reference to opportunity cost. I cannot accept that the objectives of the Commerce Act are served by a method of pricing that secures the profits of a firm in a dominant position. Further between these parties such an agreement potentially places Telecom in a position to secure from Clear a subsidy for Telecom’s toll business needed to overcome the vigorous price competition from Clear in that area. That cannot be right.16 Otherpoints
of consideration
Besides the issue of pricing, the Court was asked - by both Clear and Telecom - for additional rulings on the other aspects of Telecom’s interconnection proposal. Telecom’s proposal included the requirement for an access code, an intention to pass to subscribers Clear’s termination charges, and a refusal to interconnect the Department of Justice as a DDI customer of Clear, in lieu of a local interconnection agreement. Justice Gault affirmed the decision of the High Court that an access code was not necessary, he did not consider that Telecom should pass on to its consumers Clear’s termination charges, and he confirmed the High Court’s decision that Telecom’s refusal to give Clear DDI was anticompetitive. In other words, he dismissed Telecom’s cross-appeal considering that: Taken together as a package Telecom’s terms for interconnection were more onerous than could have been insisted upon in a fully competitive market. They were not justified. Insistence upon them was use of Telecom’s dominant position and necessarily they prevented Clear from entering the market. i7 Points
of departure
on appeal
For the above reasons, the Court of Appeal departed from the High Court’s acceptance of the Baumol-Willig rule in a number of respects. The Court: took a significantly different view on the issue of monopoly price and cross-subsidy, both to their existence in Telecom’s pricing structure and to their application in respect of section 36; l took a broader view on the terms of section 36. The High Court was of the opinion that if there was some overall improvement in the competitive process, the dominant party could not breach section 36. However, it was Justice Gault’s view that section 36 focuses on the conduct in question, not the overall picture; 0 considered that the price and terms of conditions offered by Telecom after it sought specialist economic advice did not differ significantly from its position before it sought such advice. Telecom was still seeking an access price which included a monopoly element; and l considered that the High Court might have felt obliged to accept the Baumol-Willig model, even with its recognized defects, in the absence of another acceptable formula. l
“Ibid 436; emphasis added
’ 71bid437
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Taken as a package, Justice Gault considered that Telecom’s interconnection offer to Clear had the purpose of preventing and restricting Clear’s endeavours to enter the central business district calling market. He was of the view that Telecom would hold its position ‘until it could secure conditions which would result in competitive disadvantage’.l’ For this reason he considered that Telecom’s position before and after it received specialist economic advice breached the requirements of section 36. Relief In terms of relief, the Court was united. Sir Robin Cooke focused his attention on whether it was appropriate for the Court to determine how Clear and Telecom should determine the price each other charged for connection.” He did not consider this appropriate, and was of the opinion that: It may be regrettable that the Court cannot resolve the matter [of price], perhaps painting with a broad brush, but the Act rightly does not contemplate this. We are not a price fixing authority. The most that can be done is to state a principle, which can only be that Telecom is entitled to a fair commercial return for granting Clear use of the network assets, without regard to the present monopoly.20 Turning to the issue of the broader negotiation, Justice Gault was not prepared to issue separate declarations and injunctions relating to Telecom’s negotiating position before the trial. Instead, he thought it sufficient to say that Telecom’s position before the High Court trial contravened section 36 of the Commerce Act. He went further to say that separate orders could impede future negotiations, and was adamant that: the parties must return to the negotiations. It is unprofitable to reflect upon the economic efficiency of the process by which they have reached this point. This Court clearly has no jurisdiction to direct the negotiations nor terms for interconnection. In my view agreement might be reached sooner if there is some re-evaluation of approach by each side.*l
“ibid 438 “For further discussion on the role of the courts determining the price and terms of interconnection, see Blanchard op cif Ref 2, 160; also Pengilley, W ‘Queensland Wire and its progeny decisions: How competent are the courts to determine supply prices and trading conditions?’ Western Australian Law Review 1991 21 225-257; and Wright, R ‘Injunctive relief in cases of refusal to supply’ Ausfralian Business Law Review 1991 19 65-97. %/ear Communications, op tit Ref 1,417 “ibid 442
He cautioned both parties that if negotiation proved unsuccessful, and if they could not successfully arbitrate their respective positions, the government would have no choice but to regulate the industry more heavily than at present. Turning to the issue of damages, Justice Gault focused on whether Clear had suffered damage as a result of Telecom’s position. Loss, and quantification of the loss, is necessary before a court can award damages. In this respect the Court considered whether all access charges were anticompetitive, because in the High Court counsel for Clear conceded that Clear would not have signed any interconnection agreement which included an access charge. Justice Gault was of the opinion that a price which included monopoly and cross-subsidy components was anticompetitive. Specifically, in relation to cross-subsidy he considered: The Kiwi Share obligation has been imposed by reference to prices to subscribers and not to costs. However any calculation of the extent of any cross-subsidy must include identification of the true costs of providing services said to be subsidised. There seems no reason, therefore, not to fix the relevant component of the charge for interconnection directly by reference to those costs. Should the charge be set other than by reference to actual costs it should
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not exceed the amount that represents the appropriate proportionate part of those costs. That is the level of charge that could be recovered in a competitive market? Justice Gault concluded that an access charge based on the true costs of the service provided to Clear would be competitive in nature. He was also of the view that Telecom’s and Clear’s positions were so far apart that it was unlikely that both parties would have reached agreement without the need for litigation. For this reason, Clear suffered no loss and could not receive damages.
Implications of the verdict The Court of Appeal judgment has significant implications for the future direction of telecommunications regulation in New Zealand. Clearly the principles used by the Court of Appeal departed significantly from those used by the High Court. In particular, the Court of Appeal considered: Injunctive relief for the specific terms and conditions contained in the Telecom offers is not appropriate. Instead, the Court considered it more appropriate to judge the terms of interconnection in totality. 0 A price which included components of monopoly price and crosssubsidy was anticompetitive. A monopolist could only charge the price which it could charge in a competitive environment. l It should not recommend to the plaintiff and defendant a pricing model to allow interparty charging. The Court’s role was to determine whether that model was of a competitive or anticompetitive nature and to lay foundations on which the parties could set about developing a pricing formula. 0 The Court should focus on specific issues of conduct rather than view the overall competitive environment. Therefore, if the competitive environment was improved, that would not be a defence under section 36 if some actions were still clearly anticompetitive. l
=/bid 442
23Blanchard op cif Fief 2 “Clear Communications, op tit Ref 1, 443
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These principles place the onus on negotiating parties to determine the terms of an agreement within the ambit of section 36. However, to the extent that either party cannot reach agreement and the Court cannot guide the parties on the terms of the agreement by way of injunction or damages, then the government may wish to consider the regulatory environment under which negotiation proceeds. I do not wish to open this discussion again - for that refer to my previous articlez3 - but certainly the issue of revisiting the regulatory environment was apparent to the Court. Justice Gault considered that the future of the current ‘light-handed’ framework depended on the negotiating parties’ resolve to reach agreement. He commented that ‘in the end if agreement cannot be reached the parties may need to arbitrate or face direct Government regulation’.24 In my opinion the Court’s judgment is consistent with the state of regulation in New Zealand. Their Honours do not prescribe a pricing model or discuss specific terms of interconnection, terms which may interfere with, and perhaps even supplant, the negotiating process. Instead they urge both parties to return to negotiation, after recognizing that the results of prior negotiations in totality were anticompetitive. The courts could, in turn, consider any results of further negotiation if either party felt aggrieved, but the time taken to achieve courtroom
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2S’Williamson warns feuding carriers to settle differences’ The Dominion, 7 Februsty 1994, 1 Zs’Clear/Telecom interconnect settlement imminent’ National Business Review March 1994, 1
resolution might not suit the government, consumers or negotiating parties. It would seem that Clear and Telecom used the judgment and the advice of the Court as the basis for re-entering negotiations on the terms of local network interconnection. However, that avenue seemed prematurely closed when Telecom lodged an appeal on the whole judgment to the London-based Privy Council. Clear has also counter-appealed, with the case due to be heard by the Law Lords in June 1994. At the time of writing the Law Lords have not yet given their judgment in this case. Their judgment will be the subject of a subsequent article. The government has also become increasingly concerned about the failure of telecommunications companies to reach agreement on the terms of interconnection. The Communications Minister, Maurice Williamson, recently warned Telecom and Clear to settle their differences quickly or ‘face the prospect of unpalatable legislation . . . Such regulation would probably require legislation, the form of which could be driven as much by political imperatives as commercial ones . . . It may well be more extensive than any party wanted and it would take time to put in place. ‘25 More recently Telecom and Clear have entered into renewed negotiations over the terms of local call network interconnection and have reached agreement on the roll-out of Clear’s toll network. Now the company has 100% toll coverage irrespective of whether a particular town is served directly by it. 26 Negotiations for a local call interconnection agreement have also appeared increasingly likely, with both Clear and Telecom signalling that if agreement can be reached by June, then the appeals to the Privy Council will not proceed. However, this was not the case, so it appears that resolution of these difficulties will be left to the Privy Council and the judgment of the Law Lords.
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