Vertical integration versus vertical separation

As said before, naturally monopolistic and competitive segments co-exist in infrastructure-based industries. Typically, access to the former is necessary to render services in the latter. In these circumstances, when a firm that controls a naturally monopolistic segment is allowed to participate in the competitive ones, it has incentives to try to monopolize the competitive markets with the aim to regain the profits forgone by regulation. Therefore, some form of regulatory intervention is warranted. There are two main regulatory approaches to address this problem :

a. To forbid owners of the non-competitive segments to participate in potentially competitive ones, i.e., to enforce the vertical separation of the industry.

Vertical separation implies, for example, that neither terminal operators nor their related firms can supply other services that are necessary to complete the logistics chain.

b. To regulate the terms and conditions under which participants in competitive markets acquire access to non-competitive segments of the industry.

OECD (2001) advocates vertical separation as a preferable approach. This document argues that vertical integration increases incentives on the incumbent to restrict

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competition in competitive activities. Vertical separation, in contrast, would lessen the regulatory burden, thus enhancing the quality of regulation and the level of competition. They claim, for example, that as long as prices are set above costs, the incumbent has incentives to sell as much of its product at those prices. Therefore, rather than refuse access, the incumbent “has an incentive to welcome access, as each new entrant in the competitive market will enhance competition, innovation and product differentiation (…) enhancing demand for the non-competitive service”¹¹. Furthermore, the authors argue that allowing integration makes regulatory tasks more complex, since regulation must overcome the incumbent’s incentive to deny access.

Given the information asymmetry between regulator and regulated firm, the risks of regulatory failure are increased. In contrast, by removing this incentive, vertical separation would allow lighter regulation which, in turn, may permit the incumbent to use its information in a more efficient way. For example, the regulated firm could have more discretion to use complex access pricing schemes, such as multi-part or peak-load pricing.

The incentive system that vertical separation introduces may also facilitate investments in new capacity that integrated firms would not have incentives to undertake, like new capacity that would be mainly used by rival firms. These incentives become crucial when, as in most cases, regulators lack legal powers to force incumbents to invest. Another reason the authors cite to advocate for vertical separation of related activities are the longer time that negotiations between incumbents and entrants may take, given the incentives the former have to delay entry, raise prices and lower quality. In addition, they claim that separation improves information by eliminating the use of transfer prices and, at the same time, reduces the possibility of cross-subsidization between regulated and non-regulated activities.

Paredes (1997) analyzed the issue in the context of the debate on the convenience of vertical integration initiated in Chile in the mid-nineties. The author firstly presents Coase’s theory about the origin and nature of the firm (Coase, 1939). According to this theory, a firm is an institution that avoids the costs of using the market. For Coase, the activities carried out by a firm in an integrated manner can also be subcontracted to the market. However, the use of the market is not free. It generates transaction costs that under some circumstances can prevent using it. Therefore, the integration of those processes that substitute the costly use of markets constitutes the essence of the firm.

According to the author, economic literature identifies three factors that cause non-trivial transaction costs that avoid using the market:

a. Uncertainty about the future that causes the incompleteness of written contracts;

b. Uncertainty about the compliance word or implicit contracts; and,

11OECD (2001), pp. 21.

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c. Specificity of investments to third parties.

For example, a producer may contract transport services to carry his products to the market or integrate this activity within the firm. According to this theory, the producer will be more inclined to integrate transport within the firm if he or she is uncertain whether the supplier of transport services will comply with the contract or that will be able to find another one in the market. In this case, the likelihood of finding another supplier is reduced when a substantial part of his investments are specific to the original supplier, because of packing specifications, IT systems, etc. Therefore, according to the circumstances, the most efficient solution may be vertical integration.

Forcing the separation of activities in these cases raises costs and damages consumers.

However, if uncertainty can be somehow reduced or the cost of the service being provided by a specialized party is so low that compensates for any risk involved, the producer will naturally contract out transport services. The cost of using the market would be trivial and it would not be necessary to force separation. In fact, the advancements made in logistics and the rapid surge of third-party logistics providers confirms that this is what has occurred in the manufacturing industry.

Paredes also analyzes the argument that vertical integration facilitates the extension of monopoly power. If a monopoly is left unregulated, it is possible for the monopolist to maximize profits in the monopolized market. Thus, integration does not produce extra benefits to the monopolist. But when the monopoly is regulated (and the monopolist’s profits capped), he has incentives to recover foregone profits by integrating downstream and excluding rivals. It is worth noting that an integrated monopolist could only extract monopolistic rents if he is able to exclude rivals in the competitive segment. The author argues however that this is not the general case.

Vickers (1995) presents a theoretical model that is consistent with Paredes’ assertion.

In this model, both imperfect information in the monopolistic segment and imperfect competition (there are more firms than needed) in the downstream market are supposed. The information asymmetry makes the regulation of the upstream (monopolistic) segment to be imperfect, hence allowing the incumbent to charge a price mark-up. Imperfect competition in the downstream market causes duplication of fixed costs. According to this model, when the incumbent is allowed into the downstream market, prices are higher and output is lower than in the case of vertical separation; but the number of firms in the imperfectly competitive downstream market, and hence, the number of times that fixed costs are incurred, is lower.

Therefore, concludes the author, the overall effect on welfare is ambiguous. It depends on whether the reduction in the duplications of fixed costs offsets the greater price mark-up.

It can be seen that, as in many other topics in regulation theory, there is not an approach that can be considered, a priori, the best. As we will see in Part II, vertical separation is the norm in liberalized electricity markets. In telecommunications, the owners of fixed-line networks are commonly allowed to render mobile services. In

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ports, the experience is mixed. In Australia, for example, regulated terminal operators can provide complementary services or be related to companies providing them (pilotage, towage, shipping, etc.). In Chile, there are limits to vertical integration. Up to 40% of a port concessionaire’s shares may be owned by “relevant players”, i.e., shipping companies or cargo owners accounting for more than 25% of the traffic at the concessioned terminal or more than 15% of the traffic at ports in the same region (Foxley and Mordones, 2000).