Cons

Vertical integration has disadvantages (related to efficiency) as well. Generally these may come as enhanced bureaucratic, strategic and production costs.

At the heart of enhanced bureaucratic cost there is the increase of size through vertical integration. As the size of the company increases the governance is getting more complex which requires more staff. While there is a potential of better communications, coordination etc. within the organisation (as compared to trading

114 Geradin, O’Donoghue (2005) 370

115 Cf Massimo Motta, ’Competition policy: theory and practice’ (CUP 2004) 308

116 Justus Haucap, ’The Costs and Benefi ts of Ownership Unbundling’ 2007 (Nov-Dec) Intereconomics, 303

117 Joseph T. Mahoney, ’The choice of organizational form: vertical financial ownership versus other methods of vertical integration’ 1992 13:8 Strategic Management Journal, 568

97 partners) this may only materialise at additional costs. Higher organisational complexity can hamper previously well-functioning structures.¹¹⁸

Vertical integration may lead to higher production costs. First of all, vertical integration causes a situation that is similar to monopoly. For example the acquired supplier (upstream) company will no longer have to compete with other firms for sales; the whole purpose of the acquisition is that the downstream firm will use the acquired company to produce the necessary inputs. Therefore, just like a monopoly, the acquired business, can enjoy a quiet life not focusing so much on cost-effectiveness. Another issue is efficiency of scale. If efficiency of scale is considerable and the company’s demand is limited, than the company will face enhanced costs.¹¹⁹ Demand fluctuation can cause a similar problem, because when less input is needed for the production downstream, the acquired (upstream) business may have over-capacity which is ultimately inefficient.¹²⁰

After the (vertical) integration the firm is locked in: it has to stick to one supplier.

This has multiple implications. While it has been suggested earlier that vertical integration may help to eliminate asymmetric information, there is also an argument that access to alternative information will be lost since connections to other suppliers will be severed. Integrating to another level may also involve the acquisition of assets that ultimately enhance the firm’s sunk costs (higher exit barriers). Integration also reduces the firm’s strategic flexibility; after the acquisition of another business divestiture can cause administrative and other issues and may lead to a commitment for the business even if it sets back the

118 Mahoney (1992) 569

119 Mahoney (1992) 570

120 Without vertical integration the downstream firm could just purchase the amount of input necessary from the market.

98 company and using the services of another company would be more advantageous.¹²¹

When the industries are integrated, the issues arising out of the separation as an intervention should also be considered. Vertical separation may be a drastic interference with private rights,¹²² although, this is rather just an issue when at the time of the separation the sector is in private ownership.¹²³ Moreover separation in itself will incur some costs.¹²⁴ Ultimately, the assessment of the benefits expected from artificial vertical separation should also take into account that rapid technical evolution may change the face of the sectors naturally.¹²⁵

1.2 Concerns over competitiveness: the monopolistic element(s) in electricity and telecommunications sectors

It has been shown that whether integration or trade is more beneficial for a company depends on multiple factors. Companies are likely to expand to a related level of the distribution chain when such a move is more beneficial than using another firm’s services on that related level.¹²⁶

121 Mahoney (1992) 570

122 For example restrictions on ownership right in case of ownership separation. At the same time, regulation restricts the owner’s rights too, to some extent.

123 Major exceptions are the electricity sector of the U.S., Japan, Spain, and Germany – CF Joskow, Noll (1999) 1297

124 Davies, Waddams (2007) 298

125 Michel Kerft, Damien Geradin, ‘Controlling market power in telecommunications: antitrust vs.

sectorspecific regulation - An Assessment of the United States, New Zealand and Australian Experiences” (1999) 14 (919) Berkeley Technology Law Journal, 919, 1012

126 Cf Richard Cadman, ‘Means not ends: Deterring discrimination through equivalence and functional separation’ (2010) 34 Telecommunications Policy, 367, Richard Whish, Competition Law (6^th edn OUP, London 2009) 607-608

99 But what does this imply for society? Vertical integration may lead to enhanced productive efficiency, but may at the same time lead to market power and therefore less total welfare, so to a less efficient outcome from the society’s perspective. This is illustrated in the graph below:

Figure 44 Illustration: competition vs. monopoly

Here we assume that integration leads to lower costs than separation (MCint ˂ MCsep).¹²⁷ If the company is integrated and there is competition the society will be able to purchase an amount of Q3 for a price that is equal to MCint. In the lack of integration due to the lower efficiency the price is going to be somewhat higher (=MCsep) and the sold quantity is lower (Q2). The worst case scenario arises out of a lack of competition, when even though the company can produce efficiently, it will

127 The shape of the cost curves abstracts from the natural monopoly element.

100 charge a monopoly price which is higher than in both previous cases (Pm(i) ˃ MCsep ˃ MCint) and the quantity sold (Q1) will also be the lowest (Q3 ˃ Q2 ˃ Q1).¹²⁸

In a competitive setup the firm is forced to look for the most efficient solutions.

Higher efficiency allows the firm to compete with its rivals by offering better deals to the consumers. Ultimately, therefore, in a competitive market gains arising out of enhanced efficiency will be passed-on to the consumers. Accordingly, vertical integration in itself may not be harmful for competition or consumers,¹²⁹ but (when leading to higher efficiency) may rather benefit them.

Vertical integration is rather just harmful for consumers and is unwanted from a competition point of view, when it is combined with some sort of horizontal integration as well, which results in market power on one of the levels,¹³⁰ or when market power is already existent in one of the levels concerned. Multi-product firms often cross subsidise between their businesses.¹³¹ From a competition perspective this is only a concern when it enables exclusionary practices.¹³² This is reflected by competition law, which is generally less strict when it comes to vertical integration than horizontal integration.¹³³

128 CF Joskow, Noll (1999) 1250-1252

129 Niamh Dunne, ‘Margin squeeze: theory, practice, policy – part 1’ (2012) 33(1) European Competition Law Review, 29, 29

130 Geradin, O'Donoghue (2005) 358

131 Ibid 368

132 Damien Geradin, ‘Regulatory issues raised by network convergence: the case of multi-utilities’

(2001) 2 Journal of Network Industries, 113, 120

133 According to Whish, “[v]ertical agreements are likely to have an effect on competition only where the firm imposing a vertical restraint already has market power”. - Whish (2009) 613

101 In the industries concerned, however, this is exactly the case. The Electricity industry can be separated into four different levels: ¹³⁴ generation, transmission, distribution and supply.¹³⁵ Electricity is produced by generators, transmitted via high voltage wires over longer distance then it is distributed to lower voltage wires and gets supplied to the consumers.¹³⁶ Electricity cannot be stored,¹³⁷ therefore the system should be balanced to make sure that the quantity produced and consumed is constantly equal,¹³⁸ this creates another function that has to be carried out: balancing of the demand and supply. In the electricity sector the

„bottlenecks” are the transmission and distribution networks.¹³⁹ Their duplication is not viable, or at least has not been carried out yet. These monopolistic levels are in between the two competitive levels: generation and supply.

Fixed telecommunications services work essentially as the following. A home device (telephone, modem etc.) sends and receives electric signals. These signals are transported by a wire to the first switch (in the case of the UK so called Digital Local Exchange). The network between the premises and the first switch is called the

134 There is another function, which is somewhat separate, but very important: system balancing. As electricity cannot be stored and the production and the consumption should be constantly equal some entity is needed to arrange this balance.

135 Joskow, Noll (1999) 1291-1292, Richard Pond, ‘Liberalisation, privatisation and regulation in the UK electricity sector’ Working Lives Research Institute, LMU- Country report on liberalisation and privatisation processes and forms of regulation (2006) 1

136 Gillian Simmonds, ‘Regulation of the UK Electricity Industry’ (2002) CRI Industry Brief, 15

137 On further specialties: Richard Meade, ‘Electricity Investment and Security of Supply in Liberalized Electricity Systems’ Available at: http://ssrn.com/abstract=831585 accessed 25/08/2010 11, Joseph P. Tomain, ‘The Past and the Future of Electricity Regulation’ (2002) 32 Environmental Law 438, Peter D Cameron, ‘Reforming Energy Markets: a Review Article’ (2000) 18 Journal of

102 local loop, which arguably still cannot be duplicated in an economically viable way, and therefore constitutes the bottleneck of the sector, although the cable networks can offer an alternative.¹⁴⁰ In practice there are multiple levels of switches in the network and more variations of how the signals can be transported to the receiver, whose device (again, telephone, modem etc.) interprets the electric signal.¹⁴¹ Network utilities in most European countries used to be organized as one vertically integrated monopoly.¹⁴² It is interesting to note that in the earlier on, integrated firms’ ability to cross subsidize was seen as a plus, since it enabled the firms to pursue social goals, such as provide affordable services to customers in rural areas where providing the service would perhaps not been profitable (or would simply be very expensive) on the cost of other customers.¹⁴³ Vertical integration was combined with market power, because of the link between the network (the monopoly element) and the incumbent present in the competitive level(s) as well.

The reason for this was that an essential part of these industries is the network, which cannot be duplicated in an economically viable way and, therefore, constitutes natural monopoly.¹⁴⁴ Vertical integration was considered to be

140 Pierre Larouche, ‘A closer look at some assumptions underlying EC regulation of electronic communications’ (2002) 3 Journal of Network Industries, 129, 142-143 vs. 138

141 See in detail: Andrew Sharpe, ‘Communications Technologies, Services, and Markets’ in Ian Walden ed. Telecommunications Law and Regulation (3rd edn. OUP 2009) 38-43

142 Graeme Guthrie, ‘Regulating Infrastructure: The Impact on Risk and Investment’ (2006) 44 (4) Journal of Economic Literature, 925, 958

143 Michel Kerft, Damien Geradin, ‘Controlling market power in telecommunications: antitrust vs.

sectorspecific regulation - An Assessment of the United States, New Zealand and Australian Experiences” (1999) 14 (919) Berkeley Technology Law Journal, 919, 923

144Joskow, Noll (1999) 1251, Ole Jess Olsen, Anders Henten, Morten Falch, ‘Functional separation in telecommunications: A comparative analysis of infrastructural areas’ (2008) Conference paper 17th Biennial ITS Conference 2-3

103 beneficial because of scale and scope economies. Some form of regulation¹⁴⁵ was put in place to prevent the monopoly from charging monopoly prices and thereby causing deadweight welfare loss for the society.¹⁴⁶ This view was heavily criticised in the `80s for being inefficient.¹⁴⁷

The idea behind the reform is that, although the network is a true natural monopoly,¹⁴⁸ the services attached to it can be provided by more than one firms,¹⁴⁹ hence competition can emerge, with all its potentially beneficial effects.¹⁵⁰ This mixed system comprising of regulated monopolistic level(s) and connected competitive levels have been anticipated to lead to higher consumer welfare than an integrated regulated monopoly.¹⁵¹

Simply liberalising the sectors did not seem to be a viable option for achieving competition¹⁵², as the incumbent would most likely restrict access to this network,¹⁵³ which is still more or less a natural monopoly¹⁵⁴ and make the entry of

145 The form primarily depends on the ownership of the monopoly. In the case of a public monopoly regulation is implicit: the government can give direct orders to the management. If the monopoly is in private hands it has to be regulated explicitly (by a ministry or a regulator).

146 CF Kerft, Geradin (1999) 924

147 David Parker, ‘Regulation of privatised public utilities in the UK: performance and governance’

(1999) 12 International Journal of Public Sector Management 213, 213

148 Although the situation is different in telecommunications where cable network can be an alternative.

149 Guthrie (2006) 958

150 Joskow, Noll (1999) 1251

151 CF Joskow, Noll (1999) 1253

152 Damien Geradin, ‘Institutional aspects of EU regulatory reforms in the telecommunications sector: an analysis of the role of national regulatory authorities’ (2000) 1 Journal of Network Industries, 5, 8 Geradin (2001) 113-114

153 Vickers (1995) 5

104 new firms impossible.¹⁵⁵ Squeezing the competitors’ margins and thereby making them unprofitable¹⁵⁶ is a major threat since it only requires vertical integration and dominance on the level which competitors need as an input¹⁵⁷, both of which are given in the sectors concerned. At the same time tackling these practices is difficult because it essentially requires the establishment of a fair price (based on fair costs).¹⁵⁸

As part of reforming ex-monopoly network industries, some sort of legal intervention¹⁵⁹ (regulation¹⁶⁰) was necessary to control monopoly power¹⁶¹ and to enable competition and enhance its development.¹⁶² Providing access is still a key issue and will remain so as long as the network will constitute a bottleneck in the supply chain.

154 More or less: because it is more straightforward in the case of electricity, but somewhat contestable with telecommunications.

155 Guthrie (2006) 959

156 Geradin, O’Donoghue (2005) 357-358

157 Ibid 358

158 Ibid 359

159 Geradin (2000) 5-6

160 Regulation in general has many other aims, if fact regulation might impede competition, here, however the issue is access regulation.

161 Geradin (2000) 8

162 Thomas von Danwitz, ’Regulation and Liberalization of the European Electricity Market – a German view’ (2006) 27 Energy Law Journal 423, 423, Geradin, O’Donoghue (2005) 360

105