New Zealand: Tails, you lose - the Data Tails decision and misuse of market power

The Court of Appeal has its say on Telecom's 'data tails' pricing

The Court of Appeal has dismissed Telecom's appeal against the High Court decision in the Data Tails case.¹ It also allowed the Commerce Commission's cross-appeal that the High Court had not in fact gone far enough in the extent to which it had found that Telecom had breached the misuse of market power prohibition in the Commerce Act 1986.

This Alert highlights some of the observations made by the Court of Appeal on the application of the market power prohibition, and in particular, the application of ECPR pricing. The decision provides welcome recognition that provided a vertically integrated supplier genuinely tries to calculate an appropriate ECPR price it will not be lightly overturned, and that such calculations can be difficult. However, the Court of Appeal's finding that complying with ECPR pricing may be insufficient to avoid a breach of the Act, without articulating a clear test to replace the business certainty that ECPR provided, increases risk for both entrants' and incumbents' investment decisions.

Background

Telecom appealed against the High Court's 2009 decision that it had taken advantage of its market power to deter existing and potential competition from telecommunication service providers ("rival telcos") in high-speed data transmission markets. The background to the finding was that in the early 2000s, rival telcos conveyed data between and within major CBD areas either using their own network, or, outside their own network area, over Telecom's local access network. At the relevant time, rival telcos needed to purchase the 'last mile' components - data tails - from Telecom, and package those inputs together with their own transmission to deliver business customers a retail end-to-end high speed data transmission service.

The High Court found that, between March 2001 and late 2004, Telecom had taken advantage of its market power in relation to the relevant data transmission markets to deter competition from the rival telcos. Telecom appealed, and the Commerce Commission ("NZCC") cross-appealed, submitting that the breach should be extended to a greater range of pricing practices, including to the period before March 2001.

Taking advantage of market power²

It was alleged that Telecom had caused a "price squeeze" by setting prices for data tails in the wholesale market that prevented equally or more efficient rival telcos from profitability operating in the downstream market for high-speed data transmission.

The Court of Appeal agreed with the High Court that Telecom was obliged to supply data tails to rival telcos. The central issue was therefore the appropriate wholesale price at which the tails should be supplied. The leading case on vertically integrated companies pricing inputs to rivals is the Privy Council's decision in Telecom v Clear.³ This case established that the economic model known as the Efficient Component Pricing Rule ("ECPR") should be used as guidance to businesses on how to price network access.

Under ECPR, the access provider (Telecom) can charge competitors a price that compensates Telecom for its incremental costs together with its opportunity costs (the profits foregone by not providing the full retail service to the customer itself). This approach has been consistently applied since the Privy Council decision in 1994. The Privy Council thought that any other approach would turn the Court into a price regulator and that the role of constraining monopoly profits was to be fulfilled either by competition over time or else through price regulation under Part 4 of the Commerce Act 1986 ("Act").

The appeal raised a number of general points, each of which provides some useful observations on the application of the ECPR pricing rule:

Ability to price above ECPR: Telecom argued that the Privy Council in Telecom v Clear regarded ECPR as a safe harbour only, not a price ceiling. This meant that while Telecom would not breach the Act if it priced at ECPR, it would not necessarily breach the Act if it was priced above ECPR. The Court of Appeal rejected this argument, finding it "inconceivable" that the Privy Council considered that an incumbent could with impunity charge more than ECPR.⁴

Ex ante commercial certainty: Telecom argued that that ECPR could not have applied because it was impossible as a matter of practical or commercial reality, at the time it determined its pricing of the relevant tails, to calculate ECPR prices for those tails.⁵ The Court of Appeal's first response was that it did not find any evidence that Telecom had made a real effort to calculate ECPR prices in advance. It also rejected the submission that ECPR was too difficult to calculate.⁶ It found the Privy Council's decision in Telecom v Clear envisaged that the calculation of ECPR prices would require a high degree of focus from Telecom, including regular reviews.

The Court of Appeal did, however, demonstrate some sympathy for the difficulties in applying an ECPR price. It described the courts' involvement in this type of analysis as being to create a "philosophical abstraction" that is applied to a practical market price.⁷ However, it ultimately found that Telecom was a sophisticated company with the capability and organisational structures to at least attempt an estimation of ECPR pricing.⁸

Helpfully, for future cases, the Court did also hold that it would have been reluctant to second guess a genuine attempt by Telecom to apply ECPR prices, had such an attempt been made.⁹ This must, however, be read subject to the comments below that compliance with ECPR pricing does not necessarily avoid a breach of section 36.

A comparison of NZ, US and EU approaches to "price squeeze" analysis: Telecom argued that the High Court should have followed the United States approach to price squeeze claims where they are only illegal if the predatory pricing test is also met. This approach can be contrasted with approach taken in Europe, which is significantly stricter on price squeezes.

The Court of Appeal distinguished both the United States and European jurisprudence, primarily on the basis that the cases cited to it addressed industries which were already subject to regulation, so the relevant issue was the interaction between competition law and regulatory regimes. It found this question was not relevant to the instant case, because at the time of the alleged misconduct the pricing of data tails was not regulated.¹⁰

The Court of Appeal also rejected the United States approach that a price squeeze claim can only be established through the lens of predatory pricing, that is, the firm with market power must price below cost at a retail level and have a reasonable prospect of recoupment of losses arising from the predatory conduct. The Court of Appeal found that, whilst predatory prices may create price squeezes, not every price squeeze will involve predatory pricing. It found the key issue was the relativity between Telecom's wholesale and retail pricing.¹¹

The Court of Appeal at the same time cautioned against drawing too much assistance from European cases. Unlike in Europe, in New Zealand a firm with a lawful monopoly is not under a general duty to assist competitors, and monopolies have no 'special responsibility' to assist smaller competitors. The Court of Appeal sought to distinguish the European cases (which have been distinguished also by the Privy Council and the Supreme Court in the s36 context) by requiring that price squeezes will only be anti-competitive if they prevent "equally efficient" competitors from "climbing the ladder of investment".¹²

Application of ECPR to data tails: The Court of Appeal agreed with the High Court that Telecom had priced above ECPR in its 'two tail' pricing scenarios (where Telecom provided data tails at each end of an end-to-end circuit).

It also accepted the NZCC's cross-appeal in relation to 'one-tail' scenarios (where a rival telco self-provided one or more tails and Telecom supplied the remainder). In the High Court, the judge had found that, in setting the price for the 'one tail' scenario, Telecom should be able to recover profit forgone on its entire network, as this was consistent with the ECPR principle that Telecom should be indifferent between supplying itself and supplying a new entrant. The High Court noted that, given the high proportion of fixed costs in the industry, that price was unlikely to give rise to any actual entry. The Court of Appeal disagreed with that approach.

The Court of Appeal emphasised that a key aspect of the Telecom v Clear judgment was that efficient competitors should not be excluded from competing.¹³ It also found that it was unlikely that Telecom's pricing would allow monopoly profits or inefficiencies to be driven out of the market (short of a rival telco building a ubiquitous network).¹⁴ Accordingly, the Court of Appeal concluded that, while Telecom's one-tail pricing was compliant with ECPR, it was still inconsistent with Telecom v Clear in that it excluded entry and allowed a monopoly profit to be earned.

While the Court of Appeal did not expressly set a new test, its approach seems to match that of the Court of Appeal in Telecom v Clear (ie the approach overturned by the Privy Council): the access provider should set the access price by reference to the incremental costs of providing access and a reasonable return on capital employed without regard to the present monopoly. What a "reasonable return" is, that falls short of being a monopoly profit, is a matter of considerable uncertainty in the absence of regulation.

Summary

The Court of Appeal provided welcome recognition that calculating an ECPR price is a particularly difficult undertaking. In reliance on Telecom v Clear, it also held that genuine attempts to price at ECPR should be not be overturned lightly by the courts.

However, the Court's reasons for distinguishing the US case law, under which a price squeeze cannot occur unless pricing is also below cost, were not compelling .¹⁵ Its dismissal of the concerns about "chilling" investment by incumbents through price squeeze claims, because chilling investment is also a concern arising from allowing a duty to supply, is similarly unpersuasive.¹⁶ Its reliance on the effectively lower European threshold, which is derived from an administrative system governed by the European Commission, where dominant companies have a 'special responsibility' to assist competitors, is an intensely worrying development.

It is also concerning to see the Court depart from the previously accepted proposition established by the Privy Council nearly 20 years ago that ECPR is a safe harbour. This creates considerable uncertainty for companies with high market shares in supplying to downstream rivals - a common situation in New Zealand in our highly concentrated markets. Ultimately, prices above incremental costs are necessary to attract entry into industries with high fixed costs, and certainty around likely return is necessary for entrant and incumbent investment decisions. The Privy Council's approach in creating a safe harbour through ECPR struck a reasonable and workable balance. Tampering now with that safe harbour does very little for market confidence or business certainty at a time when both are needed for proper functioning of markets.

Footnotes

¹ Telecom Corporation of New Zealand Limited v Commerce Commission [2012] NZCA 278 ("Decision"). See previous Alerts on the High Court liability and penalty judgments.
² See our October Alert http://www.russellmcveagh.com/_docs/CompetitionUpdate14October2011_422.html for fuller description of the s36 prohibition.
³ Telecom Corporation of New Zealand Limited v Clear Communications Limited (1995) 1 NZLR 385.
⁴ Decision, [88].
⁵ Decision, [92[.
⁶ Decision, [93]-[95].
⁷ Decision, [103].
⁸ Decision, [100].
⁹ Decision, [101].
¹⁰ Decision, [120].
¹¹ Decision, [123].
¹² Decision, [124].
¹³ Decision, [235]-[236].
¹⁴ Decision, [238].
¹⁵ Decision, [120] and [121]. The distinction suggested, that the US case law cited to the Court only dealt with the situation where a sector-specific regulation was in place, and no such regulation existed in relation to Telecom at the relevant time, is not convincing. Although the relevant data tails were not at that time subject to the Telecommunications Act 2001, other aspects of Telecom's service were regulated, just as in the US authority in Trinko.
¹⁶ Decision, [122]. It is equally arguable that while a duty to deal may "chill" investment by incumbents, that concern is ameliorated if the incumbent can charge ECPR and so be assured a full return on its investment if such a duty to deal arises.

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